Earlier today some others criticized the Paulson bail-out plan for assuming that the investment banking model on Wall Street could survive the current crisis, provided it was cleansed of its bad assets. It turns out the model didn’t even make it to Monday’s New York Open.
In a move that marks the end (for now) of the high-leverage, no oversight, risk-taking investment bank model, the Federal Reserve announced that its board had approved, “Pending a statutory five-day antitrust waiting period, the applications of Goldman Sachs and Morgan Stanley to become bank holding companies.”
It’s too early to reach conclusions, but here are some initial observations on why the move was made and what it means going forward:
- The ban on short selling hits leveraged players the hardest. You don’t get more leveraged than Goldman and Morgan Stanley. The banks have to de-lever in an orderly fashion without being driven into the arms of a commercial bank partner with deposits. Goldman and Morgan have accepted the oversight that comes with commercial banking in exchange for maintaining their existence.
- Goldman and Morgan move from being prey to predators. As bank holding companies, they can now take deposits. But it’s much more likely they’ll simply acquire deposits. They can acquire the deposits of firms like Washington Mutual or Wachovia. Or, even better from their perspective, the deposits of regional banks hit hard by the collapse in Fannie and Freddie bonds.
- Goldman and Morgan gain enhanced access to Fed lending facilities now that they are bank holding companies. Even though the Fed had already set up a Primary Dealer Credit Facility, as deposit-taking institutions the new Goldman and Morgan have even greater access to more Fed loans (should they need them. What’s more, the new versions of the old investment banks would presumably be covered by the FDIC as deposit taking institutions.
The Fed must hope this moves Morgan and Goldman out of the “problem” category and into the “solution” category. Given a big enough line of credit by the Fed, these new bank holding companies can become new non-government homes of “good assets” while the Fed and Treasury deal with the bad assets. It also keeps the unthinkable from happening: Wall Street losing all its investment banks and two big counter-parties in the derivatives market.
***Treasury includes all asset-backed securities in new plan
Even though it is just a few days old, the scale of the proposed US$700 billion bailout of troubled mortgage-related assets has already gotten bigger. Bloomberg reports today that the Treasury Department has suggested the new program include a much wider variety of asset-backed securities than previously suggested.
“The change suggests the inclusion of instruments such as car and student loans, credit-card debt and any other troubled asset. That may force an eventual increase in the size of the package as Democrats and Republicans in Congress negotiate the final legislation with the Bush administration, analysts said.
“How much are we talking about here? At least another US$500 billion. According to a September third article by Bloomberg’s Sarah Holland, “More than $358 billion of credit card asset-backed securities were outstanding as of March 31, according to the Securities Industry and Financial Markets Association. Another $196.6 billion in securities were backed by auto loans.”
However the SIFMA’s latest data from 2007 (above) shows that once you include home equity lines of credit (HELOC) and student loans, the number quickly jumps to over US$2 trillion. It is almost certain that student loans would be eligible for purchase under the Treasury plan. But HELOCS?
If Paulson and company are doing a true “Control-Alt-Delete” systemic re-boot of the financial sector, then all securitised assets that will be affected by consumer non-payment (nor or in the future) must be transferred from private balance sheets to the public.
That means that though he’s only asked for $700 billion up-front to deal with the bad assets, the Paulson plan could eventually require as much as $2 to $3 trillion in new Treasury money to buy asset-backed securities. Of course Wall Street will only want to get rid of the worst paper and keep the best for itself.
But you are still looking at a number that’s likely to be much bigger than what Congress has been told. That number is even more bearish for the dollar than the current one, which is already bad enough.
***Forget the short-covering rally, a Futures Freeze?
One point we failed to make clear earlier today is that by eliminating shorting from the market today, regulators make it harder for the market to find a bottom, even though they are trying to help the market find a floor. Why?
Shorts help begin a new bull market by covering their positions. They do this, naturally, by being the first buyers of shares. To cover your short you buy back the shares you previously lent. Without the shorts in the market, who’s going to step in and buy at the lows?
In any event, there are still a few tricks up the regulatory sleeve if the prohibition on short-covering fails. First, there is the futures market, where one can still go short an index or security. Activity in the futures market could be shut down if the regulators think it would help. We’re not saying it would help. But now that we’ve gone through the looking glass, anything is possible.
