Friday, September 19, 2008

What I don't know about the proposed RTC like solution

In an earlier post I was relieved that perhaps my idea of a RTC like solution was not that whacky after all. But I didn't know then and still don't know now:
Assuming that the same institutions who invested in these securities can classify them as toxic or possibly non-radioactive then a workout perhaps similar to the Resolution Trust for S&L can be created for the toxic securities (and its underlying assets -- again assuming these can be identified).

Can these securities be identified and if so what does this new entity do with these securities? Calculated Risk wonders the same thing:

The new entity, according to the WSJ, would purchase illiquid assets "at a steep discount from solvent financial institutions and then eventually sell them back into the market".

With the RTC, the government already had direct responsibility for the assets since they acquired them from insured S&Ls that had failed. The role of the RTC was to liquidate certain of these assets.

In the current situation, the government has no financial responsibility for the assets, except for a few exceptions like the assets of Fannie and Freddie, and the NY Fed's assets acquired in the JPMorgan / Bear Stearns deal. The new entity will both buy assets "at a steep discount" and eventually sell the assets. So unlike the RTC, this new entity puts the taxpayers at risk.

Details of how this will work aren't available yet. But one of the key problems - in addition to the risk to the taxpayer - is that this program will actually reduce regulatory capital as losses are realized. The opposite of the goal!

Another previous entity mentioned today was the Reconstruction Finance Corporation (RFC) that was created in 1932 by Hoover. A key purpose of the RFC was to purchase preferred stock in banks to increase their capital positions and expand their landing capacity. This might also be part of Paulson and Bernanke's "comprehensive plan".

A new RFC might help certain FDIC insured banks, especially banks with significant losses associated with Freddie and Fannie preferred shares. But since the first part of the plan - buying impaired assets at a steep discount - appears to reduce regulatory capital, a RFC preferred investment might be included to help boost regulatory capital. We will know more soon.

My other thought: Will the government by holding the toxic securities for a longer amount of time than originally intended eventually lead to these securities gaining in some value? My thoughts here are along the lines of the LTCM liquidity crisis (except that in this case, it is not a liquidity crisis) - if LTCM had enough capital to meet margin calls it would eventually have survived and made a gain in its positions. (I've heard this argument made, but is this true?)

My sense is that firms really do know how bad their securities are or at least have a rough idea. My assertion is based on this statement:
For months, short-sellers were convinced that Lehman’s real-estate losses were bigger than it had acknowledged. As more bad news about the real estate market emerged, including the losses at Freddie Mac and Fannie Mae, this view spread.

Or perhaps, they don't know what they have - here is Paul Wilmott, the quant of quants:
“You have traders and you have quants, and very rarely do you have someone who sees both sides,” says Wilmott, who considers this disconnect to be the root of the current crisis. The quants were using their models to value products that they had no experience trading, and the traders were dealing with products they could never properly value themselves.

“Banks and hedge funds employ mathematicians with no financial-market experience to build models that no one is testing scientifically for use in situations where they were not intended by traders who don’t understand them,” Wilmott wrote in a recent post on his blog. “And people are surprised by the losses!”

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