Monday's rally was presumably caused by the fact that we actually have a bank plan. Almost any plan is better than either no plan or a constantly shifting plan. Let's stipulate that anything which gets us out of this self-reinforcing negative feedback loop is great. If this involves us all chanting for a day at the Sun (or perhaps even being forced to watch the Leno and 60 Minutes Obama interviews again and again) then great. But I assume confidence, generally, is derived from some semblance of rationality, even if such rationality itself sits on top of a pool of the unknown and the unknowable. The Geithner plan seems reasonable enough, although it still leaves certain questions unanswered.

It is disconcerting how long this took. The most obvious thing to state is that this could have been done 6 months ago, or 3 months ago. There is nothing here of any great complexity. Lack of complexity is good. It is different from the original TARP proposal in that the private sector shares the first 16 2/3% of losses with the Government. That is basically it.  Not to be a wiseguy, but how is it possible it could have taken this long to come up with this? This is truly something that could have been devised in a month last Fall by Geithner and Paulson. These guys were so focused on the joke which has become the AIG/ Wall Street derivatives scandal, they had no time to think clearly.

The second most obvious thing about this announcement is it reinforces my belief about the relative triviality of this crisis from day 1. To be more precise and to repeat for the 25th time, we took a severe but localized recessionary real estate bubble and proceeded to declare loudly, by words and deeds, that this was the worst crisis since the Great Depression. This caused panic. This I blame on Obama, before and after the election, and the media who supported him; and Hank Paulson who had other objectives in mind besides solving the liquidity crisis, like saving Goldman Sachs. (Some call it a solvency crisis, which is different; at some point these two interpretations can merge. I do not want to get into that issue).   Obama played minister of propaganda since October while Hank Paulson was the minister of operations. The confusion created by Obama's FDR/Depression obsession and Paulson's disastrous TARP bill and AIG bail out were both acts of great irresponsibility.

THE MARKET CONTEXT OF THE PLAN

THE GEITHNER PLAN

I agree that the collapse of the housing bubble created a "negative economic cycle" beyond what was warranted. However, the persistent stubbornness on the part of Treasury to not name the areas of the country where these problems actually exist in extreme disproportion to the rest of the country is disturbing. Readers of this blog know these areas to be California, Vegas, Phoenix, and Florida (primarily the cities and surrounding areas of Miami, Tampa, and Orlando). The West dominates. I believe this lack of disclosure has contributed to the general panic. It also prevents us from finding a more precise set of reasons for what caused this bubble to begin with.

The premise behind the program is that owning mortgages and securities collateralized by mortgages has created uncertainty regarding banks' solvency/liquidity due to price "uncertainty" regarding these instruments. This has made it difficult for banks to raise capital and thus has limited their ability to make new loans. The Treasury says it would like these banks to sell many of their mortgages. They also say they want "price discovery". These 2 objectives are not the same and, in fact, the latter can preclude the desirability of the former.  Price discovery presumably eliminates "uncertainty" about the values of mortgages. This makes it safer to provide capital for banks. Investors will now presumably be more likely to believe the stated values at which the banks have these assets priced. This would help restore confidence in the financial system. That is the idea anyway. It is unclear this program will create enough price discovery, although I think it potentially can. Of course, the recent hissy fit thrown by the Obama Administration and the Democratic House of Representatives on "compensation" limits is damaging to the extreme. For this plan to even have the chance of working that lack of trust in the Feds has to be addressed.

There are 2 categories of loans discussed in the "Fact Sheet". Category 1 is what we all understand, mortgages made by banks and still owned by banks. They call these "legacy loans". Your local bank lends you money and they hold your mortgage. The second category is "legacy securities". Legacy securities were issued by banks. They created off balance sheet entities called special purpose vehicles ("SPVs"). These SPVs purchased regular mortgages. They borrowed money to buy these mortgages by selling bonds to other financial institutions, including other banks. These bonds are the "legacy securities" and are called "residential mortgage backed securities" or RMBS. These SPVs have securities  with different risk characteristics. They have subordinated securities which would lose money first if the underlying mortgages began to default. They also have senior securities which only lose money if more than 25-30% of the mortgages default. These securities were rated AAA. The only legacy securities eligible for bidding are these senior RMBS that were originally rated AAA (also commercial real estate and consumer credit securites, but these are relatively small compared to residential mortgages).

There is another whole class of securities explicitly not mentioned, at least I did not see them in the plan.  Implicitly excluded from Geithner's plan are CDOs or Collateralized Debt Obligations, of which a few hundred billion were issued. CDO's are another type of special purpose vehicle (or SPV) that purchased what Treasury is calling "legacy securities", or the bonds sold by the RMBS special purpose vehicles mentioned above. They then financed the purchase in the market by selling "CDO debt". No mention was made by Treasury as to why these were not explicitly included in the program. I don't know what to make of the CDO exclusion, other than it seems very peculiar. I have a hunch the largest percentage of these are owned by foreign institutions and non-banks.

WHAT DOES THIS ALL MEAN?

What does this all add up to? Not sure yet. Even the worst of the sub-prime and so called "Alt-A" mortgages issued in 2005-2007 (Alt -A are typically undocumented loans which are a step up in credit from sub-prime) have "only" defaulted at a 25-30% rate. These typically were the mortgages purchased by the RMBS vehicles. This means that the "legacy securities" eligible to be bought are close to being at some level of default. But not all of these formerly AAA legacy securities should be experiencing actual defaults, although some will, because default rates need to rise higher than 25-30% for this to happen. They are certainly no longer AAA rated securities, however. But these have presumable already been marked down by the banks. The "legacy loans", on the other hand, are just pools or groups of loans, so any potential buyer can subjectively determine their own implicit "credit rating".

One reason we have a financial crisis, I believe, is that these legacy securities and loans have been marketable only at a price that implies a much higher probability of default then is likely to occur, or at least that the current economic forecasts imply. We do not know what price these instruments are marked by the banks on average, but are likely marked well less than par. Since it is more likely than not that banks and RMBS holders believe 90% plus of these securities and loans are likely to pay fully, or close to fully, they will probably want to hold them, if they have not been marked down severely, rather than sell at a deep loss. Some smaller losses may be acceptable. If they have been marked down severely, they may want to sell if they can get a quick gain and be done with it.  Buyers are going to want a big payday. Their initial thoughts on this will likely be to want to bid too low. But the leverage provided by the government can make returns very high at higher prices, with arguably very acceptable risk.

For the "legacy loan" pools, investors are risking a maximum 16.6% loss if defaults rise to an extremely high level from what the current default levels are projected to be. Government shares the first 16.6% loss with investors---they also share gains---think of it as joint venture . Actually, investors risk 16.6% of the purchase price of the mortgages which could be 100% of the cash they put up. But the potential returns are also very high if defaults do not materially rise from current levels. The likelihood of total loss should be low. So while the Treasury is capping losses, they are capping them at presumed disaster levels. For "legacy securities", the potential percent losses are less but the amount of capital put up is greater. They risk in theory 33%- 50% of the purchase price  because the leverage provided is less and the cap on losses triggers at much lower prices than the loans. The odds of losses hitting those triggers should be remote, relative to a baseline of a 10% default rate.

In other words, while the investors are getting capped losses for both loans and securities, they appear to be at levels which could only occur if we truly have Armageddon default levels, much higher than 10% over all. Therefore, the greater benefit the Government is providing is the actual financing, not the guarantee.

If it is the case that price discovery has been prevented primarily because investors have been unable to get financing, then maybe this plan can get the secondary market moving again. Still, the language used by Geithner in his fact sheet implies the objective is to get "bad assets" off the books of banks. But, on the other hand, implicit in the plan's proposals is these assets have been undervalued by the market. This appears like a contradiction in their understanding of what needs to happen and why. It certainly is confusing communication.

The plan can be helpful in the following sense. The bidding process can make it more explicit to both buyers and sellers that we may have in fact discounted these securities and loans too low. It can also prove the opposite. But as potential buyers do their calculations, they may find that potential returns due to leverage is so high they can afford to bid prices up higher than has been the case since financing dried up.This could have the benefit of  prices moving closer to what banks and Treasury hope and believe is fair value. Banks may just want to put the whole thing behind them, at least to some degree by selling some percentage of assets even by taking more losses.

Of course, the devil is in the details. The government ultimately has final say on what leverage will be on any pool. We also do not know how much damage has been done by the latest anti-capitalist outburst by the administration. It is hard to imagine why anyone would blindly trust the government not to renege. We also do not know if the current wide spread between where banks want to sell and where buyers will buy is so great, the gap cannot be closed. There may be price discovery only on certain classes of securities and loans but not others. One can still argue that all we are doing is providing price supports for Zombie banks through subsidies for new buyers. This may be accurate, although I do see it as less price subsidy and more financing. If buyers do believe that foreclosure rates above 5% are not implicit in their economic forecasts, the cheap financing can be an incentive to buy. Still, the perceived risk reward may not be sufficient without just letting these prices drop further. If this happens, then the government should just get out of the way.

I believe the present actors caused this financial crisis to be more severe than it needed to be through panic and opportunism. Therefore, I also, ironically, share their view this is likely to be more a crisis of transparency and confidence rather than one caused by some global systemic set of deterministic causes. If the "systemic risk" proponents---Roubini, et. al---are right (or investors simply fear they may be right) and see something more ominous than what I see, this will not work. It still may not work, even if "the Roubinis" are wrong. If certain buyers are prohibited from bidding, that will be a problem. If bidders do not come in for whatever reason, that could be a  problem. It certainly will be a huge embarrassment. Ultimately, we may have to let the Zombie banks go if default levels rise from here. Let's see what happens. I hope it works. Then we can focus on the largest problem of all---the Pelosi/Frank/Reid/Obama Statist agenda.