Over the weekend, more very positive details about the US government’s planned rescue package became known. Here is an update on the latest developments from Raiffeisen RESEARCH.

 

Plans call for the creation of a special company, which – under the direction of the US Treasury – will be able to buy up a total volume of up to USD 700 bn in mortgage loans, securities backed by such loans (Mortgage Backed Securities (MBS) from the residential and commercial sectors) and other assets, to the extent that such seems necessary for the stabilisation of the financial markets (in consultation with the US Federal Reserve in respect of the latter). The purchase price is to be determined in a market-conform manner, e.g. via reverse auctions in which the lowest bidder wins. Under the guidance of the US Treasury, administration is to be performed by private asset managers which have yet to be appointed, whereby only assets created on or before 17 September 2008 will be eligible for purchase.

 

On the one hand, this would provide massive relief for the balance sheets of the banks which are holding such assets and it would channel badly needed liquidity into these banks through the sale of such assets.

First and foremost, however, it would prevent fire sales of such assts (e.g. due to critical situations at banks) on the completely illiquid market at greatly reduced prices, which would result in further declines in the market price of these assets and would force all other banks to record further (mark-to-market) impairments, which in turn would negatively affect their equity capital situation.

 

While the plan will not result in a quick resolution of many of the fundamental problems (and as a result we may soon see a degree of cool sobriety returning to the markets following the first euphoric reaction), it should prevent the crisis from spiralling completely out of control and provides a supporting framework for the US mortgage asset market and thus also for banks’ balance sheets. And also the boost in confidence that it facilitates will be a major positive impetus for the banking sector.

 

Market reaction so far: US equity markets reacted with vibrant rebounds in share prices (with the S&P producing its strongest 2-day rise since 1987!), government bonds came under pressure (yields on 2-year US Treasuries jumped by 47bp at times to 2.12 percent, in the largest single-day increase in the last 23 years!).

 

 

The positive mood on the equity markets should remain in place for the next few days, but the strongest increases in prices were probably recorded already at the end of last week. One should not forget that the major financial institutions will still have plenty of write-downs in store for the third quarter and for the fourth quarter as well. Moreover, the low point in the economic cycle is still ahead of us. And economic malaise will also spread to affect other areas/sectors of the economy. Hence, there is obviously plenty of room for disappointments still (e.g. corporate earnings).

On the other hand, the stock markets have already priced in a great deal of negative development in share prices and valuations. As a result, one can assume that any new setbacks will present some good opportunities for new long-term investment.

 

 

This seems unlikely, particularly in the euro area. While the correction on the bond market is likely to continue over the short term, if the plan is not scuttled (and we do not think it will be) there will be more reallocation of capital into riskier assets. As a result, over a short-term horizon we recommend taking a neutral position on government bonds, in order to avoid further declines in prices (despite the favourable medium-term conditions for bonds, over the short run it is more likely that the decline in risk aversion will dominate events).

Over the medium term, however, government bonds should be able to recoup these losses in prices by year-end thanks to the weak economy, falling inflation and the outlook for falling interest rates (in Europe), even if the equity markets should not dip back down to their lows registered last week. This is true in particular for Europe, whereas the leeway for new declines in yields on the US bond market is considerably narrower. Our bond market forecasts (cf. our “Weekly Market Outlook” on Friday) remain unchanged. 

 

The credit markets will profit from the measures that are being taken. In particular, spreads on bank bonds should continue tightening, in line with the massive narrowing seen last week. To what extent the package of measure actually has an effect should also be reflected by the primary market, which should now begin to function again. Not only banks and highly rated companies will profit from this, as companies with lower ratings will also then have the possibility of financing (and refinancing) themselves more cheaply (the primary market has essentially been shut down for these companies for a year now).

 

The USD has weakened to around EUR/USD 1.45 in a first reaction, but there is no obvious clear direction for the USD as a result of the rescue plan alone: naturally, the rescue plans will result in a massive increase in US national debt, and this may undermine confidence in the USD, but a full-fledged banking crisis in the USA would certainly have had this kind of effect anyway. If the plan facilitates the stabilisation of the US economy next year and reduces the need of further cuts in interest rates, then the long-term impact on the USD may actually be quite benign. Over a 6-12 month horizon, we thus expect to see the USD appreciate versus the EUR. Over the short term, FX volatility will remain extremely high, however, and new increases towards 1.50 are quite possible in the coming weeks, especially since the latest USD strengthening took place very quickly thus making a countermove quite likely. Consequently, we opt to wait before making any longer-term bets about USD appreciation.

 

The proposal is similar to the approach used in the major crisis among savings and loans associations in the late 1980s. With the framework of this approach, the Resolution Trust Corp. (RTC) was founded in 1989, through which the state bought up a total USD 394 bn worth of property, mortgages and other assets from hundreds of insolvent savings and loans banks (equivalent to roughly 8% of US GDP at that time). RTC sold these assets over a period of several years and was finally wound up in 1995.

Nonetheless, the proposed rescue plan would be the largest intervention of the state since the Great Depression in the 1930s.

 

Yes. This crisis has long since reached an order of magnitude, at which failure to take drastic steps of this nature would jeopardise the functioning of the US financial system at least. The savings and loan crisis in the late 1980s was harmless in comparison to what is occurring now and that crisis also had to be resolved by creating a rescue company of this kind.

 

While the solution may not look pretty, as taxpayers’ money has to be use to bail-out private financial institutions (to save them from problems of their own making to a certain extent), as Treasury Secretary Paulsen correctly noted, the ramifications (for taxpayers as well) would be even more devastating if the rescue package was not implemented.

 

Judged by some criteria, the current crisis on the real estate and financial markets in the USA is the worst since the 1930s. Continuation of the crisis as in the past weeks would not only lead to the collapse of more larger banks, it would also be extremely damaging for the economy as a whole (with far more severe consequences than a traditional-style recession).

 

In contrast to an ad-hoc approach to rescuing individual financial institutions, the rescue company is the first substantial measure (which we deem to be unavoidable over the long term anyway) that gets to the root of the problem and is suitable for breaking the vicious circle of “write-downs -> capital bottlenecks at certain banks -> insolvency -> more write-downs for all the other banks”. The plan also paves the way for easing tensions in risk premia on financials on the corporate bond market and in the situation for equities as well, which would result in a major improvement for the state of the entire banking system (outside of the USA as well). This would also help to significantly reduce the risk of systemic collapse of relatively healthy banks.

 

Of course, this does not mean that the economy is going to be back on its feet in a snap and we will probably see more write-downs at banks and insurance companies: in this regard our forecasts remain unchanged. The move will also be unable to prevent the collapse of some weaker institutions. But a solution of this nature would be able to finally break the aforementioned vicious circle in the financial sector and, in contrast to the efforts to merely boost liquidity and the ad-hoc rescue operations seen so far, it would mark the beginning of a real solution to the problems in the US mortgage market (for example, if Lehman Brothers had been able to offload its distressed real estate and mortgage security assets to a company of this kind, it probably would have found a buyer).

 

The government proposal is now being discussed with the Democrats, whose approval is needed to move the package of measures through the US Congress (Senate and House of Representatives). The Democrats have signalled their agreement in principal, in respect of the necessity and form of the rescue plan, and promised that a decision will be made by the end of the week at the latest. Right now, there are still negotiations on some additional points, which the Democrats have set as conditions for their approval: for example, their support is dependent on an unspecified amount of curtailment in the remuneration of the top management of the financial institutions which are to participate in the programme. Furthermore, the Democrats want to see additional measures to take some of the burdens off people who took out mortgage loans. According to the latest news, however, the Democrats no longer see the approval of a new economic stimulus package as a condition for their support of the rescue plan.

 

In light of the acute nature of the situation, we believe that an agreement will be reached soon and that the plan will be finalised by the end of this week at the latest, essentially in the form in which it was proposed, along with some concessions to the Democrats, and there are even hopes and a realistic chance that the deal could be done within the next couple of days. As a result, the market is eagerly awaiting the testimony of Fed Chairman Ben Bernanke and Treasury Secretary Paulson before the Senate on Tuesday (and the House of Representatives on Thursday), if an agreement is not already announced prior to these dates. The rescue company could then actually start its work within a few weeks.

 

At what conditions (prices) should the rescue company buy up the problematic loans and securities from the financial institutions: this will determine to what degree the burdens are taken off the financial institutions and what kinds of further write-downs are going to be necessary (in the event that the assets are purchased below market prices). If the price offered is too far below the market, participation and the effect of the measure would be weak: for example in the mid-1990s in Japan, a similar rescue company (Resolution & Collection Trust) created with the same goal only bought up an irrelevant sum of USD 3 bn in bad credits, because the prices offered were too low.

 

No. The package will not prevent another slowdown in the US economy in the second half of the year and the prospects of weak economic performance in Europe. Our economic forecasts remain unchanged. Nevertheless, by defusing the potentially explosive financial crisis, the package will at least mean that we do not have to drastically downgrade our economic forecasts for the coming year, as this would have been necessary in the event that dramatic conditions in the banking sector (in particular in the interbank money market) from last week had continued for a longer period of time.

 

No. The plan will not prevent individual banks from going bankrupt and will not be able to turn around the extremely difficult liquidity and equity capital situation for many banks. Lack of confidence and the resulting high premia on the money market will thus quite probably continue well into next year (cf. our special report on the money market problems released last week). Nevertheless, if the package is approved (and is supported by central bank measures, for example as seen last Thursday), it should be possible for the money market to hopefully return to its limited level of functioning seen before the collapse of Lehman Brothers.

 

The total volume which is targeted is USD 700 bn, which of course is an enormous sum, equivalent to some 5% of US GDP. By way of comparison, the USD 394 bn that the RTC bought up by 1995, was equivalent to about 8% of US GDP back then, whereas it was originally thought that “only” USD 200 bn was going to be needed. In any case, however, the package will not fail for lack of funds: the US government still has an excellent credit rating when it comes to USD, and even massive inflows of capital into US government bonds (safe haven) have been seen since the crisis started. Above and beyond this, the debt level of the US federal government (Federal Debt) was around 37% of GDP recently (2007), which is not particularly high; Austria’s total public debt, for example, is equivalent to around 60% of GDP right now.

Increasing the upper limit on debt in the USA, which is set by law, is a mere formality for the Congress.

Aside from that, at the current price levels many of the securities and loans that are up for sale are probably a good deal over the longer term. Just because many banks have to jettison these assets to obtain liquidity and to avoid further impairment losses does not mean that an investor with deep pockets and the wherewithal for the long run (both of which characterise the government) cannot make a profit on these assets over the long term. As a result, the net cost for the taxpayer will be well lower than the total volume of assets which is purchased.

 

The US Treasury Secretary has called upon other countries to follow suit, but the reaction has been negative in London and Berlin so far. We believe that it is very unlikely that other countries will adopt such packages in the near future, but we cannot rule out the possible necessity of such a solution, for example in the UK in 2009. 

 

Foreign banks with substantial operations in the USA are directly qualified for this rescue plan, according to the existing proposal. But what is more important is, on the one hand, that the market will stabilise and this will mainly profit all banks which have such assets on their books, regardless of where they are in the world, and on the other hand, the package will reduce the risk of further bank failures, which will also benefit the banking system at the global level, thanks to improvement in the market’s perception of risk in the banking sector (leading to lower risk premia).