The Creation of a Provisional Federal Bank
In order to buy equipment, a company borrows $1 billion in the form of a secured bank loan. This loan is placed in structured portfolios by lenders, where equity is levered at a minimum of 10-to-1. This means for every $1 of cash equity invested, $9 are borrowed from financial markets.
Due to economic conditions, the company loan has lost 40% of its value, representing a $400 million loss to lenders. However, because structured portfolios are not easily unraveled, lenders must continue to pay interest on borrowed money (8.5%) until maturity (8 years), despite faults and declines in asset values. Because lenders have used leverage and payments of interest remain owing ($900 million x 8.5% x 8 years = $612 million), a decrease in value of 40% can equate to losses to the detriment of financial markets in excess of $1 billion ($400 million + $612 million) due to the effect of lost asset value and remaining interest owed on borrowed money.
Another $10 billion of synthetic term loan has been fabricated - pulled from thin air- and sold to the market (via CDS) by banks. CDS loan security is modest or insignificant as CDS represents bets on the underlying performance of the original term loan described above. The 40% loss of asset value now equates to an additional $4 billion ($10 billion x 40%) of losses that ripple through our financial markets.
While the company, in the normal course, borrowed $1 billion against purchased equipment, market mechanics engineered an imbalance of $11 billion potential liabilities ($10 billion CDS, $1 billion loan) to conflict with a much smaller asset base. Accordingly, $5 billion of losses are borne by financial markets ($1 billion on leverage; $4 billion on CDS) as a consequence to a 40% decline on a company's $1 billion term loan.
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published Tuesday, October 14, 2008
page B3
The New York Times
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New York Times Editorial:
Mr. Paulson’s Client
Call it bailout, take two. With credit markets frozen and the financial system teetering on collapse, Treasury Secretary Henry Paulson has decided to invest $250 billion directly in the nation’s banks in exchange for an ownership stake. It is a bold move for a desperate time. But Mr. Paulson still has to do more to ensure that American taxpayers, whose money he is investing, get the best deal.
The hope is that new capital — along with a government guarantee for new bank debt issued over the next three years — will get the banks lending freely again. The approach — an about-face from Mr. Paulson’s earlier plan to buy up the banks’ bad assets — is more in line with European efforts. Coordination is essential to manage what has clearly become a global financial crisis.
By taking an equity stake, taxpayers could have a better chance of seeing an eventual return on their investment. If the banks do turn around, then the government, as a shareholder, reaps the benefits.
But we are disturbed that Mr. Paulson wants the government to be a passive investor with little say on how these banks are run, despite the billions of dollars at risk.
That means the banks’ current boards and current management — the same people who got the country into this mess — will still be making all of the decisions.
We are not arguing that the government must take direct control of the banks it invests in. But in the case of extreme mismanagement, insisting on the replacement of some of the negligent executives, managers or board members may be the prudent thing to do.
Mr. Paulson also is insisting that the government get preferred shares in exchange for its investment in the banks. Given how much risk American taxpayers are being asked to take on, that seems reasonable. Among other advantages, dividends on such shares are paid before common shareholders receive their payouts.
The Treasury should also insist on stepped-up government supervision to ensure that sound lending resumes — and that reckless lending does not. Government regulators need to frequently review the rescued firms’ operations, daily if necessary.
The government must also have a say in major business decisions, including mergers and acquisitions. It’s also important to note that Mr. Paulson has not abandoned his original idea to buy up the banks’ bad assets. (Congress gave him the power to use a variety of tactics to restore stability, and he is rightly keeping his options open.)
That idea has always suffered from an inherent conflict of interest: the financial firms with assets to sell are in many instances the same firms the Treasury will rely on to value and manage the assets it is buying. That is an invitation for these firms to set the price too high or to indulge in other mischief at the taxpayers’ expense.
The Treasury has promised to independently evaluate potential conflicts, but it appears that officials plan to start with the firms’ own self-assessment of any problems. The Treasury needs to set clear standards and procedures for the firms it hires, not allow the contractors to set the rules.
We are pleased that Mr. Paulson is flexible enough to adapt his ideas to manage a crisis that has, as yet, defied all attempts to control it. But as a former investment banker, Mr. Paulson must remember that the American taxpayer — not the banks — is now his client, and he is using taxpayer dollars. Congress has the duty to ensure that he does.
Editorial
Published: October 14, 2008
page A28
The New York Times
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"The financial crisis will bring an economic downturn that will force Americans to change their habits, including oil consumption. It's not the end of Capitalism but it is the end of Consumerism."
--Leafy Green
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