Guest Post: Hedge Fund Socialism?

Submitted by Leo Kolivakis, publisher of Pension Pulse.

Wall Street got the news it wanted on the economy’s biggest problems — banks and housing — and celebrated by hurtling the Dow Jones industrials up nearly 500 points:

Investors added rocket fuel Monday to a two-week-old advance, cheering the government’s plan to help banks remove bad assets from their books and also welcoming a report showing a surprising increase in home sales. Major stock indicators surged about 7 percent, including the Dow, which had its biggest percentage gain since October.

Analysts who have seen the market’s recent false starts are still hesitant to say Wall Street is indeed recovering from the collapse that began last fall. But the day’s banking and housing news bolstered the growing belief that the economy is starting to heal, and that is what had investors buying.

“It’s just hard to argue that there isn’t an improvement in economic activity on the horizon,” said Jim Dunigan, executive vice president at PNC Wealth Management.

The market began turning around two weeks ago on news that Citigroup Inc. was operating at a profit in January and February. A spate of more upbeat economic reports helped the market build on its gains, although the rally stalled last Thursday and Friday.

Analysts said they saw more fundamental strength in Monday’s buying than they saw at the start of the rally. Dave Rovelli, managing director of trading at brokerage Canaccord Adams, said there appeared to be less short covering, which occurs when traders are forced to buy to cover misplaced bets that stocks would fall. Short covering contributed to the market’s surge after the Citigroup news.

“There is definitely new buying,” he said. Rovelli also said the approaching end of the quarter can make money managers eager to buy into a market to make the statements they send to clients look stronger.

Stocks shot higher at the opening and kept going. The Treasury Department said its bad asset cleanup program would tap money from the government’s $700 billion financial rescue fund and involve help from the Federal Reserve, the Federal Deposit Insurance Corp. and the participation of private investors.

The market had been waiting for weeks to hear details of the government’s plan for helping banks get rid of bad assets. Treasury Secretary Timothy Geithner announced an outline of the program last month but provided few details then about how it would work, leading to a stock plunge that sliced 380 points from the Dow.

But while analysts were pleased with the market’s performance Monday, they were also still cautious; Wall Street more than gave back its big yearend rally and continued falling during January and February.

Subodh Kumar, an independent investment strategist in Toronto, said the Fed’s announcement that it would buy government debt and the details on plans to help banks are giving traders hope for recovery.

“The market is shedding some of its excess pessimism. That doesn’t mean the market goes straight up,” he said.

The National Association of Realtors’ existing home sales report was overwhelmingly positive for investors although it showed a decline in home prices in February.

Investors are embracing any sign that a glut in homes for sale may be easing. Monday’s data followed a dose of good housing news last week as housing starts for February came in much better than expected.

The Dow rose 497.48, or 6.8 percent, to 7,775.86, its highest finish since Feb. 13. It was the biggest point gain for the blue chips since Nov. 13 when they rose 552 points and the biggest percentage gain since Oct. 28, when they rose 10.9 percent. It was the fifth-biggest point gain in the Dow’s history.

Broader stock indicators also surged. The Standard & Poor’s 500 index rose 54.38, or 7.1 percent, to 822.92, crossing the psychological milepost of 800. The Nasdaq composite index rose 98.50, or 6.8 percent, to 1,555.77.

The Russell 2000 index of smaller companies rose 33.61, or 8.4 percent, to 433.72.

The Dow Jones Wilshire 5000 index, which reflects nearly all stocks traded in America, jumped 7 percent. That’s a paper gain of about $700 billion.

More than 10 stocks rose for every one that fell on the New York Stock Exchange, where consolidated volume came to nearly 7.5 billion shares, about even with Friday’s pace.

The Dow is now up 1,228 points, or 18.8 percent, from March 9, when it finished at its lowest point in nearly 12 years, although it’s still down 1,000 points in 2009. The S&P 500 is up 21.6 percent in that time.

The Dow and the S&P 500 index remain more than 45 percent below their peak in October 2007.

So what should you make out of this rally? It basically confirms that the big banks were waiting for Treasury Secretary Geithner’s plan to shore up their balance sheets. Citigroup (C), Bank of America (BAC), Wells fargo (WFC), JP Morgan (JPM) and Goldman Sachs (GS) were all up big today.

Hedge funds and prop traders who wanted more “juice” were out buying the Direxion Financial Bull 3X Shares (FAS), up a whopping 41% today as the financial orgy gripped Wall Street.

Why shouldn’t the Masters of the Universe party? Geithner’s new plan needs hedge fund and private equity backing:

President Barack Obama and Treasury Secretary Timothy Geithner today unveiled an ambitious plan for a public-private partnership to buy up the toxic assets that have caused bank lending to grind to a halt. But the hedge funds and private equity firms needed to make the Public Private Investment Program work are expressing misgivings amidst Congressional action to restrict bonuses at companies receiving bailout money.

Geithner’s plan would use up to $100 billion in bailout money to back private investors that buy some of the hundreds of billions of dollars of illiquid assets and loans that have thus far proven resistant to a solution.

“Our judgment is that the best way to get through this is if we can work with the markets,” Geithner told The Wall Street Journal. “We don’t want the government to assume all the risk. We want the private sector to work with us.”

Some alternative investment executives were briefed on Geithner’s plan yesterday. They expressed their concern, not about PIPP, but about the American International Group bonus outcry, and legislation that would tax at a 90% rate any bonuses handed out by firms receiving more than $5 billion in government bailout money.

According to The New York Times, those executives said they would only participate in PIPP if Treasury sets no compensation limits. The Journal says Geithner agrees that they should not be subject to the terms of the AIG legislation, should it pass the Senate and receive the president’s assent.

Now that they are not subject to compensation limits, they can focus on scamming the TALF:

Today’s new public-private partnership bailout scheme is very similar to the TALF, the Fed program that will let hedge funds lever up their purchases of distressed assets. It’s the same deal: The banks get to dump “toxic” assets, the hedge funds set a price, and taxpayers get their money back if anyone makes a profit.

But it looks like the TALF could easily be scammed, resulting in huge losses for the taxpayer.

Zero Hedge explains the process.

1. First the hedge fund buys an asset with a face value of $100 for $80. The hedge fund puts up $2.40, while the Fed contributes the rest, $77.60. Huge leverage.
2. The next day, the hedge fund re-runs the model and realizes that they overpaid the bank. Turns out, it was only worth $20 — which was where the market had been, sans-government leverage.
3. The hedge fund loses it entire $2.40, and the taxpayer loses its entire $77.60.
4. BUT! The bank buys the asset back from the hedge fund at $20, while paying it a $5 million fee for its trouble.
5. The upshot: The banks sells high, buys low. The hedge fund collects a fee for holding the asset. And the taxpayer is screwed.

Good deal, eh!?

It’s a great deal for everyone but the chumps footing the bill. And some very smart people are not convinced this plan will succeed.

Nobel-prize winning economist Paul Krugman said in remarks published on Monday that the latest U.S. Treasury bailout program is nearly certain to fail, triggering a sense of personal despair:

U.S. Treasury Secretary Timothy Geithner on Monday unveiled a plan aimed at persuading private investors to help rid banks up to $1 trillion in toxic assets that that are seen as a roadblock to economic recovery.

“This is more than disappointing,” Krugman wrote in The New York Times. “”In fact it fills me with a sense of despair.”

“The Geithner scheme would offer a one-way bet: if asset values go up, the investors profit, but if they go down, the investors can walk away from their debt,” the Princeton University economist said, citing weekend reports outlining the plan.

“This isn’t really about letting markets work. It’s just an indirect, disguised way to subsidize purchases of bad assets,” he added.

Krugman called it a recycled idea of former Treasury Secretary Henry Paulson, who later abandoned the “cash for trash” proposal.

“But the real problem with this plan is that it won’t work,” he says, adding that bad loans may be undervalued because there is too much fear in the current climate.

“But the fact is that financial executives literally bet their banks on the belief that there was no housing bubble, and the related belief that unprecedented levels of household debt were no problem. They lost that bet. And no amount of financial hocus-pocus — for that is what the Geithner plan amounts to — will change that fact,” Krugman wrote.

While the real economy is being hurt by the meltdown of the financial system itself, Krugman says this is not the first or the last time this has happened. And there are lots of roadmaps to get us out.

“It goes like this: the government secures confidence in the system by guaranteeing many (though not necessarily all) bank debts. At the same time, it takes temporary control of truly insolvent banks, in order to clean up their books,” Krugman said.

Time is running out on the Obama administration to take control of the banks – and the crisis.

“If this plan fails – as it almost surely will – it’s unlikely that he’ll be able to persuade Congress to come up with more funds to do what he should have done in the first place,” he wrote.

The White House strongly disagreed with Krugman’s assessment, defending the administration plans on the morning talk shows.

“I think Paul’s just wrong on this one,” Christina Romer, head of the White House Council of Economic Advisers, said on ABC’s “Good Morning America” show just ahead of the plan’s release.

“This is really tails both the government and the private sector win, heads both the government and the private sector lose. We both are going to have, as the saying goes, skin in the game.”

Those same thoughts were expressed by James Galbraith who called Geither’s plan “extremely dangerous”:

In short, because the plan is yet another massive, ineffective gift to banks and Wall Street. Taxpayers, of course, will take the hit Why does Tim Geithner keep repackaging the same trash-asset-removal plan that he has been trying to get approved since last fall?

In our opinion, because Tim Geithner formed his view of this crisis last fall, while sitting across the table from his constituents at the New York Fed: The CEOs of the big Wall Street firms. He views the crisis the same way Wall Street does–as a temporary liquidity problem–and his plans to fix it are designed with the best interests of Wall Street in mind.

If Geithner’s plan to fix the banks would also fix the economy, this would be tolerable. But no smart economist we know of thinks that it will.

We think Geithner is suffering from five fundamental misconceptions about what is wrong with the economy. Here they are:

The trouble with the economy is that the banks aren’t lending. The reality: The economy is in trouble because American consumers and businesses took on way too much debt and are now collapsing under the weight of it. As consumers retrench, companies that sell to them are retrenching, thus exacerbating the problem. The banks, meanwhile, are lending. They just aren’t lending as much as they used to. Also the shadow banking system (securitization markets), which actually provided more funding to the economy than the banks, has collapsed.

The banks aren’t lending because their balance sheets are loaded with “bad assets” that the market has temporarily mispriced. The reality: The banks aren’t lending (much) because they have decided to stop making loans to people and companies who can’t pay them back. And because the banks are scared that future writedowns on their old loans will lead to future losses that will wipe out their equity.

Bad assets are “bad” because the market doesn’t understand how much they are really worth. The reality: The bad assets are bad because they are worth less than the banks say they are. House prices have dropped by nearly 30% nationwide. That has created something in the neighborhood of $5+ trillion of losses in residential real estate alone (off a peak market value of housing about $20+ trillion). The banks don’t want to take their share of those losses because doing so will wipe them out. So they, and Geithner, are doing everything they can to pawn the losses off on the taxpayer.

Once we get the “bad assets” off bank balance sheets, the banks will start lending again. The reality: The banks will remain cautious about lending, because the housing market and economy are still deteriorating. So they’ll sit there and say they are lending while waiting for the economy to bottom.

Once the banks start lending, the economy will recover. The reality: American consumers still have debt coming out of their ears, and they’ll be working it off for years. House prices are still falling. Retirement savings have been crushed. Americans need to increase their savings rate from today’s 5% (a vast improvement from the 0% rate of two years ago) to the 10% long-term average. Consumers don’t have room to take on more debt, even if the banks are willing to give it to them.

Importantly, Galbraith thinks the plan is flawed because it does not deal with the collateral of the borrowers. “Banks will sit there and they will not come back and start a new credit expansion”.

“Furthermore, the structural problem of banking system will remain which is that the financial system as a whole is much too large relative to the economy, so the shrinking of the financial system which has to occur to restore its health will not have occured.”

For those who think there is no alternative to the public-private investment fund, professor Galbraith says that is “hogwash”:

Aside from being legally proscribed, the upside of FDIC receivership is the banks are restructured and reorganized for potential sale (either in whole or parts), Galbraith says. Such was the fate in 2008 of, most notably, Washington Mutual and IndyMac.

Crucially, FDIC receivership also means new management teams for insolvent banks; and Galbraith notes new leaders will have no incentive to cover up the fraudulent or predatory lending practices of their predecessors. Given the entire system was “massively corrupted by the subprime debacle,” the professor believes criminal prosecutions on par with the aftermath of the S&L crisis – when hundreds of insiders went to jail – is a likely (and necessary) outcome of the current crisis.

But don’t expect to see many “perp walks” if Geithner’s current plan comes to fruition. That’s one reason Galbraith called the plan “extremely dangerous” in part one of our interview.

So why isn’t the Obama administration pushing for FDIC receivership? “Political influence of big banks,” the economist says.

One person who enthusiastically supports the new public-private plan is Bill Gross of PIMCO. Mr. Gross was on the Nightly Business Report on Monday calling it a “win- win-win” and stating that the plan will allow buyers and sellers of toxic assets to meet find common pricing levels:

GHARIB: Another prickly area is pricing. The banks are going to want to sell these assets as, at as high a price as possible and the private investors are going to want to buy them at a low a price as possible. So there is a big gap. Could that pricing issue derail the plan?

GROSS: I think it’s still a problem. We’re just going to have to find out, probably in 30 to 60 days when all of this comes together. I mean the banks up until this point for a typical loan have wanted $0.70 or higher, the private market in terms of buyers have wanted $0.40 or lower and that a huge gap. What this financing does though, this leverage, this availability of money at 1 to 1 1/2 percent financing, in other words, the ability to borrow money at a cheap rate, what that does is make it possible for the 40 percent price to move up to $0.60 or $0.65 and still be on a comparable basis. So buyers and sellers have moved much closer together based upon this particular plan.

GHARIB: All right so if the buyers and sellers finally can work something out, how soon do you think that this could get the credit flowing in the economy?

GROSS: Well, it will take some time. You know, I mentioned it will take 30 to 60 days to implement or to begin to implement this particular plan. And then once the toxic waste so to speak is cleared off the balance sheets if it is, then you know, the new lending will begin and that will take six to 12 months. So this not a situation by any means where the U.S. economy or the global economy is out of the woods. We expect further deterioration in terms of unemployment, further deterioration in terms of economic growth but this is a major step to cushion that process.

GHARIB: But today President Obama was saying that he sees glimmers of hope in the economy and last week we also got some very optimistic comments from Fed chief Ben Bernanke. Are you beginning to see a turn at all in the economy?

GROSS: Not yet. You know, I think that’s still six to 12 months out and I think ultimately Susie that when the economy does turn, that those that are expecting it to turn and to move back up to normal levels, to levels of growth of 3 to 4 percent, unemployment rates back to 4 1/2 to 5 percent, that they are sadly mistaken. We are moving to what we call a new normal which reflects a very subdued level of economic growth and a very subdued rate basically of growth for economic assets and financial assets.

GHARIB: Just have a little time left and I hate to leave it on a down note. But worst-case scenario, what if this Treasury plan doesn’t work? What does that mean for the economy and for reviving the financial system?

GROSS: Well, if it doesn’t work, it means that the basically the $5 trillion hole that Pimco estimates that the U.S. economy has to fill back in, that the Fed, the Treasury, that the fiscal stimulation plan in terms of the budget deficit has to fill in, it means that that would be a tremendous, tremendous effort going forward. Basically this program has to work.

Late tonight, Charlie Rose invited Andrew Ross Sorkin, Joe Nocera and Paul Krugman to discuss the public-private plan (click here to view this interview but it might not be available until tomorrow on the website).

Joe Nocera stated that you can’t use the stock market as a barometer of the financial system’s health because it too volatile. He said the credit markets hardly flinched on Monday (read this Bloomberg article on bank bond spreads). He was also concerned about the populist backlash, saying it could be profoundly “destabilizing”.

Andrew Ross Sorkin mentioned his New York Times article, If Goldman Returns Aid, Will Others?, where he states that Goldman is planning to give back its TARP money soon. On Charlie Rose, he agreed with Joe Nocera’s concerns about the populist backlash because it could engender a “domino effect” where weaker banks also want to return TARP funds.

I quote from the article:

It remains possible that Treasury could try to persuade Goldman to hold off on paying the money back until the economy stabilizes. That could stir up a new flavor of public outrage.

For his part, Krugman once again made the most sense, stating that the plan is ensuring another Japanese-style lost decade of “zombie banks”. He went over the Geithner plan arithmetic and he said that it’s basically trying to “bribe” private funds into buying these assets using government subsidies.

Krugman thinks we need to adopt the Swedish model and bring back the Resolution Trust solution that was used to work through the S&L crisis. He said that he finds it ironic when people say “we are not like the Japanese because we moved faster”. In his eyes, we are only prolonging the agony. I couldn’t agree more.

Finally, I leave you with this Harper’s Magazine article by Ken Silverstein, Hedge Fund Socialism:

There’s already much debate about the merits of the administration’s plan to clean up toxic assets, but one person I spoke with—a well-connected Democrat representing a big investment firm — was absolutely crystal-eyed about the fundamentals:

Even as details are being worked out, he saw ample opportunities for his firm to make huge profits. Banks, hedge funds and other investors that take part in the plan cannot lose money, thanks to the government’s support and guarantees. Taxpayers, he said with a mix of regret and satisfaction, were getting shafted again.

Paul Krugman has it just right:

For the private investors, this is an open invitation to play heads I win, tails the taxpayers lose. So sure, these investors will be ready to pay high prices for toxic waste. After all, the stuff might be worth something; and if it isn’t, that’s someone else’s problem.

Incidentally, try to imagine if the Bush Administration had floated this plan. Is there anyone from the liberal blogosphere who wouldn’t be denouncing this as a Wall Street giveaway? Particularly given the architects of the Obama administration’s plan? As Frank Rich wrote:

“Given that Summers worked for a secretive hedge fund, D. E. Shaw, after he was pushed out of Harvard’s presidency at the bubble’s height, you have to wonder how he can now sell the administration’s plan for buying up toxic assets with the help of hedge funds. It will look like another giveaway to his own insiders’ club. As for Geithner, people might take him more seriously if he gave a credible account of why, while at the New York Fed, he and the Goldman alumnus Hank Paulson let Lehman Brothers fail but saved the Goldman-trading ally A.I.G.

I want you to think about something else. Who funds hedge funds and private equity funds? Pension funds, insurance companies, endowment funds, and some banks.

I find it perverse that pension funds will pay 2% management fee and 20% performance fee to some hedge fund or P.E. fund that will then get a government subsidy to buy these assets at 30 or 40 cents on the dollar hoping to sell them to a greater fool at a higher price.

I got a better idea (call it the ‘Kolivakis Pension Plan’). Why don’t the world’s largest pension funds band together to create a “Pension Resolution Trust” taking these assets off the banks’ books and then selling them off slowly over many years as the global economy eventually recovers?

Why pay fees to hedge funds, private equity funds or the PIMCOs of this world when you can band together and use your financial clout and deep pockets to make money by directly taking ownership of these assets?

Admittedly, this will require some serious planning, some changes in individual investment policies and some resources to make it work, but it can also help pensions deal with their deficits while they help the credit system get going again.

I think it’s time we start thinking “outside the box” and start implementing some long-term solutions to deal with a virulent financial crisis that threatens global peace and prosperity.