Geithner's choice

First the preliminaries - this is my first post on the business blog. I'm off to a slow start. This is because I am a bond manager who remains employed. Those of us who are lucky enough to have jobs are busier than one-armed paper hangers trying to figure out an unprecedented market.  "Mindles Dreck" is a pseudonym I stole from a critic back in the jurassic period of blogging. In addition to the pseudonym, there are certain topics on which I won't comment for ethical and "compliance" reasons.  Most obviously, I cannot offer investment opinions on securities or funds.  On to more substance.

Monday (update: Tuesday) we expect an announcement of the Administration's plans for saving the banking system (part III).  Many of the advance rumours suggest that the primary "reforms" will focus on the remaining toxic assets on bank balance sheets.



Here's the problem:  All of the large banks have substantial loans on their balance sheets that resemble the assets underlying home equity asset-backed securities and commercial mortgage-backed securities.   In the asset-backed security markets, these loan assets are valued anywhere from $0.50 to $0.90 on the dollar, depending on type, location, avg. credit score, etc.  Home equity lines of credit ("HELOCs" in bond parlance) are particularly severely discounted.  Apart from State Street and Bank of NY/Mellon, there isn't a bank among the TARP recipients that does not own these assets in multiples of their capital, nor is there a bank that has charged off more than 5% of their value.  State Street has managed to expose itself to the aforementioned ABS securities through its SIVs and securities lending activities.  The upshot is that taking true marks-to-market on assets leaves all of these banks without any tangible equity.  Restoring confidence is a large chore when there is no capital supporting the bank.

Geithner is faced with the choice of "ring-fencing" the assets at book value, thereby incurring the wrath of the oversight committee, or at mark-to-market levels, exposing the banks lack of capital.  There are of course some intermediate solutions.  At both AIG and Citibank, asset guaranties have involved a discount and a residual interest for the rescued company.  The latter structure may be preferable as it disguises, somewhat, the degree of write-off taken. One hopes the fiction holds better than Merrill Lynch's 22%..er..5% deal with Lone Star.

The deepest, darkest concern of bond professionals is whether bond holders of banks will ever be asked to share the bailout pain.  Ever since Lehman the Fed's reluctance to impair bank bonds has been palpable.  For starters, finance issues represent more than 60% of 1-5 year maturity bonds.  They are ubiquitous in pension funds, insurance company portfolios and, until last fall, money market funds (most money market funds have moved up the capital structure to CDs at this point, spooked by the post-Lehman panic).  So there are "systemic" reasons to protect them.  The same logic protects General Electric.  Furthermore, the capital structure of large banks is horribly convoluted.  If you wanted to get bondholders to contribute to recapitalization you'd have to create a scheme of cascading discounts to cover preferred stock and capital notes issued by the holding company and the senior and subordinated debt of the banks.  Near the top of this stack is the preferred stock investment of TARP, so a bondholder discount necessitates a TARP revaluation.  Also, the Guarantied "TLGP" obligations are holding company debt and would have to be discounted.  So the government would participate in any loss.

Still, one understands public sentiment on this issue. Apart from Lehman, bondholders, like trading counterparties, have benefited at the expense of taxpayers.   This potential uncertainty is one of the things supporting wide bond spreads.  Despite the obvious government support, Citibank's holding company bonds offer a plus-sized 5% premium over their government-guarantied paper.  Pimco, the gorillas of bond investing have publicly positioned themselves as if this pain-sharing will never happen.  "Shake hands with the Government", they claim. Others among us have hedged our bets.     On Monday Tuesday, Geithner will choose where to locate losses, or delay the reckoning again.