" Oh Timmy, we had such high hopes for you. You are such a disappointment."
This is the message the markets sent to new treasury secretary Tim Geithner and his rather opaque rescue plan. Other than stating that the government will use copious amounts of money to purchase various asset backed securities and to somehow (details were not given) to encourage private investors to invest along side the government in hundreds of billions of toxic assets currently populating bank balance sheets. Conspicuously absent from today's announcement is how prices of these assets will be determined and who will incur losses.
The street abhors the unknown. It wants bad assets of bank balance sheets, losses realized by either banks (with weak institutions being dissolved or merged with other firms), the government or a combination of the two. Mr. Geithner did not state how toxic assets would be removed from bank balance sheets. This is because he has no idea how to accomplish this without either the banks or the taxpayer (government) taking losses, and losses are there to be had.
The problem stems from determining what should be paid for complex asset-backed securities, such as CDOs. The assets are plain-vanilla mortgage pass-thrus. Some are backed by complicated pools of collateral. Others are backed by other CDOs and are known as CDO-squared. Determining the values of these vehicles is extremely difficult. Although the exact value of these assets are difficult to ascertain, it is widely agreed upon that many (if not most) of these assets are not worth (nor will they ever be worth) par. Another problem, especially for distressed institutions, is that selling these assets, whether it be to speculators or to a bad bank, at prices much below par could lead to insolvency. If the government purchases these assets at or near par it would likely lock in losses. So instead of purging banks of these bad assets we get more reality avoidance. Around and around we go.
The markets also want the government out of the bank support business. The opinion espoused by some pundits that investors should be comforted by investing along side the government is not shared by the majority of market participants. One only need look at the markets reaction to various news items. Every time it appears that government assistance and involvement for the banks will increase and be prolonged the market or the securities issued by the bank in question will react negatively. When, as with Goldman Sachs when it announced its intention to pay back TARP funds early thereby ending government involvement in the firm, Common and preferred share prices rose, as did bond prices. The Street fears politically-driven government decisions.
Another unsettling development for investors holding securities of more troubled banks are comments made by Fed Chairman Ben Bernanke that a mechanism must be put in place to facilitate the orderly dissolution of large, systemically-significant institutions. This could mean that no institution is to big to fail. Investors should keep this in mind when investing in large, troubled institutions, especially far down the capital structure. Quality is king and senior equals safety. Buy CDs, Muni revenue bonds and high quality GOs. Buy corporate bonds of the biggest and best companies in their respective sectors (I like JPM, Wells, PNC and USB) and ladder or barbell. With a ladder, overweight the belly of the curve (5-years or so) and do not extend past 10 years. For a barbell, overweight the short end with CDs as much as you can adding callable agency bonds to round out that portion of the barbell. High quality bank bonds JPM, WFC, PNC and USB out in the 10-year area. Trust preferreds are aggressive investments and non-cumulative preferred equities are speculative. Economic conditions are likely to put more pressure on banks in the coming months.
The following is the link to Treasury Secretary Geithner's proposed rescue plan (conditions for further bank assistance are not necessarily equity investor friendly):
http://financialstability.gov/docs/fact-sheet.pdf
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