USA: Deal Struck but Uncertainty Has Risen

Overview: Following more than a week of intense discussions between the Democrats and Republicans over the initial bail-out plan put forward by Treasury Secretary Paulson last Sunday, a compromise was finally reached this weekend (see details below). The main part of the proposal is intact – the Treasury will set up a fund to buy troubled assets from financial institutions and it will have 45 days to set up guidelines for the implementation of such purchases. The House of Representatives may consider the proposal today and the Senate could vote by October 1. Although highly likely, it is not certain that the proposal will pass in its current form.

There are, however, some new issues that were not included in the initial proposal. The most important in our view are the following. First, the proposal of government insurance for troubled assets, which will help to take out uncertainty in markets relating to the risk of further writedowns. Second, that if after five years the TARF has a net loss, the president will be required to propose legislation that seek reimbursement from participating financial institutions. That means that the risk related to the troubled assets is only removed temporarily from banks balance sheets. While the programme buys the banks important time to recover before bearing a possible loss the amendment to the initial proposal nevertheless adds uncertainty over the "real" value of the financial institutions participating in the programme.

Assessment and outlook: Markets have not taken the news of a compromise proposal with much relief so far. The financial crisis hit Europe hard over the weekend with a series of government bailouts, which is likely to be an important factor keeping sentiment subdued (see details below). The events over the weekend clearly underline that the fallout from the financial crisis is global and it is now hitting Euroland hard. In the current market environment it is not difficult to imagine further victims in Euroland of the financial crisis going forward.

Fundamentally, the proposal should remove uncertainty over future bankruptcies among the big players and decrease systemic risk substantially. Banks are still going to see more losses related to consumer loans and company loans as the US economy weakens further in the coming quarters. But by removing the uncertainty over further writedowns on mortgage assets Treasury has gone to the core of the problem in the financial crisis instead of only treating the symptoms. This should buy the financial sector important time to raise the required capital and deleverage in an orderly fashion avoiding a major credit crunch for consumers and cooperates.

However, uncertainty has increased in the past week. The strains in money markets have reached unprecedented levels and the risk is that investors and market participants have lost faith that the medicine will work. The current crisis has evolved into a confidence crisis which could become self-fulfilling. Market participants are reluctant to engage in transactions with each other because of heightened counterparty risk and fear that they could be the next in line to experience a "bank run" and therefore need all the liquidity they can get themselves. The risk is that the crisis has now evolved so far that the bail-out plan is only just enough to maintain the status quo, but is not enough to restore confidence and trust in markets.

To grasp whether the proposal succeeds in restoring some confidence in markets we would first and foremost watch developments in the US money market and financial equities in the US. While we do expect any improvement to be gradual, as it takes time to rebuild confidence, we would need to see some progress in US money markets relatively quickly, that is within the coming days and weeks. If the proposal is not enough to ease strains in US money markets in the coming weeks, the risk that the current crisis will result in a severe credit crunch for consumers and cooperates has definitely increased.

Details of the proposed compromise:

• Scale of the TARP: The bill authorises up to USD700bn for the Troubled Assets Relief Program which will be paid in instalments. The Treasury will get USD250bn for the TARP right away with an additional USD100bn immediately accessible. Congress would have the option of blocking the final instalment of USD350bn by issuing a joint resolution within 15 days of any request.
• The implementation: The proposed legislation leaves the Treasury 45 days to set up the guidelines for methods for pricing and valuing troubled assets, the mechanism for purchasing troubles assets, procedures for selecting asset managers and criteria for identifying troubles assets for purchase. The assets must be bought at "the lowest price that the Secretary of the Treasury determines to be consistent with the purposes of this Act" either through auctions, reverse auctions or direct from institutions. The Treasury expects to start buying the simplest assets first followed by more complex securities.
• Timing: The House of Representatives may consider the proposal today and the Senate will vote by October 1. It is not yet certain that the proposal will pass through Congress in its current form. Dependent on the time it will take the Treasury to come up with the guidelines it would at the max take 45 days before the TARF can start purchasing assets.
• Protecting taxpayers: The Treasury will receive warrants in the companies that participate in the programme. If a financial institution sells its assets trough an auction the Treasury will get a nominal amount of non-voting warrants. If the Treasury buys assets directly it could get a majority equity stake or debt position. In addition, if after a five-year period, the TARF has a net loss on its purchased assets, the president is required to submit a legislative proposal to seek reimbursement from the financial institutions that participated in the programme.
• Oversight: A bipartisan congressional commission will receive reports from the Treasury every 30 days. The programme will also be overseen by a board compromising the heads of the Treasury, the Federal Reserve, the Securities & Exchange Commission, the Housing and Urban Development Department and the Federal Housing Finance Agency.
• Executive compensation: In the case were the TARP has bought assets directly from a financial institution, no "golden parachute" exit payments must be made as long as the Treasury holds an ownership stake in the firm. Financial institutions that sell assets using a pricing method such as auctions will be subject to limits on senior executive compensation as well.
• Helping homeowners: The legislation requires the Treasury to the extent that it holds, owns or controls mortgages, MBS and other assets secured by residential real estate to implement a plan that seeks to maximise assistance for homeowners and use its authority to encourage the servicers of the underlying mortgages, considering the net present value to the taxpayer, to take advantage of the HOPE programme to minimise foreclosures. In the case of a residential mortgage loan, modifications may include reduction in interest rates, reduction of loan principal and other similar modifications.'
• Government Insurance: The bill requires the Treasury to establish a programme to guarantee troubles assets originated or issued prior to March 14, 2008, including mortgage-backed securities. Financial institutions that want to participate would pay a fee to the Treasury which would depend on the credit risk associated with the particular asset, the exact methodology for setting the fee and the class of assets that can participate in the programme will be published by the Treasury.
• Help to community banks: The legislation takes steps to let some 800 community banks that held preferred stock in Fannie Mae and Freddie Mac before the institutions were taken over by the government to make better use of tax deductions for the losses they took.
• The Fed: The parties agreed to move forward a legislation that allows the Federal Reserve to pay interest on the reserves banks hold at their accounts at the Fed. This would mean that a floor for overnight interest rate has effectively been set.

Details on events in Europe over the weekend:

The Dutch-Belgian bank Fortis has been rescued by the governments of Belgium, Luxembourg and the Netherlands. Fortis is in retail banking and insurance in the Benelux countries and has been hit by a crisis of confidence making it impossible to raise the badly-needed liquidity. Only last year Fortis was part in the consortium that took over ABN Amro along with Royal Bank of Scotland and Banco Santander. Fortis has had large losses on its structured credit portfolio and has been trying to sell most of its ABN Amro holdings.

In the UK troubled mortgage lender Bradford & Bingley is latest victim of the financial crisis. Spanish banking giant Santander is buying the branches while the troubled mortgage book has been taken over by the UK government. The move came after failing to find a private buyer of the mortgage part of Bradford & Bingley. This is the second government bailout of a mortgage lender following Northern Rock earlier this year. This is another result of the downturn in the UK housing market combined with lacking credit policies.

German Hypo Real Estate has been bailed out by the German government and a group of private banks which has offered a credit line of 35bn. Hypo Real stated that they faced "extremely challenging conditions on the international money markets". Hypo Real had already announced heavy losses on US subprime related investments earlier. The recent trouble comes from funding needs in its Irish unit of Depfa Bank. Depfa Bank offers public sector financing and was taken over by Hypo Real last year.

Danske Bank
http://www.danskebank.com/danskeresearch

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