Willem Buiter once again provides an entertaining analysis of the crisis, with a blog post titled Save banking, not the bankers or the banks; the case of ING. The source of his ire is a Dutch bail-out of ING, which he terms a “guarantee”:
The assistance takes the form of a back-up guarantee facility for a portfolio of $39bn (face value) worth of securitised US Alt-A mortgages. Under the deal, the state shares with ING any gains and losses on this portfolio relative to a benchmark value for the portfolio of $35.1 bn. The shares of the state and ING in any gains/losses are 80% and 20% respectively.
The bank pays a guarantee fee to the state. The state document I saw did not specify the magnitude of the guarantee fee, or how it was arrived at.
The state pays ING a management and funding fee. Again, I don’t know the amount or how it was arrived at (it would be cute, however, if the guarantee fee and the management and funding fee just happened to cancel each other out!).
The other relevant conditionality is that ING is to provide 25 bn euro of additional credit to businesses and households and that there will be no bonuses for 2009 and until a new remuneration policy is adopted. The CEO was told to fall on his sword.
I strongly disagree with the characterization of the facility as a guarantee. According to me, a guarantee will have an asymmetrical reward profile, whereas this has a payoff diagram that looks a whole lot more like 80% ownership. This isn’t a guarantee: this is a futures contract.
Buiter has complaints about the strike price of the contract:
The guarantee is a good deal for ING and a bad deal for the tax payer because the market valuation of the Alt-A portfolio did not imply the 10% discount (from $39 bn to $ 35.1 bn) that was used to define the reference value for the guarantee, but a 35% discount (from $39 bn to $25.4bn). It is possible that the hold-to-maturity value of the portfolio (the present discounted value of its current and future cash flows, discounted at an interest rate that is not distorted by illiquidity premia, is $35.1 bn or more. Possible, but not likely.
It is possible that the guarantee fee appropriately prices the risk assumed by the state. Until I see the numbers and can verify the assumptions on which they are based, I consider it possible but not likely.
Dr. Buiter prefers a good bank / bad bank solution, blithely skipping over the question of asset value determination:
The good bank would take the deposits of ING and purchase any of the good assets of ING it is interested in.
The valuation of these good assets would not represent a problem, because part of the definition of ‘good asset’ is that there either is a liquid market price for it or, in the case of non-traded assets, that the buyer can determine their value in a straightforward and transparent manner. It is possible that none of the existing assets of ING would be bought by New ING. In that case, the assumption of ING’s deposit liabilities by New ING would be effected by a loan from the state to ING, and the asset-side counterpart on New ING’s balance sheet to the deposits acquired from ING could be a matching amount of government debt.
This, to me, misses the point. As I see it, the problem is not so much that certain assets have gone bad, but that banks are over-levered and – more importantly – confidence has been lost. It is the problem of overleverage that the contract addresses, in an attempt to restore confidence.
I agree with him wholeheartedly, however, on the dangers of social engineering and political grandstanding:
Often government financial assistance to banks imposes conditionality, costs and constraints on the bank’s management and existing shareholders without taking full ownership and control of the bank. Examples are; onerous financial terms; constraints on bonuses and other aspects of executive and board remuneration; constraints on dividend pay-outs and share repurchases; constraints on new acquisitions and on foreign activities; guidance and direction on how much to lend and to whom. All these encumbrances last until the state has had its stake repaid.
This creates terrible incentives encouraging banks that are already in hock to the government to hoard liquidity and hold back on new lending activities to get rid of the government’s interference.
Pref Market Inefficiency Shocks New Player
February 15th, 2009A newly Assiduous Reader who is also new to the market writes in and says:
You and me both, brother, you and me both.
This month’s edition of PrefLetter (currently at the Graphic Artist’s Spa, having its hair done and nails manicured) will contain a section with a new pricing model for Fixed-Resets … so I won’t discuss it here. Instead, I will refer to my last post on Sloppy, Sloppy Markets and take another look at a not-entirely-randomly chosen example of market inefficiency in the Pereptual Discount sector.
Closing, Feb 13
Dividend
This table presents a difficult question to Efficient Market zealots – who implicitly presume infinite liquidity as part of their efficient market. How on earth is it possible to rationalize the quotation on BMO.PR.H?
We’ll review a little … I estimated in my 2007 essay on convexity that being 15% or more away from the call price was worth about 15bp in yield; that is, a PerpetualDiscount trading at around $21.75 should yield about 15bp less than a similar issue from the same issuer trading at par; the higher coupon / higher price issue should yield more since any gains from a decline in yields should be expected to be called away, while the lower priced issue has a higher potential for capital gains.
We can argue for as long as we like regarding details such as:
but there definitely should be an effect and this effect should be positive. In June of 2008 this relationship went negative … while the curve returned to normal after a little while, it certainly resulted in a poor month for the fund I manage. It is these episodes in which the market defies common sense that make leverage such a dangerous game!
Note also that the ModifiedDuration of PerpetualDiscounts (which is a measure of price sensitivity to yield changes) is – to a first approximation – dependent solely upon the yield of the instrument. Any PerpetualDiscount with a given yield has the same yield risk as any other PerpetualDiscount with the same yield, except as distorted by the potential for calls taking away your winnings. So we can’t use yield-sensitivity as an argument.
In sum, I have to advise my newly Assiduous Reader to relax and enjoy the market inefficiency. Once you have a decent model for prices, you can make good money by exploiting transient anomalies and waiting for them to correct. This will increase your turnover and therefore your commission cost (which concerns a lot of people who are inspired by regulatory emphasis on the Trading Expense Ratio), but all moneymaking endeavors have some kind of cost.
Further examples of inefficiency and pricing models for PerpetualDiscounts will be presented at the seminar on February 26. Or, if you don’t want to do it yourself, you can always consider an investment in my fund, which uses many pricing models to check each other and is always on the prowl for anomalies.
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