Posts from — October 2008

Since the bailout was enacted, three-month LIBOR declined from highs of 4.75% to 3.52%. Further, three-month LIBOR dropped 90 basis points in this last week.

Room to drop?

The market votes yes. Three-month Eurodollar contracts closing in December (the three-month LIBOR futures rate) is pricing at 2.63%. By June, three-month LIBOR is expected to decline to 2.48%.

Context on the market prediction is critical. We must understand how much risk is priced into spreads.

TED Spreads, the base spread of risk between private capital and riskless funds, remain large.

• Today, three month treasuries yield .93%.
• Investing in treasuries today for returns in March 31st, 2009 yields 1.2125%.
• The implied treasury yield matching the Dec EuroDollar Contract is therefore .72%.
• Further, for three month March LIBOR, projected at 2.50%, equivalent three month Treasuries yield .22%.

So, good news and bad news. LIBOR is declining, but the TED spread remains wide.

As a side note, it is now obvious that Treasury Yields have priced a massive rate cut over the coming months.

Since last we spoke, the government invested $125 billion into the nine biggest banks and will invest $125 billion into an additional number of banks, potentially other financial companies. The investments, up to $25 billion or 3% of risk weighted assets into any specific company, are supposed to ease liquidity issues, and reduce cost of funds between banks.

For Taxpayers, the returns depend on your view.

• The terms of the treasury (on behalf of the tax-payer) investment are a dividend of 5% of invested capital.
• The preferred share investment is callable anytime after three years.
• Should the banks issue new equity prior to three years, they can buy out the tax-payer at par with that funding. In essence, any current equity owner is diluted regardless.

The taxpayer does not have any savings (found in lack in government surplus), so it must raise debt to fund the bank bailout.

Examining two and five year treasury yields, they are priced at 1.555% and 2.609%. respectively.  Assuming the Treasury Department does the right thing (See Note Four A), it will sell five year debt to finance the bailout.

Doing the math, paying 2.609% to receive 5% seems like a good deal. It does make a lot of arguments against it seem not as compelling.

Here’s another way to look at the deal though.

Assume the treasury invests up to $250 Billion, the returns over three years are $6 Billion a year. Enough to pay for approximately one year of pork projects John McCain rails against continuously.

Is this then a good investment? You decide.

The Treasury can choose how to finance this purchase.

First though, the plan gives us insight into when Treasury foresees the US Economy recovering. If all preferred shares are callable in three years, but only redeemable through equity (and not debt) prior to, then in essence, Treasury believes we will not fully calm the credit markets until three years from now.

At present, The Treasury issues 2 Years, 5 Years, and 10 Years. Yet Treasury must know most banks will call the preferred shares by year five when the dividend percentage increases from 5% to 9%.

Yet how many banks will take out the preferred shares prior to year three? Probably not many.

The safest debt instrument then is a five year treasury debt instrument. Here is why:

• The Yield on Five Year Treasuries is 2.609%, cheap money.

• No refinance risk. The preferred shares are retired back piece by piece through the next five years. While there is a chance of buying back treasuries at a premium when the debt is retired, the debt is so cheap; this problem is hard to imagine.

• Isolates the problem to the current administration. No doubt, models exist predicting when various banks will pay back the preferred shares, estimating duration and a possible combination of two year debt, five year debt and accept some refinance risk if funding is further needed.

Hank Paulson is a graduate of Harvard Business School, my cross town rival. (I went to MIT Sloan).

As 60 minutes shadowed him prior to the Congressional Approval of his bill, he was a leader handling a crisis:

1. Keep calm
2. Keep the solution simple
3. Execute the simple solution

So he must have known using the Treasury Department to buy asset back securities would be challenging, painful, and timely.

Today, the Financial Times, the New York Times, and the Wall Street Journal are all reporting the Treasury Department is considering equity stakes in banks, rather than purchasing asset backed purchases.

This solution, proposed and scoped early last week in our Third Note, is simpler and more effective.

1. Take equity ownership,
2. Ease capital constraints,
3. Start working through this mess.

On Timing, Hank has no choice.

If a bank asked you for a debt investment of 10 years, would you say yes? At what rate? Most banks are having real problems rolling over their long term debt. Sans long term debt, banks must use short term LIBOR, crippling our working capital system.

Yesterday, US Overnight LIBOR closed at 5.375%, up 1.48% for the day.

Hank, it is time to hit the reset button.