Thursday, March 26, 2009

Why Geither's Toxic Asset Program Won't Float

There are many reasons for us to share the distrust with the apparent misplaced optimism credited to Tim Geither's Public-Private Investment Program or PPIP. Chief among them are issues on market price discovery and distorted incentives from government subsidies.

Nonetheless, I'll leave it to the experts debate on it.

But aside from technicality issues the following charts should explain why this program isn't likely to attain its goals...
One, leveraged loans defaults are likely surge.

The quotes a Moody's study (chart above from researchrecap)

``“Given tight credit markets, a worldwide economic slump, and a deteriorating issuer ratings mix, we expect default rates on leveraged loans will continue to climb in 2009, while recovery rates are expected to fall further,” said Sharon Ou, Assistant Vice President in Moody’s Credit Policy Default Research Group.

``Moody’s U.S. leveraged loan default rate ended 2008 at 3.5%, up from the 0.3% recorded in 2007.

``The ratings agency forecasts that 11.1% of U.S. leveraged loan issuers will default by the end of 2009.

``First-lien loan recovery rates fell to 63.4% at the end of 2008, down from 68.6% at the beginning of the year. By comparison, senior unsecured bond recovery rates dropped from 61.8% to 33.0% during the same period." (bold highlight mine)

Next, Fitch Ratings says losses in Residential Backed Mortgage Securities will rise further, see above chart.

The wrote, ``A dramatic rise in delinquencies has led Fitch Ratings to raise its average loss estimates for recent vintage jumbo prime mortgage pools to between 3 and 5 times higher than its previous estimate...

``In analyzing recent prime mortgage performance Fitch found that:

``Loans with multiple risk attributes such as limited income documentation and second-liens, are defaulting at rates approximately three times that of loans without those characteristics;

``A growing percentage of prime borrowers have lost all home equity due to declining home prices. Borrowers with negative equity in some recent vintage mortgage pools are approaching 50%;

``After adjusting for home price declines to date, loans estimated to have no equity in the property are defaulting at rates approximately three times that of loans estimated to have equity remaining.

``In addition to high default rates, recovery rates on defaulted loans are also trending downward."(bold highlight mine)

Lastly, Commercial Mortgage delinquencies are likely to worsen, see above chart.

The Researchrecap wrote, ``Commercial mortgage delinquencies rose sharply in February, driven by retail properties and lodging, according to Standard & Poor’s Credit Research, which lowered ratings on more than 200 commercial-backed mortgage securities during the month.

``The delinquency rate in February for U.S. CMBS rose to 1.57 percent from 1.39 percent in January.

``The amount delinquent is rapidly approaching the $10 billion level, closing February at $9.68 billion. The amount delinquent has increased by over 40 percent since the start of 2009, but the rate of growth slowed in February."(bold highlight mine)

The Commercial Mortgage Backed Securities could be the next tsunami of the serial deflating debt bubble.

According to the Wall Street Journal, ``Commercial real-estate debt is potentially more dangerous to the financial system than debt classes such as credit cards and student loans because of its size. The Real Estate Roundtable, a trade group, estimates that commercial real estate in the U.S. is worth $6.5 trillion and financed by about $3.1 trillion in debt. Partly because the commercial real-estate debt market is nearly three times as big now as in the early 1990s, potential losses in dollar terms loom larger.

``According to an analysis of bank financial reports by The Wall Street Journal, the broad shift to real-estate lending can be seen by comparing commercial real-estate loans -- including both mortgages and construction loans -- with banks' so-called Tier 1 capital, a key indicator of a bank's ability to absorb losses. In 1993, less than 2% of the nation's banks and savings institutions had commercial real-estate exposure exceeding five times their Tier 1 capital. By the end of 2008, that had risen to about 12%, or about 800 financial institutions. A higher ratio means a thinner cushion for loans that go sour.

And in contrast to residential mortgages which had been held by a few but largest banks, the general "community based" banking system seems highly exposed to the probable deterioration of commercial loans-as banking capital hasn't kept pace with the identified risks.

Again the Wall Street Journal, ``Of $154.5 billion of securitized commercial mortgages coming due between now and 2012, about two-thirds likely won't qualify for refinancing, Deutsche Bank predicts. Its estimate assumes declines in commercial-property values of 35% to 45% from the peak in 2007. That would exceed the price drops in the downturn of the early 1990s.

``The bank estimates the default rates on the $700 billion of commercial-mortgage-backed securities could hit at least 30%, and loss rates, which figure in the amounts recovered by lenders, could reach more than 10%, the peak seen in the early 1990s.

``Besides securities backed by commercial real-estate loans, about $524.5 billion of whole commercial mortgages held by U.S. banks and thrifts are expected to come due between this year and 2012. Nearly 50% wouldn't qualify for refinancing in a tight credit environment, as they exceed 90% of the property's value, estimates Matthew Anderson, partner at Foresight Analytics. Today, lenders generally won't loan over 65% of a commercial property's value.

``In contrast to home mortgages -- the majority of which were made by only 10 or so giant institutions -- hundreds of small and regional banks loaded up on commercial real estate. As of Dec. 31, more than 2,900 banks and savings institutions had more than 300% of their risk-based capital in commercial real-estate loans, including both commercial mortgages and construction loans."(bold highlight mine)

So if "toxic" asset prices will remain under pressure, the PPIP won't be enough to provide support as a wider range of loans are likely to crumble from the pressures of the combined weight of economic weakness and persistent financial sector eleveraging.

Private investors who are aware of the situation might see this as tantamount to "catching a falling knife"- and may refrain from participating- even if the private sector's risk participation is said to be only 7% while the rest is guaranteed by the goverment. Otherwise this should translate to huge taxpayer losses.

Hence, we can expect Geither's plan to probably expand coverage or introduce more innovative forms of bailout packages-all at the expense of US taxpayers-or for the US government to print more money to make up for the financial blackhole.

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