Paulson abandons TARP asset purchase and risky assets plummets

If you are wondering why the stock market has been declining, you only need to flip your TV to C-SPAN and see Hank Paulson explaining why he has abandoned his original plan to save America from depression.  Basically, Paulson has done a complete 180 and now refuses to invest a dime of the TARP (Troubled Asset Relief Program) in buying the troubled assets for which the program was named.  The result:  those assets have cratered, pulling down many shares with them.

Multiple stories are flying about that demonstrate how Paulson’s statements have affected asset prices.  Business Week has a particularly good one.

When Treasury Secretary Henry Paulson first pitched the bailout in September, it sounded like a plumbing job. The “troubled assets” on lenders’ books were clogging the financial system, he said, and the government needed to buy up the bad debt to get credit flowing again. But in the six weeks since the $700 billion plan passed, Paulson hasn’t spent a dime on asset purchases, and on Nov. 12 he scrapped the idea altogether.

What happens to the toxic investments now? They will probably sit right where they are.

Buyers and sellers have been at an impasse for weeks. Fearful of being undercut, potential investors wanted to see what the U.S. would pay for securities backed by subprime mortgages and other troubled loans before jumping in with any offers. Financial firms were reluctant to unload holdings at fire-sale prices, hoping they could get more from Uncle Sam.

The standoff could intensify now that Paulson has changed course. The fundamental problem remains: Buyers are worried that the assets will continue to fall in value as the economy weakens, and sellers don’t want to cut their asking prices, further battering their balance sheets. “There’s a stalemate,” says a 16-year market veteran at a major money manager.

Meanwhile the government’s hasty retreat has only made the assets more poisonous. Some top-rated securities backed by home equity loans are valued at 40¢ on the dollar, vs. 67¢ when the rescue plan was announced two months ago, according to data provider Markit. Even those quotes, though, are somewhat questionable, since the market for housing-related securities is all but dead. “They’re not being traded,” says Christian Menegatti of research firm RGE Monitor. “The value of [some] securities might be close to zero.”

While I thought Paulson’s original prescription was terrible, it still seems counterproductive for the U.S. Government to undermine asset prices this way. The increase in volatility due to doubts about U.S. Government intentions is also increasing risk spreads in other more liquid markets like the corporate bond market.  The Financial Times reports on this.

Average yields on US junk bonds have topped 20 per cent for the first time amid rising concerns about a protracted recession and a wave of corporate defaults.

The spike in yields could have a dramatic impact on economic activity, making new debt prohibitively expensive for companies with credit ratings below investment grade. Such junk-bond issuers account for 17 per cent of the S&P 500 and nearly half the corporate bond market, according to Standard & Poor’s.

“This is really off the charts in terms of anything we have ever seen,” said Martin Fridson, chief executive of Fridson Investment Advisors, an investment management firm specialising in non-investment grade debt.

The yield on the benchmark Merrill Lynch US High-Yield index hit 20.81 on Wednesday after climbing to 20.27 per cent on Tuesday. Before Tuesday, the previous high for the index was 18.66 per cent in January 1991. The risk premium, or spread over comparable Treasury securities, is close to double what it was in 1991, when Treasuries were yielding more than 8 per cent.

Risk premiums on bonds with ratings below investment grade have hit new highs repeatedly in recent months as the credit crunch has grown worse.

To be sure, there are many other reasons these assets are decreasing like increasing unemployment, weak retail sales, a deep recession and the risk of deflation. However, Paulson’s statements have really spooked the market. Every company is now under suspicion and investors sooner sell than ask questions. This has been the case with Warren Buffet’s Berkshire Hathaway as Bloomberg reports.

The cost of protecting against default by Warren Buffett’s AAA rated Berkshire Hathaway Inc. has almost tripled in two months, a sign of just how skittish investors have become amid the global financial crisis.

The cost to protect against Berkshire being unable to meet its debt payments, based on credit-default swaps, is more than four times that of rival insurer Travelers Cos. At those levels, the swaps are typical of companies rated Baa3 by Moody’s Investors Service, one level above junk. The price may have risen on concern that the billionaire’s firm could lose a $37 billion bet on world stock market values more than a decade from now.

“That’s just so stupid,” said Mohnish Pabrai, head of Pabrai Investment Funds and a Berkshire shareholder. The swap buyers are projecting “present circumstances into infinity” and concluding Buffett’s bet will cost the company $40 billion, Pabrai said. “It will never happen,” he said.

And Buffet’s shares are way down as well. The operative word in all of these events is volatility. There is a whipsawing occurring in markets that makes it difficult for even the most agile of traders. Hank Paulson is amplifying that volatility tremendously.

With investors rightfully skittish, it would serve everyone better if the U.S. Treasury Secretary had something to say that did not add to market uncertainty.

Sources Mortgage-Backed Securities Remain Toxic – Business Week Junk bond yields spike – FT Berkshire’s Credit Risk Soars on $37 Billion Bet – Bloomberg Buffett’s Berkshire Falls Most in at Least 23 Years – Bloomberg

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