Monday, October 6, 2008
The Paulson Plan for Survivor Bias by 'London Banker'

As I re-post this from The RGE Monitor, markets are crashing in Asia, Russia, and Europe. It is clear from the conference call transcript below that market participants who are not insiders with the Bush Admin. and may not receive "survivor bias" are reacting very negatively Friday and Monday. These are certainly interesting times. Thanks to David of Kauai and RGE Monitor, or I wouldn't know what is going on.

From: http://www.rgemonitor.com/financemarkets-monitor/253850/financial_eugeni...
"Financial Eugenics: The Paulson Plan for Survivor Bias" by London Banker

"As I write this I don’t know the outcome of the attempt to ram through legislation for looting the US Treasury of $700 billion before the end of the Bush administration. I suspect that Congress will force the passage of the bill in some form because the media and political narrative on the necessity of the measure is unremitting and so horribly biased.

No alternatives will be considered.

No constraints on the unilateral executive authority of Hank Paulson will be considered.

No assurances that funds will be used to unlock credit markets or promote lending to the real economy (as opposed to the financial robber barons) will be considered.

Instead, the bill will get laden with an additional 300 pages of pork to sway the dissenters, adding to the tab imposed on the American taxpayer.

Having listened to all 42 minutes of the late night Treasury briefing of investment banks on Sunday, there is no doubt in my mind that this legislation represents the sort of federal largesse for Goldman Sachs, Morgan Stanley, Citibank and JPMorgan Chase that the Iraq war provided for Halliburton and Blackwater.

The most cynical moment in the call is when the Treasury official confirms, ”our preference would be to help the healthy banks become even healthier” rather than helping troubled banks or illiquid banks.

America is now a centrally planned economy where the Treasury will determine which firms survive and prosper through allocation of scarce capital to an undercapitalised financial sector.

Clearly what is going on here has nothing to do with kick starting the credit markets or stabilising the equity markets or restoring depositor confidence in banks. (Treasury official: “No provision in the legislation that mandates re-lending.”) What is going on here is a blatant attempt to provide government funds to a select cadre of firms (not all banks) which are chosen to be the survivors feasting off the carcasses of their less fortunate and less well-connected brethren as the downturn intensifies in the years to come.

The crash in equities will still happen. The debt deflation of the economy leading to mass commercial and consumer credit defaults will still happen. The collapse of many national, regional and local financial institutions will still happen. The bankruptcy of many municipalities and shortfalls in state budgets will still happen.

This bill is about engineering survivor bias to friends of the Bush administration so that they profit disproportionately from the collapse of these markets using the funds provided by the taxpayer via the unreviewable and unconditional authority of the Secretary of the Treasury.

The basic plan is to set up a federal money laundering operation. Bad assets come in, get laundered by the Treasury and put in a new AAA “wrapper” (as it’s termed on the call), and good assets go out, issued as Treasury guaranteed securities. Whether the final value of the legislation this week is $700 billion or $150 billion is irrelevant as long as the laundering operation can accommodate the throughput, as that number is only a cap on total extensions at any one time.

The SEC will support the plan and survivor bias by relaxing FASB 157 on mark to market accounting. If there is no agreement on what an asset is worth, it is worth whatever the firm holding it says in its Level 3 accounts or the Treasury Secretary accepts in buying it.

The Federal Reserve will support the plan by relaxing the definition of “control stake” in US banks and bank holding companies to allow secretive cabals to hold through private equity and offshore hedge funds. No one knows the beneficial owners of these ill-transparent private equity investors, and so it is the ideal way to reward loyal and helpful insiders, legislators and officials – as well as cede further ownership of American assets to foreign stakeholders who would be politically unacceptable if publicly acknowledged. Many foreign creditors are irate at the losses their funds, banks and pensioners have sustained from investments in the United States, and this plan provides a secret way to buy them off and keep them lending and investing as their own economies are roiled by the deflation to come.

For the past year the survivor bias has been orchestrated from the Federal Reserve, with its extension of innovative credit facilities and selectively engineered rescues or forced mergers. That has been very useful, but that well is now dry. The Fed has no more good assets to trade for the bad assets the banks can offer. And the supply of bad assets just keeps growing as market illiquidity spreads further from the core of the mortgage backed securities market. Instability is now leading to a realistic threat that the Fed and Treasury could lose control of the deflationary process.

Part of the reason the Paulson Plan is so attractive is that it recapitalises the Fed by promoting the unwinding of repos and lending facilities which left the Fed holding toxic assets. As the repos and credit facilities gradually unwind, these toxic assets can now be taken back by the banks and exchanged for good cash. The Fed gets its balance sheet Treasuries and cash back to restore its flexibility to intervene anew.

Favoured private equity and insiders who swap US dollars for equity in the banking system will presumably be aware of the survivor bias being engineered on their behalf. Sovereign wealth funds, investment funds and private equity investors ripped off in the first round of recapitalisation may be willing to come back in once it is clear to them that the next round will benefit from official favouritism. Warren Buffett’s timely stake in Goldman Sachs is clearly linked to his confidence the Paulson Plan will benefit them disproportionately.

A factor which is probably critical but has received little discussion is that literally thousands of Bush administration apparatchiks will need jobs come January, and a fair selection of GOP House and Senate legislators and their aides too. What better way to enahance their CVs in their final months in power than to distribute $700 billion or so in pre-Christmas largesse to the most remunerative employers in the world? And what better way to ensure the corporate largesse is returned to the GOP to win back the White House and Congress in 2012 as the recession fuels public anger?

And then there is a huge arbitrage opportunity as well so that everyone makes money. According to the conference call, the pricing on offer from the Treasury will be a bit below Level 3 pricing. The toxic assets will be repackaged and resold with a new AAA wrapper, possibly priced well below what the Treasury paid, assuring a huge profit on both immediate liquidation by the banks and ultimate maturity by investors. The Fed gets its cash and Treasuries back; the banks make huge profits; the foreigners and off-shore tax avoiders get disguised ownership of the American financial system; the taxpayer gets ripped off. What’s not to love?

Think back to Fisher’s Theory of Debt Deflation in Great Depressions. Dollars become “bigger” as deflation takes hold because each dollar can buy more assets as assets deflate. That means that as these clowns crash the markets, their $700 billion of liquid cash funnelled to their friends and recycled through the Treasury laundrymat can progressively buy up the rest of the pieces on the gameboard at low discount prices. Game over with those who caused the crash and robbed the bank winning.

Deflation is going to happen – globally. Either we can use the course of deflation to shape healthy economies that will provide growth and employment and productive returns on investment in future, or we can allow deflation to further enrich those miscreants whose irresponsible policies led to the violent financial collapse we are about to experience.

There is a fundamentally healthy economy in America – somewhere underneath all the financial excess and chicanery and all the financial/oil/military/healthcare/developer corruption of local, state and federal politics. It will be a painful and slow process to kill off the metastasising cancerous growths on the economy, but if Americans achieved that, they could embrace a healthier and more productive and more prosperous future.

I would like to believe Americans expressed the courage to change over last weekend when they 25 to 1 rejected an unconstrained and unconditional bailout of Wall Street in favour of cold turkey deleveraging of the economy. I wish I could believe that it mattered in the political calculus, but the result of the House vote on the bill will tell us that.

Fight the survivor bias. It’s not your survival they’re engineering."

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Treasury Conference Call on Bailout Bill to Analysts

If you want to get some insight into how Paulson would like to try to enact the new "$700 Billion Bailout," and how that may be altered, read the following:

From: http://www.nakedcapitalism.com/2008/09/mussolini-style-corporatism-in-ac...
[There are two very interesting audio files via the above link]
Monday, September 29, 2008
Treasury Conference Call on Bailout Bill to Analysts (Updated)

"Various readers wrote us, and it was confirmed by a detailed report on the call at DealBreaker, that the Treasury Department held a conference call this evening for analysts on the bailout bill. A memo was evidently sent to SIFMA members; others may have been contacted by other means. But the report I got from one person who was on the call was the the questions came from financial services industry members. In other words, this was most assuredly not intended to be a call open to the public at large. If anyone from the media or other member of the great unwashed was listening in, it was by accident.

This is simply scandalous. To have a group of interested parties get a privileged briefing by government officials on a matter of keen public interest flies in the face of what a democracy is supposed to be about. The proper method would either be a published FAQ on the Treasury website or a briefing with the media included. But why should I be surprised? Favoritism has been a staple of the Bush Administration.

There is a live blogging recap at DealBreaker. Someone who was on the call is going over his notes and other recaps on the Web and sending me his version, which I hope will add some color. Check back for that update.

Update: Here are the notes promised. Calculated Risk had put up the conference call number. so some of this is the listener's notes, some are hoisted from CR. They are admittedly skeletal at points, but track and enhance the live blogging report at DealBreaker. You can download a torrent for the call here, which I intend to do post haste and will amend the post accordingly. I've included the long form notes below, but some items jump out:

1. The tranching is a mere formality, and the Treasury boys as much as said so. They could take the $700 billion max as soon as the bill has passed,

2. However, they do not plan any action immediately, will wait a couple of weeks. They want to focus their efforts on stronger companies but also made noise about protecting the financial system. This, by the way, is the Japanese convoy system all over.

3. There seemed to be a lot of tap dancing about what price they will pay for assets and no straight answer about their policy on warrants. They did say that if the amount sold was greater than $100 million, they would take warrants. FYI, the current draft allows them to pay up to the price at which the assets were initially booked (yikes) . I wonder if this is obfuscation, if they have an idea of what the plan to do but will not admit it in any public forum.

4. As the person who listened to the call stressed, DealBreaker wasn't clear on the bifurcated process. If you come to the Treasury and you are in trouble, you get reamed. Bear/AIG style treatment, execs probably fired. But if you participate on a voluntary basis, the intent is to make it very user friendly. That is consistent with Paulson's position during the negotiations.

5. The exec comp provisions sound like a joke, They DO NOT affect existing contracts, they affect only contracts entered into during the two years of the authority of this program and then affect only golden parachutes. More detail on that point, but I don't need more detail to get the drift of the gist.

Further below are the notes, admittedly somewhat cryptic at points, but hopefully helpful. But if you have time, listen to the download. Be warned I may revise and add to the post once I have done so.

Update 12:30 AM: Have queued up recording of conference call but not yet listened to it. But reader and sometime contributor Lune provides a useful take. Hoisted from comments:

1) If even the Treasury is saying tranching is a formality, then it really is nothing. Not sure why Dems fought so hard for a fig leaf.

2) Waiting a couple of weeks because no one has any idea when or where the next bomb will blow up. In other words, all their doomsday scenarios about Black Monday were B.S. They screamed the check had to be written by Monday, but now they're saying they actually have a few weeks before they need to cash it. Plus, this will allow them to "seek guidance" from GS, JPM, and other selfless public servants about where the money should be funneled.

3. The tap dancing is because they don't want it to get out that they'll be giving a sweetheart deal. The public won't be following each individual transaction to see exactly what price is being paid. So ridiculously overpriced asset sales can be hidden in the details, and by the time some reporter (or blogger :-) combs through and analyzes the transactions, the deed will have been done. But if Paulson makes a statement that assets will be bought at par before the bailout's even begun, that will be reported and might kill the deal.

4. In other words, we need to sweeten the pot to encourage banks to come "voluntarily". Pardon my ignorance, but why the hell should we be begging banks to borrow from us? I thought a bailout should be the absolute last option for a bank. I.e., it should be so unpalatable, so unprofitable for a bank and its executives that they exhaust every private means of survival before coming for their public "reaming". I wonder if foreclosed homeowners would rate their foreclosure process as "user friendly."

5. Of course the exec comp provisions are a joke. Who do you think is going to be hiring all those banking cmte staffers and newly retired congresspeople next year during the inevitable post-election turnover? Do you really think they're going to vote to limit their salaries? Remember that for lots of people on the Hill (including elected reps), govt work is merely time you spend accumulating credentials in preparation for your real life's work in the vastly richer private world.

Taxpayer losses: "golly, let's just pray to Jesus and hope he'll make sure that in a few years our country won't be bankrupt."

Oversight: "let's appoint a committee which will file toothless reports that no one will ever read."

I'm glad to see that while much time was spent in Exec comp. and tranching kabuki theater, the real points of protection of taxpayer losses and implementation of new regulation seem to be afterthoughts."

"This is an audio recording of the conference call with the US Treasury Department, giving information for financial analysts (about 800 people were in this conference call) regarding the planned financial bailout legislation. Apologies for the audio quality - it was recorded using a mini digital recorder, half with the microphone and half with an inductive pickup. The first minute or so is cut off (we were too slow!), but the rest is intact through the end.

*update: now also posted on youtube in five parts*

Memo found at: http://dealbreaker.com/2008/09/treasury-to-hold-conference-ca.php

MEMORANDUM

TO: SIFMA Government Reps Committee

FR: SIFMA Washington Office

DA: September 28, 2008

RE: Conference Call w. Treasury / 9:00 PM TONIGHT

At 9:00pm tonight, Sunday, September 28th, there will be a call with Treasury officials to discuss the Troubled Asset Recovery Plan. This call is specifically for analysts. Please distribute ASAP to analysts in your firm who might be interested in participating. We have also distributed this call notice through various SIFMA Committees to solicit analyst participation."

Please find the conference call information below:

Date: Sunday, September 28th
Time: 9:00PM ET
Toll-free Dial-in: 1-866-843-0890
Entry Code: ******** "

"The notes on the call per our helpful anonymous reader (and former investment banker, it turns out) [Live blog of the conference call below]:

"Draft bill is very positive for both markets and our companies"

Much explanation of Executive Comp

Residential and commercial mortgages. But very importantly, it can be any asset.

Excited about ability to guarantee assets in exchange for a guarantee fee.

Sought as much authority and as much flexibility as possible.

Eligibility: as broad participation by institutions as possible. The more participation, the more effective it will be. Want banks of all sizes or any financial institution that has a meaningful presence in the US to be interested and enthusiastic.

Purpose is to help private sector clean up their balance sheets.

Highest priority: make sure it works, will attract companies to participate. Warrants and exec comp. were very highly negotiated.

still listening ...
some1 09.28.08 - 9:14 pm #

Warrants:

Direct purchases from failing institution e.g. Bear Stearns, AIG, F&F: will do the same thing, take maybe 79.9% equity.

Market mechanism: Congress wanted taxpayer benefit in upside. Sell warrants for assets over $100M, but the amount of warrants is still TBD. WE want healthy institutions to participate so it should not be punitive.
some1 09.28.08 - 9:17 pm #

Exec comp.

Most difficult part of negotiation.

Direct deal: fire the management, like AIG etc.

Market mechanism: if sell over $300M into fund, some exec comp limits come with it. For 2 years, the firm could not enter into NEW contracts including golden parachute, for involuntary departure. And lose some deductibility.

We feel really good that we have encouraged healthy institutions to participate, not just bailouts of sick institutions.
some1 09.28.08 - 9:22 pm #

Clawback of taxpayer losses:
1. it's a long way out, "a lot can happen in that time"
2. it's targeted at all financial institutions, not just participants! (that means it will never happen)3. would need more congressional and presidential action to implement this.
some1 09.28.08 - 9:24 pm #

Oversight (Bob Hoyt)
1. Financial Stability Oversight Board
2. General Accountability Office and Comptroller
General managing purchase auctions
3. Special Inspector General
4. Congressional Oversight Panel
5. Reporting provisions
some1 09.28.08 - 9:27 pm #

Tranching of $700B (I didn't know that was a limit)

Entire 700B is appropriated entirely by the act, no further appropriation necessary.

Tranching: first $250B
Then Secretary determines that more is needed and tells Congress, another $100B
Then Secretary determines that more is needed and Congress has 15 days to refuse, the remaining $350B
No time limits. Can request all the tranches at once, no need for delays.
some1 09.28.08 - 9:29 pm #

More about tranching:

To block the last $350B, Congress has to say no. Then the President can veto that. To override that veto, Congress needs 2/3 majority.

ALL of that must happen within 15 days, otherwise the money goes out.

Can't the President wait and veto it with one minute left in the 15 day?

RTC had to go back to Congress. Kudos for making this program much EASIER!
some1 09.28.08 - 9:32 pm #

Price: not a fire-sale price, not an outrageous price, a "fair" price. Firms might get a price higher than their current mark.

(Congress will be voting on this, with this aspect totally undetermined.)
some1 09.28.08 - 9:35 pm #

Not trying to maximize return to the taxpayer, but to provide liquidity to the system as a whole.
some1 09.28.08 - 9:39 pm #

They will prefer to help healthy banks become even healthier, as opposed to rescuing a failing bank, because the healthy bank is more likely to relend into the system.

They expect that the exec. comp. limits won't constrain the healthy banks, since they are so light.
artichoke 09.28.08 - 9:43 pm #

xIt will take several weeks, before any assets can be bought, to hire asset managers and get systems up and running.

(They're going to let the weak banks fail, then help the rest.)
artichoke 09.28.08 - 9:45 pm #

No provision to mandate re-lending.

Stuff that is still to be determined, will be issued as "guidelines" therefore exempt from discussion and comment period.

About 800 people on the call.
some1 09.28.08 - 9:47 pm # "

Topics: Banking industry, Credit markets, Regulations and regulators
Posted by Yves Smith at 12:21 AM

Aloha, Brad