Yesterday's Rally Is No Silver Bullet

Yesterday's Rally Is No Silver Bullet
by: Sameer Bhatia March 24, 2009 |

Wow! That's the word that comes to mind in response to yesterday's stock market rally in response to the U.S. Treasury's $1 Trillion plan to buy toxic assets.

Yesterday was one of the most exciting days in the stock market in recent memory with S&P gaining 7.08%. A Bloomberg headline stated that the S&P capped its biggest 10-day advance since 1938. The financial sector led the rally with gains of 10.27%. Bank of America (BAC) was up 26% while Citigroup (C) climbed 19%.

So is this the silver bullet that the banking sector was waiting for? Does this rally have legs?

The answers to both these questions, if we do some elementary math, are no and no! The Treasury's plan will is at best unactionable and doomed from the start, and at worst will end up causing tax payers hundreds of billions of dollars!

Let's dig a bit deeper into the Treasury's plan.

Assume that as per the plan that the Government buys $1 trillion worth of assets, in partnership with private buyers, through a competitive auction process. The government will finance around 95%% of the purchase price (85% in the form of a non-recourse loan and remaining in the form of equity), with the other 5% coming from private investors. In other words, the tax payers will be on the hook for $950 billion.
Let's further assume that the average price paid for these assets is $0.85 cents on the dollar. Therefore, the implied value of these assets on the banks' balance sheet is actually $1.18 trillion (i.e. $1 trillion / 0.85).
According to various public estimates, the banks had already marked down these assets to $0.80 - $0.85 cents on the dollar. So the implied original face value of these assets is $1.47 trillion (i.e. $1.18 trillion / $0.80).
However, these assets are currently trading in the market at $0.40 - $0.50 cents on the dollar! Thus the real market value of these assets is only $735 billion (50% of $1.47 trillion).
Since the government financed 95% of the purchase price, the potential hit to taxpayers is $215 billion (i.e. $950 billion - $735 billion).

This also implies that the private investors, being equity holders, will be the first-in-line to lose their 5%, i.e. $50 billion. The obvious question then becomes why would private investors pay above market value only to see their equity disappear? The answer is that they won't! Private investors will only acquire assets at a price that will generate adequate returns to compensate them for the risk they take. Thus, they will either discount the assets deeply or buy only the highest quality assets at a slight discount (in the process actually protecting the tax payer).

Now this is the point where Treasury's plan is rendered unactionable!

Folks who have read my earlier post "Sucker Rally", know that around 64% of assets on a banks' balance sheet consist of Residential and Commercial mortgages.

For simplicity's sake, let's assume that only 50% of assets on a bank's balance sheet are toxic. So even if banks were able to sell these assets for $0.85 cents on the dollar, they would have to write-down 7.5% of their asset base (i.e. 50% - 50*0.85%). This will effectively wipe out the entire tangible equity at most banks, rendering the shareholder equity worthless.

Therefore, there is no incentive for banks to sell these assets, especially higher quality loans that are still performing. Banks will only sell the most toxic of the assets, which will in turn will fetch prices much less than the $0.85 cents on a dollar I mentioned initially, again wiping out the bank equity in the process!

In short, the plan does little to improve the banks' balance sheet and even if it were to be executed, could end up burning a huge hole in the pocket of tax payers.

The sad conclusion is that the stock market rally, especially in the financial sector, was based more on hope and prayers as opposed to fundamentals!


http://seekingalpha.com/article/127543-yesterday-s-rally-is-no-silver-bullet