TARP passes, but brace yourself for the second shoe to drop

With must anticipation and fanfare, the U.S. House of Representatives used the past four days to turn a US$700 billion TARP proposal into an US$800 billion piece of legislation (see prior post “Ignore the US$700B TARP rejection” September 29-08); the extra US$100 billion went to a variety of special interests and tax cuts. Think sprinkles on a chocolate sundae.

Now that Treasury Secretary Hank Paulson has his chequebook approved, let’s turn our minds to what impact his buying is going to have on the balance sheets of the very banks that Main Street thinks are being “bailed out” by this new legislation. If you watched Warren Buffett’s PBS interview two days ago, he intimated that Secretary Paulson might be able to buy US$2 trillion face value of subprime “mortgages” for US$700 billion. For those who want me to do the math for them, that would amount to 35 cents on the dollar.

Here’s a more plausible scenario, which doesn’t take away from what Mr. Buffett was saying:

– assume the Treasury buys $1 trillion of mortgages at face value from key domestic players;
– assume they are currently being carried on the books of B of A, CitiGroup, Goldman Sachs, JPMorgan, Merrill Lynch, Morgan Stanley, PNC and USB at 80 cents on the dollar on average;
– if the Treasury spent the entire US$700 billion on this US$1 trillion portfolio, these banks would need to take another 10 cent writedown, which represents US$100 billion of new charges;
– the aggregate shareholders’ equity of these 8 institutions (rough estimate) is US$590 billion.

If the above scenario plays out, these 8 institutions will write off 17% of their share capital when they do their “toxic waste” dump on Uncle Sam. If we accept that this notional $1 trillion loan portfolio is currently being carried at 80 cents, which seems low, for every one cent of new writedowns on the US$1 trillion portfolio these eight firms will be writing off 1.7% of their share capital.

Mr. Buffett wants Secretary Paulson to “pay market price” for these assets, and well below current carrying values. How else will the American taxpayer make money on this TARP program, as Mr. Buffett visualizes?

Think that a 10 cent discount wouldn’t float Secretary Paulson’s boat? How about 20 cents? That would mean that these eight institutions will wipe out 34%, or US$200 billion, of their collective share capital over the next few months.

If these 8 institutions aren’t overcapitalized today, this math suggests that more equity will have to be raised over the next few months than has been cobbled together so far this year.

Even if that figure is 4x overstated, this group (let’s call them the “Group of Eight”) still needs to line up another US$50 billion of new equity in the wake of utilizing this so-called “bailout”. If it was like pulling teeth to get US$5 billion from Berkshire Hathaway at 10% coupon with 100% warrant coverage, what’s the next round going to look like?

Secretary Paulson is going to have a terrible dilemma on his hands when he sits down to negotiate with the folks at Citigroup or Merrill Lynch. The better the price he gets for U.S. taxpayers, the worse the pain will be for the institutions in question. By selling a few securities into the marketplace to “test pricing” before the Fed pays “X”, how will anyone really know who is on the other side of the trade, validating the price that is being quoted?

If, as Mr. Buffett suggests, Citigroup wants to sell US$100 billion of securities to the Fed, they may first have to sell US$10 billion in the open market to find the clearing price. If one of the buyers for these US$10 billion of securities is a member of the Group of Eight, won’t they be incented to overpay a snick so as to preserve the marks on their own books? And isn’t that exactly why it has taken a year for these chickens to start to come home to roost?

Mr. Paulson will want to get a good price for the taxpayer; that’s what Congress has been promised. But, weak banking institutions turn to the Federal Reserve for help. The lower the price Paulson pays, the more likely it is that the bank in question will have to raise capital in a brutal market. Or rely on the FDIC for help.

The real and perceived conflicts inherent in the process to come will be incredibly difficult to manage, even for men as talented and qualified as Messers. Paulson and Bernanke.

MRM