You are on page 1of 7

US ‘detox’ After a tumultuous week of weathering the worst financial crisis since 1929, financial markets seem to have

consolidated following a multi-point rescue package announced over the weekend by the US Treasury and the Federal Reserve. While the markets have breathed a sigh of relief and have seen this as a narrow window for profit taking, the exact anatomy of the rescue package and its full implications for market movements are still somewhat unclear. In this note we examine the possible structure of the rescue package on the basis of initial information made available by the Fed and Treasury, gauge the possible risks to its efficacy and its consequent market impact. i. The $700 bn corpus support Some of the key components of the package that is pending legislative approval from the US congress are: • The US treasury will set up a USD 700 bn corpus to absorb “toxic” assets on the balance sheets of beleaguered financial institutions. While the definition of “toxic” assets includes residential and commercial mortgage –related assets including mortgage backed securities and whole loans, the Treasury has retained its discretion to expand the scope of toxic assets as per their implication for financial market stability. This will be funded by the US Federal government i.e with ‘tax-payers’ money’ While the motive behind the move is to infuse credit institutions with liquidity so that they can revert to their primary role of financial intermediation (i.e. credit disbursal in the form of investment loans that create jobs and housing and student loans) it is not clear if direct assistance will be provided to homeowners by renegotiating mortgage agreements and easing bankruptcy laws. The purchase window of the corpus is expected to be valid for two years while the actual purchase mechanism is expected to use market-based pricing (for instance Reverse Auctions1 ) wherever possible. The scope of

Reverse auctions require the Fed to pre-specify the asset it wants to buy and then purchase it from the financial institution selling it at the lowest price.
1

The RTC was used during the Savings and Loan Crisis of the late 1980s. money market interest rate volatility and exchange rate fluctuation. net asset value erosion. This makes the financial institutions eligible for credit support from the Federal Reserve against collateral acceptable for posting by a bank or a securities firm during the transition to bank holding status. Immediate implications for the entities include greater capital RTC was a US -government-owned asset management company charged with liquidating sub-standard and nonperforming assets of savings and loans (S&Ls) declared insolvent in the 1980’s. the recent turmoil in global financial markets has led to redemption pressures3 .model that the corpus is widely believed to follow. Granting of bank holding status to Morgan Stanley and Goldman Sachs Casting a shadow on the future of stand-alone investment banks. As a result. There are other. 3 At the time of Lehman Bros. in consultation with the Chairman. redemptions amounted to USD 90 bn (2. the Federal Reserve has now allocated USD 50 bn from its “Exchange Stabilization Fund” to insure the holding of publicly offered funds against braking par on their NAV in return for a pre-specified fee. collapse. With several money market mutual funds having large investments in high grade paper (AAA) issued by established financial institutions.• assistance is currently restricted to “participating financial institutions with significant operations in the US unless the Secretary makes a determination. These do not require legislative change and have already been implemented.400 bn) were widely believed to be as safe as bank deposits but were not insured by the Federal Reserve. Temporary guarantee program for money market mutual funds for a year Money market funds (with a market size of USD 3.47% of total assets) 2 . the structure of the corpus differs from the “Resolution Trust Corporation 2 ” (RTC) type. less controversial measures. RTC gave full control to private agents in the management of assets and shared rights related to their purchase (equity partnership). the Federal Reserve has accepted the proposal by the last two surviving major investment banks to be converted to deposit-taking entities. To that effect. The purchased assets are to be managed by private asset managers although control over management and any rights connected with the purchase of the troubled assets will remain with the Treasury. Federal Reserve. iii. that broader eligibility is necessary to effectively stabilize financial markets”. ii.

adequacy requirements. Other measures • • • Temporary ban on short-selling of stocks Expansion of the GSE-MBS program Lifting of restrictions on investments by Private Equity firms.000 per depositor per bank. lower profit margins and fundamentally lower risk appetite. Stand-alone investment banks came about with the passing of the Glass-Steagall Act in 1933 that prohibited a bank holding company from owning other financial companies. Sovereign Wealth Funds and corporate investors in banks and bank holding companies Risks to efficacy The recent rescue package has drawn fair degree of criticism from different corners of the market. thereby leading to a fall in depositor confidence and sparking off bank-runs. at the end of Q208. there is concern that the corpus will not be able to deal with the underlying problem of asset pricing and mortgage default. However. lower leverage. Further. banks that had invested large sums in financial markets saw the market value of their investments nose-dive. a full-fledged bank-run in the US is partially mitigated by deposit insurance offered by the Federal Deposit Insurance Corporation (FDIC). . At the time of the Great Depression. insurance is applicable only upto USD 100. The act was later repealed in 1999 when universal banking came to the fore with JP Morgan and Citibank using their low cost deposit base to compete with standalone investment banks. iv.7 bn held with US commercial banks. Most of this criticism has been centered around the viability of the USD 700 bn corpus support to absorb toxic assets from the balance sheets of troubled financial institutions.2 bn as compared to system -wide transaction deposits of USD 603. assets held by FDIC stood at a mere USD 45. The short-term amelioration offered by the corpus support notwithstanding. Although the merging of an investment bank to a traditional deposit-taking bank still exposes the consolidated entity to depositor flight in the event of faulty investments.

For the package to work. In many cases. However. Fed governor Ben Bernanke has suggested that the price at which the Treasury should reflect the “hold-to –maturity” (HTM) valuations of these assets and not go entirely by the current “fire-sale” market valuations. What these assets will fetch in the long term is anybody’s guess at this stage. For instance. If tax-payers are to recoup some of the costs of funding the bail-out. If market-based methods are to be indeed used in the absorption process.Pricing The toxic assets under consideration have illiquid markets and an opaque pricing structure. The price at which the Treasury buys these assets will have to balance the objectives of preventing capital loss by banks with protecting tax-payer interest. the discounted value of the future cash flows arising from mortgage payments possibly adjusted for different mortgage default scenarios.the optimal price that minimizes the loss incurred by both tax-payers and financial institutions will likely lie somewhere in between the current market price and the HTM price. Extraction The other more operational problem with the efficacy of the corpus is the complexity of the assets it aims to absorb. i. Especially in situations in which financial institutions have purchased assets at significantly inflated levels. this is no guarantee against further capital loss.In that case. HTM prices would reflect the intrinsic value of a mortgage. if the treasury holds them long enough. then it is unclear how the sale price will be arrived at and whether it would stem further capital erosion. One could perhaps work with the assumption that they should at least move close to the current HTM price. As opposed to the RTC which bought over thrift banks and extended support to them by pumping capital directly into their balance sheets. the USD 700 bn corpus is expected to first extract the underlying asset represented by the illiquid assets being purchased and then price it. Identification of the underlying assets and their final location will not be an easy task. financial institutions must be able to get these assets off their balance sheet at a price that is high enough to prevent significantly more capital erosion. then the purchase price will have to be at levels lower than the price at which the treasury can hope to sell these assets in the future. collateralized debt .e. each of the toxic assets targeted by the corpus have packaged a heterogeneous group of underlying assets ultimately affiliated to different banking and financial institutions.

• • . The yield on the 2-yr UST fell by 45 bps during the day of the Lehman bankruptcy and has fallen by 19 bps over last month from 2. the fiscal deficit of the nation is likely to rise from its current level of USD 480 bn (3. banks and other institutions to continue at least for the next three months. Fiscal implications Another issue of significance is the financing of the USD 700 bn corpus. The Treasury aims to fund the corpus by issuing its risk-free securities. The currency impact The short-term impact of the ‘package’ is somewhat uncertain: • If the package goes through without significant dilution.7 trillion. particularly US treasuries into riskier assets. This is likely to be USD negative. This could be USD positive. However it would also alter perceptions about the US financial economy and lead to purchases of US financial sector assets.8 trillion.000 bn (7. the US fiscal situation is in a bad shape. With total rescue efforts till date estimated at USD 1. However. 2008 stood at USD 9. the current market turmoil has seen a mass inflow of capital into UST’s since the onset of the most recent bout of the sub-prime crisis.2008. Similarly.7% of GDP)-higher than the mandated limit of USD 10. home mortgage loans and personal loans bought from different banks.obligations (CDOs) reflect securitized interests in pools of different assets comprising auto loans. it is not certain whether the US fixed-income market will be able to absorb a fresh supply of USD 700 bn (5% of GDP) worth of government paper. This involves liquidation of assets outside the US and repatriation into the US and that should drive the USD up.3 trillion (80. it would temporarily reduce the degree of risk aversion in the system and lead to flows from ’safe-haven’ assets.14% of GDP).42% to 2. the debt level will touch USD 11.0 trillion.4% of GDP) to USD 1. However. We expect the current phase of ‘de-leveraging’ by US funds.23% on September 22. Keeping with its safe-haven characteristics. US Federal outstanding debt including intragovernmental holdings as on September 19. with the announcement of recent rescue measures.

Although there is a provision in the legislation regarding “foreclosure mitigation”. it is unclear how the program will tackle the ongoing crisis. in the longer term. while the immediate (a fortnight to a month) impact could be USD negative. This was seen to be USD negative and the USD was seen to be headed for a prolonged phase of correction. we reiterate our view that over a medium term (three to six month) horizon. the USD is set to appreciate. These measures are likely to be USD negative in the long term. particularly the USD.com Shivom Chakravarti. With market experts expecting real-estate values to plummet further.barua@hdfcbank. The rescue package may offer short-term support to financial markets but will not diminish the growing probability of an economic recession in the US in the current year. Going to the root of the crisis? Skeptics believe that this package has not been able to tackle the root of the crisismaking it easier or even possible for homeowners to make good their mortgage payments. From a ‘secular’ perspective the effect of the new fiscal load should be negative for USD-sentiment. Over the past couple of years. Even the RTC took a year to impact financial markets and two years to impact the economy. nothing has been done to check the downward spiral in property prices.Thus. the perils of stretching the US Federal government’s balance sheet further is bound to effect most of the critical macro variables in the US. Treasury economics research team Abheek Barua. Economist Phone number: +91 (0) 124-4664356 . Thus. The imperatives of tiding over the current financial crisis have obfuscated some of these concerns. Chief economist Phone number: +91 (0) 124-4664327 Email ID: abheek. its details have not been outlined. there has been growing concern about the structural imbalances in the US stemming from overstretched household and government balance sheets. Given the lack of clarity on the actual structure of the rescue package and the relative flexibility that both Paulson and Bernanke want in its administration.

Reasonable care has been taken to prepare this document. satisfactory documentation and prevailing market conditions. HDFC Bank and its employees do not accept any responsibility for action taken on the basis of this document. Such an offer would be subject to contractual confirmations. Economist Phone number: +91 (0) 124-4664338 Disclaimer: This document has been prepared for your information only and does not constitute any offer/commitment to transact.chakravarti@hdfcbank. .Email ID: shivom.com Jyotinder Kaur.