Bailout May Be Granddaddy of All Carry Trades

There might be a gem in the Treasury's plan to buy $700 billion of dubious mortgage-related assets.

Call it the biggest carry trade in history. It might just put as much as $60 billion a year in the government's coffers.

All of the discussion of risk has focused on whether the government eventually could sell the assets it buys from financial institutions for more than they cost. In other words, whether the government -- and therefore taxpayers -- would incur a loss or a gain.

``I am very uneasy with the proposal to spend a trillion dollars to buy illiquid assets, toxic securities from large financial institutions, and have the taxpayers pay for that,'' Representative Spencer Bachus, the top Republican on the House Financial Services Committee, said on Sept. 23.

The government will get the $700 billion by selling a range of Treasury securities to the public with yields of 3 percent to 4 percent. With investors around the world clamoring to buy risk-free Treasuries, the market should be able to absorb the jump in supply without a significant increase in yields.

Contrast that with likely yields on the troubled assets for which there currently is no market. No one can be sure how big a haircut there will be on the assets Treasury buys, though if it's 50 percent or more, their yields should be 10 percent or higher.

That is, the government will be borrowing at 3 percent to 4 percent to buy assets yielding 10 percent or even 12 percent. Conservatively, that spread on an investment of $700 billion should generate income of $40 billion to $60 billion annually.

Wide Spreads

Obviously, there's no way to be sure of the income from this carry trade, lingo for borrowing at a rate lower than the return on an asset. We don't yet know exactly what assets the government will choose to buy, the price that will be paid or their yield.

We can be certain that the spread is going to be very wide. After all, many of the assets in question are linked to subprime mortgages one way or another, and those carry very high yields. But with real-estate values plunging, banks have recorded more than $523 billion in losses in such assets.

The income from the carry trade will make a big difference on the impact of the bailout on the federal budget. It might even help reduce deficits in coming years.

Peter Orszag, director of the Congressional Budget Office, told the House Budget Committee on Sept. 24 that the budget wouldn't reflect the $700 billion bailout plan. Instead, there would be an estimate of the net cost to the government.

Broadly speaking, Orszag said, the net cost would be ``the purchase price minus the expected value of any estimated future earnings from holding those assets and the proceeds from the eventual sale of them.''

Lower Deficits

That treatment, which Orszag said is similar to that of a broad array of loans and loan guarantees the government makes, is appropriate in this unprecedented purchase of earning assets. And given the positive carry, this very likely would mean lower deficits.

Do the arithmetic. Suppose the government buys $700 billion worth of assets after a 50 percent haircut, holds them for four years and then sells them for 40 percent of par. That would be a capital loss of $140 billion.

Meanwhile, the carry trade has earned perhaps $50 billion a year, or $200 billion over the four years -- an overall profit of $60 billion -- and lower budget deficits. Remember, there are no taxes affecting this deal.

Loss, Gain

You could make up other examples that would show a loss, or a very big gain. The point is that because of the carry trade, the risk to taxpayers is much less than you might think based on the congressional debate over the plan offered by Treasury Secretary Henry Paulson. Leaders of both political parties said yesterday they expect the bailout to be approved.

The legislative language agreed upon won't give Treasury $700 billion all at once. Only $250 billion would be available immediately, with Treasury drawing on the remainder if Congress doesn't object.

A bigger unknown is exactly what kind of auction the government would use to buy the assets. Federal Reserve Chairman Ben S. Bernanke told the Joint Economic Committee on Sept. 24 that the auction should be designed to attract the largest number of bidders to establish an acceptable price.

A key objective of the plan is to get that price established so that private holders of the assets can trade them freely once again. Of course, that process carries some risk for financial institutions owning the assets now.

If the new value established by the auctions turns out to be lower than the value at which an institution is carrying them on their books, then they would have to take a writedown. Even in that instance, at least some of the doubts plaguing institutions that have been trying to raise new capital would disappear.

And that's what the bailout, which really isn't a bailout anyway, is all about: Reducing doubt.

[Source: By John Berry, Bloomberg, London, 30Sep08]

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