Fixed Income Recap

Treasuries
Treasuries were pretty stable considering the rally in stocks. The two-year finished the day down 1/16, and the ten-year was lower by 5/16. The benchmark curve was unchanged on the day and remains at +176 bps. A basis point represents .01%.

Geithner’s Toxic Assets Plan
From today’s Treasury Department press release:

Step 1: If a bank has a pool of residential mortgages with $100 face value that it is seeking to divest, the bank would approach the FDIC.

Step 2: The FDIC would determine, according to the above process, that they would be willing to leverage the pool at a 6-to-1 debt-to-equity ratio.

Step 3: The pool would then be auctioned by the FDIC, with several private sector bidders submitting bids. The highest bid from the private sector – in this example, $84 – would be the winner and would form a Public-Private Investment Fund to purchase the pool of mortgages.

Step 4: Of this $84 purchase price, the FDIC would provide guarantees for $72 of financing, leaving $12 of equity.

Step 5: The Treasury would then provide 50% of the equity funding required on a side-by-side basis with the investor. In this example, Treasury would invest approximately $6, with the private investor contributing $6.

Step 6: The private investor would then manage the servicing of the asset pool and the timing of its disposition on an ongoing basis — using asset managers approved and subject to oversight by the FDIC.

How does this differ from Paulson’s original TARP plan from last fall? In an interview with CNBC’s Erin Burnett the Treasury Secretary says Paulson’s plan “isn’t the best way to protect the taxpayer”. In the above example the taxpayer will be shouldering 92.8% of the risk while laying claim to only 50% of the upside. If the outrage against the original plan was that the government would be subsidizing profits for hedge funds and other investors with capital to put at risk, then I don’t see how this is different at all. In fact, it’s worse.

Critics of the original TARP claimed the plan left the door open for the Treasury to overpay for bad assets, leaving the taxpayer with losses from paying too much to free-up a bank’s balance sheet. Neither Geithner’s plan, nor his interview on CNBC provided any clarification on this. This lack of clarity is going to keep this plan from being truly successful.

Without any talk of reserve levels or “last look” stipulations the market will remain skeptical. Not to mention the possibility of special 90% bonus compensation for companies choosing to sell assets. Geithner was directly asked about this also, and replied, “We need to work with the Congress to try to make sure that there's enough clarity and consistency about the rules of the game going forward so that they're willing to come in and take this risk alongside the government again”. If Geithner doesn’t have a straight answer to this question by now, I question how much of this plan he’s actually thought through.

Have a great evening.

Cliff J. Reynolds Jr.
Junior Analyst