MORGAN STANLEY RESEARCH
Morgan Stanley & Co.
Incorporated
Richard Berner
Co-Head of Global Economics
Richard.Berner@morganstanley.com
+1 (212) 761-3398
Jim Caron
Head of Global Interest Rate Strategy
Jim.Caron@morganstanley.com
+1 (212) 761-1905
September 22, 2008
Economics & Strategy
Global
The Plan to Fix the
Financial System
Will It Work, and How Will
Markets React?
Sophia Drossos
Head of Foreign Exchange Strategy
Sophia.Drossos@morganstanley.com
+1 (212) 761-2786
David Greenlaw
Chief US Fixed Income Economist
David.Greenlaw@morganstanley.com
+1 (212) 761-7157
Gregory Peters
Head of Fixed Income Strategy & Economics
Greg.Peters@morganstanley.com
+1 (212) 761-1488
A comprehensive approach: The Treasury’s plan
to stabilize the financial system and dramatic efforts
by the Fed to support money markets promise to
reduce sharply the downside ‘tail’ risks to the
economy, and likely will have significant implications
for investors, for the financial services industry and
for monetary policy.
Four elements: Key elements: Move troubled
assets from lenders’ balance sheets to the
Treasury’s; provide liquidity and an insurance
backstop to money-market funds; temporarily ban
selling financial shares short; and broaden eligible
collateral for and supply of liquidity.
Will it work? The plan has a good chance to work if
used aggressively. It can mitigate the adverse
feedback loop running from losses at leveraged
lenders to credit markets to the economy. It should
slow deleveraging, reduce risk premiums, and allow
capital raising.
Devil is in the details: At this writing, details that
matter are unclear: What are eligible assets,
institutions, nature of auctions to buy the assets, and
their pricing, and how will losses and future gains be
shared? Will Congress swiftly approve it? And what
will be the cost to the taxpayer?
Implications for monetary and fiscal policy: This
plan could take some of the burden off the Fed, but
downside economic risks still predominate. For now,
a flood of liquidity will depress the funds rate. The
plan will boost Treasury issuance dollar for dollar,
but budget accounting will limit Federal red ink.
(continued on following page)
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Please see additional important disclosures at the end of
this report.
MORGAN STANLEY RESEARCH
September 22, 2008
The Plan to Fix the Financial System
(Continued from previous page)
Implications for rates markets: The plan should
reduce risk premiums, and the reduction in systemic
risk should flatten yield curves and tighten TED
spreads. Liquidity premiums (Libor-OIS and swap
spreads) should fall, but they will likely linger until
confidence returns. MBS are the big winners.
Implications for credit and equities: By reducing risk
premiums and the downside ‘tail’ risks for the
economy, and creating balance sheet capacity for
lenders, the plan should alleviate the credit crunch,
narrow credit spreads, and promote expectations of
lower risks for and an eventual rebound in earnings.
Implications for the dollar: Crosscurrents will drive
FX markets. First, some of the flight-to-quality bid for
USD, CHF and JPY likely will be unwound.
Conversely, higher-yielding currencies such as BRL,
MXN may benefit. A reflationary policy coupled with
downside economic risks and a shaky global appetite
for dollar-denominated assets may be a short-term
negative for the dollar, but if the plan works, it would
boost confidence in the USD.
See additional important disclosures at the end of this report.
2
MORGAN STANLEY RESEARCH
September 22, 2008
The Plan to Fix the Financial System
The Plan to Fix the Financial System
Will It Work, and How Will Markets React?
Morgan Stanley acted as advisor to the United States Department of the Treasury in its announced restructuring of the Federal Home Loan
Mortgage Corporation ("Freddie Mac") and the Federal National Mortgage Association ("Fannie Mae").
Please refer to notes at the end of the report.
The Treasury’s sweeping new plan to stabilize the financial
system and dramatic efforts by the Fed to support money
markets promise to reduce sharply the downside ‘tail’ risks to
the economy, and likely will have significant implications for
investors, for financial institutions and for monetary policy. Of
course, there’s no guarantee that it will work: First, enabling
legislation must be quickly enacted, and authorities must use
their new powers aggressively to underpin markets and
restore confidence. Moreover, it won’t quickly reverse the
global economic slowdown that is now underway. But this
comprehensive plan looks like a game changer to us: It
makes more likely our expectations for economic recovery
within the next year and it means that investors should look
for opportunities in risky assets. Here’s why.
Four elements
The plan’s key elements are now widely known, but worth
emphasis:
•
First, and most controversial, the Treasury would be
empowered to buy and move up to $700 billion of
troubled mortgage-related assets from lenders’
balance sheets to the Treasury’s. Effectively,
taxpayers would provide a capital contribution to the
financial system.
•
Second, it provides a triple-barreled backstop for
money-market mutual funds by providing nonrecourse loans to depository institutions and bank
holding companies to finance purchases of assetbacked commercial paper from money funds, by
having the Fed buy agency discount notes, and by
using $50 billion from the Treasury’s Exchange
Stabilization Fund to finance a temporary insurance
plan for money funds.
•
Third, temporarily, the SEC has banned selling
financial shares short.
•
Finally, the Fed has moved to provide even more
liquidity: They broadened the list of eligible collateral
at the Primary Dealer Credit Facility and Term
Securities Lending Facility (TSLF); they increased
the frequency and size of TSLF auctions; and they
allowed banks to pass liquidity back and forth to
nonbank affiliates.
Will it work?
The plan has a good chance to work if used aggressively. It
addresses the root of the problem, namely an adverse
feedback loop running from losses at leveraged lenders to
reduced credit availability and higher credit costs, and then to
weakness in the economy that intensifies credit losses. By
segregating troubled from performing assets, the plan should
slow deleveraging, reduce risk premiums, including in the
counterparty system, and allow capital raising. In fact, in the
view of our trading desks, the Treasury only has to put a few
billion to work in money good markets to drive prices up
significantly. The plan could thus sharply reduce downside
‘tail’ risks in the economic outlook. The plan should also
gradually help stabilize money market funds. This $3.4 trillion
asset class suffered $170 billion in withdrawals last week as a
large fund that held paper issued by Lehman Brothers “broke
the buck” and redemptions accelerated. Indeed, these money
fund withdrawals were a clear catalyst for action, because
they had the potential to shut off short-term funding for all of
Corporate America virtually overnight and affect millions of
small investors.
However, there’s no question that the devil in this complex
plan lies in the details. And at this writing, details that matter
are unclear: What are eligible assets, institutions, nature of
auctions to buy the assets, and their pricing, and how will
losses and future gains be shared? Will Congress swiftly
approve it? What will be the cost to the taxpayer? Will
institutions be willing to provide the transparency necessary to
value the problem assets? And, might such transparency
indicate that the problem is even more severe than currently
believed? Even if the Treasury absorbs a lot of the problem
assets, will that be enough to unfreeze the interbank funding
markets, reduce counterparty risk aversion, and get banks to
start lending again?
See additional important disclosures at the end of this report.
3
MORGAN STANLEY RESEARCH
September 22, 2008
The Plan to Fix the Financial System
Regarding assets and institutions, the Treasury Secretary has
asked for considerable discretion that likely will err on the side
of supporting markets. The plan is aimed at “mortgagerelated” assets, but the Secretary would have discretion to
broaden the menu if needed. The plan is aimed at a broad
range of institutions with “significant presence” in the United
States, and the Secretary has latitude here as well.
Regarding price discovery, the Treasury may use direct
purchases, auctions and reverse auctions to acquire the
troubled assets. Here is how a reverse auction might work:
The Treasury would announce a reverse auction at a specific
date for collateral of a specific class, such as the tranches of
AAA subprime mortgages that make up the 06-1 ABX series.
Knowing what the collateral is will reduce the uncertainty
surrounding the Treasury’s backstop bid. Private bidders may
come into the auction process to buy the distressed collateral
or the Treasury may just own it at a good price. With the
Treasury supporting the price, markets will become more
liquid and the product should start to move.
Will $700 billion be enough? We think so. The recentlyapproved plan to put the housing GSEs into conservatorship
backstops about half of residential mortgage debt
outstanding, leaving about $5.6 trillion to be backstopped by
the $700 billion of Treasury buying power, equal to 12.6% of
that total. If troubled assets are defined as those delinquent,
with delinquency rates at commercial banks amounting to 56% of mortgage assets they hold, $700 billion would seem to
allow an ample cushion to absorb further losses.
Why now?
The piecemeal approach adopted since the crisis surfaced
with full force in August 2007 wasn’t working, because it
addressed symptoms evident at individual institutions or in
specific markets rather than the underlying problem. As a
result, losses continued to erode levered lenders’ capital
base, promoting a contraction in credit. Efforts to raise capital
or the expectation of them diluted shareholders. With no
backstop for the counterparty system and no sellers of
protection, investors were encouraged to buy protection
against and short the equities of financial institutions. The
piecemeal approach created uncertainty about which
institutions would survive. And the unanticipated collateral
damage from the case-by-case approach triggered a run on
money-market funds in particular and on the financial system
in general.
Indeed, the unprecedented volatility and destruction in the
credit markets during the past week served as a catalyst for
the policy change, in our view. What was underappreciated at
the time of the Lehman bankruptcy was the impact on the
counterparty system, the unsecured bondholder, and money
market investors. Unlike during the Bear Stearns event,
bondholders were decimated, creating a shock wave across
money market funds, pension funds, and the entire “buy-side”
community. For example, with $165 billion of total unsecured
debt, the Lehman bankruptcy created an instant loss of about
$120 billion that destabilized the credit system. This, coupled
with the first failure of a major counterparty in the modern
derivative world, was just too much for the system to handle.
Lessons from history
Are there lessons from past financial crises that are relevant
to this one and the policy response it has spawned? This
plan has elements from past efforts to fix financial crises, but
it differs from all of them in important respects. It has some
similarities with the US Resolution Trust Corporation (RTC),
set up in 1989 to “resolve” or dispose of troubled real estate
assets held by failed institutions in the US savings and loan
crisis of the 1980s and early 1990s. Rather than dump the
assets into a very weak market, the RTC was established to
dispose of the assets in a way that would minimize the losses
borne by the taxpayer.
Today, the bad assets will have to be identified, a system will
have to be established to value them, and the Treasury must
decide how much to spend to acquire them. It’s actually a far
more complicated set of issues than the RTC faced. Like the
RTC, however, this plan is aimed at ring-fencing and
discovering the prices of distressed assets so they don’t
weigh on the financial system, with the Treasury in this case
financing or providing capital for the “bad bank.” Key lessons:
The RTC worked because it was comprehensive and big, and
both equity participation and block sales gave investors
incentives to buy the distressed assets.
The plan is unlike the Reconstruction Finance Corporation
(RFC) set up in 1932 to provide loans to banks and nonbank
companies. But a lesson from the RFC is that alternative
channels for intermediation while the financial system is
dysfunctional are essential, and the enhanced liquidity
features of the current plan and the conservatorship for the
housing GSEs do just that. Similarly, the lessons of the
Swedish banking crisis in the early 1990s that apply to today
are: 1. Maintain liquidity in the banking system and prevent it
from collapsing. 2. Handle banking sector problems promptly
and transparently. 3. Avoid a widespread failure of banks and
foster macroeconomic stabilization (see Laurence Mutkin’s
recounting of then Riksbank Governor Bäckstrom’s
reflections, “A Silver Lining…and If All Else Fails, September
18, 2008).
See additional important disclosures at the end of this report.
4
MORGAN STANLEY RESEARCH
September 22, 2008
The Plan to Fix the Financial System
Implications for monetary and fiscal policy
If this plan works, it will take some of the burden off monetary
policy to help financial markets and institutions and cushion
the economic fallout. Put simply, if the plan succeeds in
easing financial conditions, then to some extent it serves as a
substitute for an easier monetary policy. But that won’t have
immediate implications for the Fed; after all, downside risks to
the economy still predominate. Money markets are still
dislocated and the Fed will continue to flood the banking and
financial system with liquidity that should depress the funds
rate below its 2% target. The plan will boost Treasury
financing needs and issuance dollar for dollar, as officials
issue debt to buy troubled assets. But budget accounting,
which will “score” the program as a loan, will limit the impact
on Federal red ink represented by the budget deficit.
determine the value of assets. Whatever can't be funded or is
expensive to fund will underperform.
As noted above, recent developments suggest that Fed policy
might also remain neutral for the foreseeable future and thus
contribute to a decline and stabilization in front-end volatility,
which had risen dramatically. Furthermore, the reverse
auction process that may be used in the Treasury’s new plan
will act to provide much needed price discovery for distressed
mortgage assets. This will greatly reduce volatility and inject
stability into the markets as well. But the inflationary impact of
all these liquidity facilities and the Treasury’s $700 billion plan
is not lost on us. Greater uncertainty in the rates market will
be transferred to back-end rates. As a result, we expect
volatility on longer tenors to remain well bid relative to shorter
tenors and term premiums to remain high.
Market Implications
Implications for equities and credit
The crisis began with the credit markets, and we believe it will
end with a credit market solution. Likewise, assessing
progress toward stabilization in the credit markets holds the
key to how the markets and economy behave in the near
future. Before going to the risky assets, however, we first
consider funding and rates markets, which are bellwethers for
the stress on underlying assets.
The plan, if well executed, should be positive for risky assets:
By reducing risk premiums and the downside ‘tail’ risks for the
economy, and creating balance sheet capacity for lenders, it
should alleviate the credit crunch, narrow credit spreads, and
promote expectations of lower risks for and an eventual
rebound in earnings. Indeed, our US equity strategy team
has upgraded equities to a buy (see “Fear is the Key —
Buying Equities Now,” September 19, 2008).
Implications for rates markets
The plan should reduce risk premiums in two steps. First, the
reduction in systemic risk should flatten yield curves and
tighten TED spreads (the spread between 3-month Libor and
3-month T-Bills). Next, liquidity premiums should fall (LiborOIS and swap spreads are expected to narrow). But liquidity
risk premiums will likely linger until confidence returns. This
equates to a slow but steady strengthening in the funding and
Libor markets that is expected to have a positive impact on
asset prices.
Mortgage-backed securities are the big winners. Spreads are
gapping tighter and may trade significantly through Libor as
the Treasury will be a buyer, and backstop liquidity facilities
exist to protect the value of that asset by providing funding
and balance sheet capacity. Private label mortgage securities
should also benefit for similar reasons. Volatility should settle
down and the curve may come under flattening pressure —
though measured by the spread from 2- to 10-year notes, it
may not fall much below 140 bp. Front-end swap spreads
should also narrow as Treasury supply increases. It’s worth
noting that these developments perfectly fit our ReNormalization thesis, which states that funding costs will
What does the plan mean for credit markets? The speed and
scope of the proposed policy actions is staggering. Given the
deeply oversold conditions in credit markets, we think the plan
will drive a sustained rebound in confidence and thus a
reduction in spreads.
This is not to say that implementation of this plan will mark the
end of the downturn in the credit cycle; cyclical forces are still
working through the macro environment. We note that the
original RTC was approved in August 1989, and the peak in
default or credit spreads only occurred in 1991. But the
reduction of systemic risk should allow for a renormalization of
“beta,” which will allow for a more rational risk measurement
and management process than we have been experiencing.
From that perspective alone, the Treasury proposal is crucial
to the credit and risk-taking repair process.
Our recommendations are grounded in the belief that the
proposal will have dramatic consequences for the credit
markets and help to renormalize beta. Notwithstanding the
benefits of this plan, we still believe that the US and global
economies face severe challenges over the next year (see
“The Slowdown Goes Global,” September 17, 2008). As
such, we strongly prefer high-quality assets and investmentgrade debt. While high yield will likely see a near-term price
See additional important disclosures at the end of this report.
5
MORGAN STANLEY RESEARCH
September 22, 2008
The Plan to Fix the Financial System
pop as risk seeking comes back in vogue, we believe that the
economic uncertainties will ultimately weigh on the more
levered high-yield market. Moreover, we believe that US
credit will outperform non-US credit as a result of this
proposal. US financials will also benefit, particularly those
institutions that have more appropriate marks on their problem
assets. It is important to keep in mind that differentiation
matters, as thinly capitalized institutions with a high
percentage of poorly marked assets likely will not benefit from
this plan. Last, we believe this plan is bullish for ABX 06-1
and 06-2 AAAs as well as CMBX; indeed, some of that is
evident in the recent price action.
Implications for the dollar
Several crosscurrents will drive FX markets. Initially, the plan
should help narrow risk premiums, which will likely promote a
reversal in the flight-to-quality bid for USD, CHF and JPY.
Conversely, higher-yielding currencies of economies that
have not yet seen a major domestic slow down — such as
BRL, MXN — will benefit. Despite this potential knee-jerk
reaction, we continue to maintain a cautious outlook on EM
currencies as the turn in the global growth cycle will pose
increasing risks for these economies going forward.
The USD may see additional headwinds in the near term as
investors digest the reflationary aspects of the policy, coupled
with downside economic risks and shaky global risk appetite.
But if the plan works, it would boost confidence in the USD in
the longer term. Our bottom line is that the USD should come
under pressure in the near term, but with policymakers laying
the groundwork for recovery, the USD may be set to resume
its rally into 2009.
See additional important disclosures at the end of this report.
6
MORGAN STANLEY RESEARCH
September 22, 2008
The Plan to Fix the Financial System
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MORGAN STANLEY RESEARCH
September 22, 2008
The Plan to Fix the Financial System
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MORGAN STANLEY RESEARCH
September 22, 2008
The Plan to Fix the Financial System
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MORGAN STANLEY RESEARCH
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