“Our greatest glory is not in never falling, but in rising every time we fall.”

Confucius

After a first quarter filled with extreme movements on the upside and downside, we find ourselves entering a critical second quarter for the financial markets. Trading in the first quarter was mostly contingent upon the words and actions of governmental leaders. The release of financial information also moved the markets, but it is no secret to investors that this information is a lagging indicator. More so, everyone already knew we were in the midst of a deep recession. What the markets have indicated as critical is action – most especially, action that will resolve our financial woes, not merely bandage them.

The recovery, which some have dubbed a “bear-market bounce”, comes as a breath of fresh air nonetheless. As with any 20%+ increase in only a couple of weeks, there is likely to be a pullback at some point. However, we see the reason for this rally, compared to the rally witnessed between late November and year-end, to be based on definitive actions, not mere speculation. The policy actions that occurred during the month of March have given the markets the increased clarity they have demanded. As these programs come together and work through the system, we believe the markets will stabilize and edge higher. Here is a brief explanation of some of the key programs the government has introduced in the month of March:

TALF: TALF is an acronym for Term Auction Loan Facility. In short, the TALF program has been initiated jointly by the Federal Reserve and the Treasury as a lending facility, collateralized by recently issued AAA rated asset-backed securities. The purpose of TALF is to incite lending to consumers in pivotal areas of the economy: student loans, auto loans, credit card loans, and loans guaranteed by the Small Business Administration. This facility will range from $200 billion to $1 trillion in size. The rationale of TALF is that as a loan is being made by a financial institution, that loan can be used as collateral to receive additional funding from TALF to make more loans. In essence, the origination of one loan can free up funding to make several more.

Direct Federal Reserve Purchases of Assets: Ben Bernanke’s doctoral thesis was on the Great Depression. He understands the Depression more than almost any other living individual working to stem our current financial crisis. When losses begin to spiral out of control and fear dominates the markets, deflation is the enemy. It takes massive intervention to step in and provide a backstop, and Bernanke has done just that. With asset values in many classes plunging, investors have not been stepping in as they normally would in a free market system because of expectation that values will continue to fall. This exaggerates the selloff, undervalues the assets and creates a perception that can keep the markets dry for extended periods of time. This program allows for the purchase of up to $300 billion in Treasury securities, $200 billion of the debt of the GSE’s (government sponsored entities such as Ginnie Mae, Fannie Mae, and Freddie Mac), and up to $1.25 trillion of mortgage-backed securities of the GSE’s. These funds will reduce the supply of securities and, thus, stop the drop in asset values.

U.S. Treasury’s Banking Plan for Bad Assets: On March 23, Tim Geithner announced his long awaited banking plan. Along similar lines of direct purchases of assets by the Federal Reserve, the Geithner Plan is a combination of public and private funds that will be used to purchase loans and/or assets touted as “bad” in the marketplace (yet may very well pay off at maturity). He is using a sane amount of leverage (not the 30:1 ratios that Bear Stearns utilized) to remove the alleged toxic assets.

Legacy Loans Program: Through equal equity collaboration of Treasury and private funding and debt financing from the FDIC, an entity denoted as a PPIF (Public/Private Investment Fund) will purchase bad loans from banks. The FDIC will guarantee debt to a maximum of six times the amount of equity in the fund.

Private investors will bid for the chance to contribute 50% of the equity of the PPIF. The price submitted by the highest bidder will represent the amount the bank would receive for the assets. The following example should make the process more understandable.

Example: A bank comes to the FDIC with a pool of loans with a par value of $100. After receiving several bids from private investors, the highest bid comes in at $84. The bank receives a lump sum of $84; the equity portion provided by private investors and the Treasury will be $12 ($6 each) and the PPIF will issue $72 in FDIC-backed debt ($72/$12 = 6). When the loan matures at $100, the $72 in debt will be repaid and the equity holders receive $28 ($14 each) for a return of 133% per equity investor.

Legacy Securities Program: Private Fund Managers and the Treasury will again be partners in a PPIF. The Treasury will initially match the investment of the Fund Manager, but would also be willing to provide an additional loan up to 100% of the equity base. The PPIF would focus primarily on AAA rated RMBS and CMBS and follow a long-term buy and hold strategy. Since the securities adhere to the requirements of the TALF program, the PPIF would be eligible to receive further financing from the Federal Reserve by using their assets as collateral.

Example: A Fund Manager raises $100 of private capital. The Treasury will match their $100. The Treasury also decides to inject 100% of the existing funds into the PPIF ($200). The fund purchases $400 of RMBS on the open market. Two weeks later, the PPIF uses $200 of previously purchased securities as collateral for a loan. They then purchase an additional $200 of securities on the open market. In totality, the PPIF owns $600 of securities which started from only $200 in equity investment. Under this program, a little equity capital can go a long way, but in a manner more responsible than the leverage the system had been using pre-2008.

Sincerely,
Jim, Mark and Greg.