Thursday, February 26, 2009

Dangers of estimating the bottom

One of the fundamental premises behind all the different financial sector bailout plans is the hope that some amount of estimated capital infusions and credit guarantees will be able to stem the downward spiral in asset values and get market confidence back on the institution and collectively normalcy restored in the credit markets. However, the stories of AIG, Citigroup and the Detroit automakers sounds a note of caution to the aforementioned premise and raises the strong possibility that tax payers money is being poured down a near bottomless put. Consider these

1. AIG, in which the government took over 80% stake, has moved from one bailout to another and there is no end in sight even after receiving capital infusion of $153 bn in three tranches. It is trying to raise an estimated $60bn more in additional capital to stay afloat.

2. Citigroup is negotiating another round of assistance, over and above the initial $45 bn, which is set to increase government stake in the firm from 8% to as much as 40%. It is also negotiating the conversion of the non-voting preferred share stake of government, which has dividend payouts, into common stock.
3. General Motors and Chrysler are seeking another $22 billion on top of the $17 billion already granted to them. And their woes continue to pile up.

So even as TARP II or FSP gets underway, new questions will be raised as to whether the assistance provided is enough to bail the firm out. The stress tests will provide a more firmer basis for evaluating the needs of those receiving the bailout money. But given the difficulty of estimating risks and uncertainty surrounding a fst deteriorating economy, many of the assumptions can easily go wrong.

Do we heave a short time horizon moral hazard here - banks trying to under-play their bailout needs, so as to avoid atleast some of the controls sought to be imposed by the new bailout plan? Since the "too-big-to fail" arguement has been publicly embraced by the government, where is the need to showcase all your rotten eggs in one basket, but stagger it over a time, so as to negotiate a better deal? Follow the path AIG has shown!

Update 1
Fannie Mae ques up again, claiming another atleast $15.2 bn to off-set record $59 bn losses last year. Freddie Mac has hinted at another $35 bn bailout assistance.

Update 2
Paul Krugman and many others, here and here, doubt the rigour in the stress tests (FAQ here), especially given the assumptions and feels that the Treasury and Fed may be grossly under-estimating the losses.

Update 3
Even as the government announced its decision to dramatically increase its stake in Citigroup from 8% to 36%, the markets gave a thumbs down sending the share prices down by 36%. It is now being reported that despite the previous two multi-billion bailouts, and the present one, Citi may need atleast another round of assistance. Citi's share price has plunged from $55 a year ago to a mere $1.56 bn, making the company virtually worthless as an entity.

Here is a chronicle of the practices that led Citi to its present fate.

Update 4
AIG gets its fourth round of bailout, as the federal government agreed to provide an additional $30 billion in taxpayer money and also loosen the terms of its huge loan to the insurer, even as the insurance giant reported a$61.7 billion loss, the biggest quarterly loss in history. The government already owns nearly 80 percent of the insurer’s holding company as a result of the earlier interventions, which included a $60 billion loan, a $40 billion purchase of preferred shares and $50 billion to soak up the company’s toxic assets. Floyd Norris calls AIG a "bottomless pit", and Joe Nocera the "rottonest financial institution"! Nocera says bailing out AIG is like "propping up a house of cards"!

Update 5
Economix examines the worst case scenarios of the US economy and the Obama administration predictions here and here.

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