Bail-out Plan: Will it Work, and How Will Markets React?

By Prieur du Plessis, on September 26th, 2008 posted in: Guest Bloggers, Investment, Markets, Money 6 people had their say - chime in!

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This post is a guest contribution by Richard Berner, Jim Caron, Sophia Drossos, David Greenlaw and Gregory Peters of Morgan Stanley.

The Treasury’s sweeping new plan to stabilize the financial system and dramatic efforts by the Fed to support money markets promise to reduce sharply the downside “tail” risks to the economy, and likely will have significant implications for investors, for financial institutions and for monetary policy. Of course, there’s no guarantee that it will work: First, enabling legislation must be quickly enacted, and authorities must use their new powers aggressively to underpin markets and restore confidence. Moreover, it won’t quickly reverse the global economic slowdown that is now underway. But this comprehensive plan looks like a game changer to us: It makes more likely our expectations for economic recovery within the next year and it means that investors should look for opportunities in risky assets. Here’s why.

Four Elements
The plan’s key elements are now widely known, but worth emphasis:

• First, and most controversial, the Treasury would be empowered to buy and move up to $700 billion of troubled mortgage-related assets from lenders’ balance sheets to the Treasury’s. Effectively, taxpayers would provide a capital contribution to the financial system.

• Second, it provides a triple-barreled backstop for money-market mutual funds by providing non-recourse loans to depository institutions and bank holding companies to finance purchases of asset-backed commercial paper from money funds, by having the Fed buy agency discount notes, and by using $50 billion from the Treasury’s Exchange Stabilization Fund to finance a temporary insurance plan for money funds.

• Third, temporarily, the SEC has banned selling financial shares short.

• Finally, the Fed has moved to provide even more liquidity: They broadened the list of eligible collateral at the Primary Dealer Credit Facility and Term Securities Lending Facility (TSLF); they increased the frequency and size of TSLF auctions; and they allowed banks to pass liquidity back and forth to nonbank affiliates.

Will it Work?
The plan has a good chance to work if used aggressively. It addresses the root of the problem, namely an adverse feedback loop running from losses at leveraged lenders to reduced credit availability and higher credit costs, and then to weakness in the economy that intensifies credit losses. By segregating troubled from performing assets, the plan should slow deleveraging, reduce risk premiums, including in the counterparty system, and allow capital raising. In fact, in the view of our trading desks, the Treasury only has to put a few billion to work in money markets to drive prices up significantly. The plan could thus sharply reduce downside “tail” risks in the economic outlook. The plan should also gradually help stabilize money market funds. This $3.4 trillion asset class suffered $170 billion in withdrawals last week as a large fund that held paper issued by Lehman Brothers “broke the buck” and redemptions accelerated. Indeed, these money fund withdrawals were a clear catalyst for action, because they had the potential to shut off short-term funding for all of Corporate America virtually overnight and affect millions of small investors.

However, there’s no question that the devil in this complex plan lies in the details. And at this writing, details that matter are unclear: What are eligible assets, institutions, nature of auctions to buy the assets, and their pricing, and how will losses and future gains be shared? Will Congress swiftly approve it? What will be the cost to the taxpayer? Will institutions be willing to provide the transparency necessary to value the problem assets? And, might such transparency indicate that the problem is even more severe than currently believed? Even if the Treasury absorbs a lot of the problem assets, will that be enough to unfreeze the interbank funding markets, reduce counterparty risk aversion, and get banks to start lending again?

Regarding assets and institutions, the Treasury Secretary has asked for considerable discretion that likely will err on the side of supporting markets. The plan is aimed at “mortgage-related” assets, but the Secretary would have discretion to broaden the menu if needed. The plan is aimed at a broad range of institutions with “significant presence” in the United States, and the Secretary has latitude here as well.

Regarding price discovery, the Treasury may use direct purchases, auctions and reverse auctions to acquire the troubled assets. Here is how a reverse auction might work: The Treasury would announce a reverse auction at a specific date for collateral of a specific class, such as the tranches of AAA subprime mortgages that make up the 06-1 ABX series. Knowing what the collateral is will reduce the uncertainty surrounding the Treasury’s backstop bid. Private bidders may come into the auction process to buy the distressed collateral or the Treasury may just own it at a good price. With the Treasury supporting the price, markets will become more liquid and the product should start to move.

Will $700 billion be enough? We think so. The recently-approved plan to put the housing GSEs into conservatorship backstops about half of residential mortgage debt outstanding, leaving about $5.6 trillion to be backstopped by the $700 billion of Treasury buying power, equal to 12.6% of that total. If troubled assets are defined as those delinquent, with delinquency rates at commercial banks amounting to 5-6% of mortgage assets they hold, $700 billion would seem to allow an ample cushion to absorb further losses.

Why Now?
The piecemeal approach adopted since the crisis surfaced with full force in August 2007 wasn’t working, because it addressed symptoms evident at individual institutions or in specific markets rather than the underlying problem. As a result, losses continued to erode levered lenders’ capital base, promoting a contraction in credit. Efforts to raise capital or the expectation of them diluted shareholders. With no backstop for the counterparty system and no sellers of protection, investors were encouraged to buy protection against and short the equities of financial institutions. The piecemeal approach created uncertainty about which institutions would survive. And the unanticipated collateral damage from the case-by-case approach triggered a run on money-market funds in particular and on the financial system in general.

Indeed, the unprecedented volatility and destruction in the credit markets during the past week served as a catalyst for the policy change, in our view. What was underappreciated at the time of the Lehman bankruptcy was the impact on the counterparty system, the unsecured bondholder, and money market investors. Unlike during the Bear Stearns event, bondholders were decimated, creating a shock wave across money market funds, pension funds, and the entire “buy-side” community. For example, with $165 billion of total unsecured debt, the Lehman bankruptcy created an instant loss of about $120 billion that destabilized the credit system. This, coupled with the first failure of a major counterparty in the modern derivative world, was just too much for the system to handle.

Lessons from History
Are there lessons from past financial crises that are relevant to this one and the policy response it has spawned? This plan has elements from past efforts to fix financial crises, but it differs from all of them in important respects. It has some similarities with the US Resolution Trust Corporation (RTC), set up in 1989 to “resolve” or dispose of troubled real estate assets held by failed institutions in the US savings and loan crisis of the 1980s and early 1990s. Rather than dump the assets into a very weak market, the RTC was established to dispose of the assets in a way that would minimize the losses borne by the taxpayer.

Today, the bad assets will have to be identified, a system will have to be established to value them, and the Treasury must decide how much to spend to acquire them. It’s actually a far more complicated set of issues than the RTC faced. Like the RTC, however, this plan is aimed at ring-fencing and discovering the prices of distressed assets so they don’t weigh on the financial system, with the Treasury in this case financing or providing capital for the “bad bank.” Key lessons: The RTC worked because it was comprehensive and big, and both equity participation and block sales gave investors incentives to buy the distressed assets.

The plan is unlike the Reconstruction Finance Corporation (RFC) set up in 1932 to provide loans to banks and nonbank companies. But a lesson from the RFC is that alternative channels for intermediation while the financial system is dysfunctional are essential, and the enhanced liquidity features of the current plan and the conservatorship for the housing GSEs do just that. Similarly, the lessons of the Swedish banking crisis in the early 1990s that apply to today are:

1. Maintain liquidity in the banking system and prevent it from collapsing.

2. Handle banking sector problems promptly and transparently.

3. Avoid a widespread failure of banks and foster macroeconomic stabilization.

Implications for Monetary and Fiscal Policy
If this plan works, it will take some of the burden off monetary policy to help financial markets and institutions and cushion the economic fallout. Put simply, if the plan succeeds in easing financial conditions, then to some extent it serves as a substitute for an easier monetary policy. But that won’t have immediate implications for the Fed; after all, downside risks to the economy still predominate. Money markets are still dislocated and the Fed will continue to flood the banking and financial system with liquidity that should depress the funds rate below its 2% target. The plan will boost Treasury financing needs and issuance dollar for dollar, as officials issue debt to buy troubled assets. But budget accounting, which will “score” the program as a loan, will limit the impact on Federal red ink represented by the budget deficit.

Market Implications
The crisis began with the credit markets, and we believe it will end with a credit market solution. Likewise, assessing progress toward stabilization in the credit markets holds the key to how the markets and economy behave in the near future. Before going to the risky assets, however, we first consider funding and rates markets, which are bellwethers for the stress on underlying assets.

Implications for Rates Markets
The plan should reduce risk premiums in two steps. First, the reduction in systemic risk should flatten yield curves and tighten TED spreads (the spread between 3-month Libor and 3-month T-Bills). Next, liquidity premiums should fall (Libor-OIS and swap spreads are expected to narrow). But liquidity risk premiums will likely linger until confidence returns. This equates to a slow but steady strengthening in the funding and Libor markets that is expected to have a positive impact on asset prices.

Mortgage-backed securities are the big winners. Spreads are gapping tighter and may trade significantly through Libor as the Treasury will be a buyer, and backstop liquidity facilities exist to protect the value of that asset by providing funding and balance sheet capacity. Private label mortgage securities should also benefit for similar reasons. Volatility should settle down and the curve may come under flattening pressure − though measured by the spread from 2- to 10-year notes, it may not fall much below 140 bp. Front-end swap spreads should also narrow as Treasury supply increases. It’s worth noting that these developments perfectly fit our Re-Normalization thesis, which states that funding costs will determine the value of assets. Whatever can’t be funded or is expensive to fund will underperform.

As noted above, recent developments suggest that Fed policy might also remain neutral for the foreseeable future and thus contribute to a decline and stabilization in front-end volatility, which had risen dramatically. Furthermore, the reverse auction process that may be used in the Treasury’s new plan will act to provide much needed price discovery for distressed mortgage assets. This will greatly reduce volatility and inject stability into the markets as well. But the inflationary impact of all these liquidity facilities and the Treasury’s $700 billion plan is not lost on us. Greater uncertainty in the rates market will be transferred to back-end rates. As a result, we expect volatility on longer tenors to remain well bid relative to shorter tenors and term premiums to remain high.

Implications for Equities and Credit
The plan, if well executed, should be positive for risky assets: By reducing risk premiums and the downside ‘tail’ risks for the economy, and creating balance sheet capacity for lenders, it should alleviate the credit crunch, narrow credit spreads, and promote expectations of lower risks for and an eventual rebound in earnings. Indeed, our US equity strategy team has upgraded equities to a buy.

What does the plan mean for credit markets? The speed and scope of the proposed policy actions is staggering. Given the deeply oversold conditions in credit markets, we think the plan will drive a sustained rebound in confidence and thus a reduction in spreads.

This is not to say that implementation of this plan will mark the end of the downturn in the credit cycle; cyclical forces are still working through the macro environment. We note that the original RTC was approved in August 1989, and the peak in default or credit spreads only occurred in 1991. But the reduction of systemic risk should allow for a renormalization of “beta”, which will allow for a more rational risk measurement and management process than we have been experiencing. From that perspective alone, the Treasury proposal is crucial to the credit and risk-taking repair process.

Our recommendations are grounded in the belief that the proposal will have dramatic consequences for the credit markets and help to renormalize beta. Notwithstanding the benefits of this plan, we still believe that the US and global economies face severe challenges over the next year (see The Slowdown Goes Global, September 17, 2008). As such, we strongly prefer high-quality assets and investment-grade debt. While high yield will likely see a near-term price pop as risk seeking comes back in vogue, we believe that the economic uncertainties will ultimately weigh on the more levered high-yield market.

Moreover, we believe that US credit will outperform non-US credit as a result of this proposal. US financials will also benefit, particularly those institutions that have more appropriate marks on their problem assets. It is important to keep in mind that differentiation matters, as thinly capitalized institutions with a high percentage of poorly marked assets likely will not benefit from this plan. Last, we believe this plan is bullish for ABX 06-1 and 06-2 AAAs as well as CMBX; indeed, some of that is evident in the recent price action.

Implications for the Dollar
Several crosscurrents will drive FX markets. Initially, the plan should help narrow risk premiums, which will likely promote a reversal in the flight-to-quality bid for USD, CHF and JPY. Conversely, higher-yielding currencies of economies that have not yet seen a major domestic slowdown − such as BRL, MXN − will benefit. Despite this potential knee-jerk reaction, we continue to maintain a cautious outlook on EM currencies as the turn in the global growth cycle will pose increasing risks for these economies going forward.

The USD may see additional headwinds in the near term as investors digest the reflationary aspects of the policy, coupled with downside economic risks and shaky global risk appetite. But if the plan works, it would boost confidence in the USD in the longer term. Our bottom line is that the USD should come under pressure in the near term, but with policymakers laying the groundwork for recovery, the USD may be set to resume its rally into 2009.

Source: Morgan Stanley, September 25, 2008.

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