Monday, March 23, 2009

Geitner's PPPIP and Krugman's Criticism

I think Geitner's Public Private Partnership Investment Program has slightly different intentions that Krugman's consideration. I think the overall objective of the program is to shift credit toxicity out of the shadow banking system and onto private investor balance sheets (i.e. those who are not part of the credit system food chain). The program is designed to subsidize investment in illiquid non-performing securities remaining on investment bank balance sheets as remnants of the securitization process. Banks have taken a huge hit. The index to watch is the ABX.HE Markit tranches including CMBX as well. The size of the sell offs in these residential and mortgage backed securities makes the stock market rout look minor (reference I expect we'll see a substantial rally in these indices. After all the Government has allowed the private sector to front run one of the largest sovereign proprietary positions in history. Similarly, the PPPIP has opened purposefully illiquid markets (as arranged by Investment Bank trading desks to preserve large bid/ask spreads) to the general public. Should be an interesting lesson in liquidity theory at the least. Experts (including Nouriel Roubini) estimate that U.S. banks have a total of $2Trillion of troubled assets on their books. Consider than Non-Agency Mortgage Backed Securities issuance for the last 8 years was as follows:

2001: ~$200B
2002: ~$250B
2003: ~$350B
2004: ~$400B
2005: ~$650B
2006: ~$750B
2007: ~$675B
2008: ~$40B

Tarp 1 and 2 have filled a considerably portion of those troubled loans in an effort to stabilize an insolvent banking sector. Consider that the near $200B to AIG was to fulfill the insurance policies pulled by the sector itself. The $350B was plugged directly into the banking industry. $1T in PPPIP to support bank asset prices. $1T in TALF to support new credit underwriting. I believe the banking sector has been stabilized. What is more uncertain is whether the latest Treasury measure will effectively move the "legacy" loans on to the public sector. I suspect that it will, considering the size of government subsidies. But, I don't think organic credit origination will occur in the secondary banking system for some time. The move to open, transparent, and regulated markets is a good one. I think securitization will generate even larger volumes of credit in the future because of the evolution of transparency, regulation, and insurance, but not for some time 5, 10, 15 years. Investment banks and credit originators are to blame for the temporary failure in credit securitization because of their efforts to defraud investors (and to some extend credit rating agencies) by purposefully complicating and obfuscating the underlying cash flows of the off-shore entities. Credit will never flow as it did, because those loans were financed and originated under conditions of fraud. But, a well sponsored, regulated, and structurally sound securitized credit market will have its benefits in maximizing the world's savings into investment. The question is, can we survive in the interim?

Thursday, March 5, 2009

PE Ratios and Life without Credit

I begin this blog after diligently trying to determine the future projected price to earnings ratio of the S&P 500. I didn't have much success because the projections varied so wildly over the next 12 months. The S&P 500 indices actually posted its first ever negative aggregate reported earnings after AIG recorded a $61.7 billion loss in Q4. Add the enormous de-leveraging element to the multiples of earnings investors are willing to pay and you won't be surprised at a stock market that is half its value from a year ago. But what I don't agree with are the pricing scenarios that assume the economy will continue to live on a zero credit diet. We've gone from one extreme to the complete opposite in no less than 6 months time. The secondary credit market is illiquid, particularly now. Why? Because all of the participants are one in the same. All are financial intermediaries. Hedge funds, financial services firms, investment banks, etc. The securitized credit market took off, it fed on itself in a positive feedback mechanism, and fell of the cliff just the same. There is no liquidity or buyer in this market because the overwhelming majority of the financial intermediaries have had huge losses. Not to mention, there is no trust about the quality of the product being sold, whether counter parties will be around long enough to provide credit enhancements. Now, probably for our own good, assets are being priced as if a world economy with credit is a thing of the past. I believe the palpable panic in the market is driving prices (particularly equities) past "fundamental" values as reasonably foreseen in an economy with a "reasonable" credit system. What I'm driving at, is the perception of future value is out of touch with the perception of future conditions. Do we really foresee an America in 2 or 3 years without a credit market? I don't. Particularly with our new insight to how critical its proper functioning is. I foresee a transparent credit exchange, severe regulation of intermediaries that will re-instill trust in the market, "skin in the game" requirements for all participants, and a simplification of credit products. In our moment of panic, let's not forget that innovation depends upon trial and error and just because systems are flawed, doesn't mean they are eliminated all together. Typically those systems are refined or adjusted until they can serve our means more effectively.