"Hold to Maturity" versus "Fire Sale" Prices

Paul Krugman says:

Balance sheet baloney, Paul Krugman: There's a turn of phrase I hate in the current discussion, because it sounds smart and serious but is in fact a complete evasion of the key issue. And I'm sorry to say that Ben Bernanke uses it in today's testimony:

More generally, removing these assets [i.e., toxic mortgage-related waste] from institutions' balance sheets will help to restore confidence in our financial markets and enable banks and other institutions to raise capital and to expand credit to support economic growth.

"Removing these assets from institutions' balance sheets" what an evasive phrase.

I mean, any bank that wants to remove toxic assets from its balance sheet can do it at a stroke - just declare them worthless, and poof! they're gone. But of course, that would reduce confidence and capital, not increase it - and that's not what Hank and Ben are talking about. They're talking about turning the assets over to Uncle Sam, and getting cold hard cash in return. And then the question is how much cash they get in return. It's all about the price.

Now, if the price Treasury pays is very low - anything comparable to what financial institutions are able to sell the stuff for now - it's going to do nothing for confidence and capital. If the price is high, confidence and capital will improve - but taxpayers may well take a big loss. The premise of the Paulson plan - though never stated bluntly - is that these assets are hugely underpriced, so that Uncle Sam can buy them at prices that help the financial industry a lot, without big losses for taxpayers. Are you prepared to bet $700 billion on that premise?

But how can we help the financial situation without making that bet? By taking an equity stake. That way, if it turns out that the feds are pumping money in at above-fair prices, at least they get ownership, just as a private white knight would have.

There is no, repeat no justification for refusing to grant equity warrants that provide some taxpayer protection. This is, for me, an absolute deal or no-deal point.

In his testimony today, Bernanke gave a partial answer to the valuation question:

Federal Reserve Board chairman Ben Bernanke said that criticism of the $700 billion plan proposed by Treasury Secretary Henry Paulson overlooked a key ingredient: it is designed to avoid forcing banks to sell or value their mortgage assets at a "fire-sale" price. In a harsher tone than he has ever used in testimony, Bernanke spelled out the benefits that would accrue when the government can buy these mortgage assets at close to "hold to maturity" prices instead of the fire-sale price. Banks would have a basis for valuing the assets and won't have to use fire-sale prices and their capital won't be unreasonably marked down, he said. Liquidity should begin to come back to the markets and uncertainty should dissipate. Credit markets should start to unfreeze, he said. If the assets are purchased near the true hold to maturity prices, taxpayer losses should be minimal, he said.

Now I just have to figure out how the "hold to maturity" price is to be determined, and how purchasing at that price minimizes losses. They must be thinking that if the assets are purchased at below their hold to maturity value, the losses from firms failing would be greater than the gains from charging a lower price.

Ah, here's more from the WSJ economics blog, and it looks like that is the thinking behind the hold to maturity valuation proposal:

Bernanke Goes Off Script to Address Fire-Sale Risks, RTE:  After listening to Senate lawmakers' opening statements for 90 minutes, Federal Reserve Chairman Ben Bernanke took a highly unusual step of ditching his prepared remarks, which ... leaked out early this morning. Bernanke used his time to argue for not buying assets at fire-sale prices in the Treasury's $700 billion bailout proposal.

Uncertainty in housing markets and the economy are forcing financial institutions to mark mortgage securities at fire-sale prices, rather than their value if held to maturity, effectively creating a vicious circle of more write-downs that further depress asset values, Mr. Bernanke explained.

Mr. Bernanke said the Treasury plan should have taxpayers buy the assets and hold them at close to their maturity value. Removing the assets, he said, would bring liquidity back to markets, unfreeze credit markets, reduce uncertainty and allow banks to attract private capital.

Forcing assets down to even lower fire-sale prices would protect taxpayers the most, since the government would own the assets below the value if held to maturity. As long as those securities didn't flat-out default, the government's purchase would have a substantial upside. However, Mr. Bernanke essentially argued that doing so would hurt markets even further and wouldn't solve the problem facing the economy. In pushing back against congressional efforts to change the Treasury proposal, Mr. Bernanke said: "We cannot impose punitive measures on institutions that choose to sell assets." The beneficiaries would be not just the companies selling, but markets and the overall economy, he said.

Still, he acknowledged that the precise approach to doing so hadn't been determined, arguing for flexibility. "We do not know exactly what the best design is," and that would come from consultation with experts, Mr. Bernanke said.

"We believe that strong and timely action is urgently needed to stabilize our markets and our economy," he said.

Still not sure exactly how the hold to maturity valuation will be done, but this is an attempt to provide an additional capital cushion to firms over and above the fire sale prices and help with both liquidity and insolvency problems (at current market prices).

As Krugman notes, taxpayers need compensation for their participation in this. The argument above seems to be that the government will be paying fair prices, not prices above true values, so there is nothing to be compensated for. But as I've noted previously, taxpayers are assuming sunstantial risk by holding these assets, and they need to be compensated for that exposure.

But, again, here I want to be careful. If we reduce the future profitability of these firms at all (by that I mean the amount available to private investors), say by demanding a share of future profits for the government, that will make it harder for the firms to raise private capital since expected future profits will be lower. So, by having the government take a share of any upside, the result may be less willingness of the private sector to participate in recapitalization. That's not a deal breaker, not at all, taxpayers need a stake in any upside, but it is something to think about, and to try to minimize (all else equal). Or have I missed something here and this is not a problem? (Comments argue that I have, but here's what I am thinking. Suppose that a firm has zero in assets, and has liabilities of $100,000, but that it is expected to be profitable it it can become solvent. E.g., it just experienced a once in a lifetime event that wiped out its assets. So it needs $100,000 to continue. Suppose that it sells ten shares at $10,000 each, nine to private investors, and 1 to the government in bailout.  In scenario 1, the government grants firm the $10,000 it needs for a bailout, but leaves future profits unencumbered. If the firm then makes, say, $10,000 in profit the next year, that will be divided 9 ways. In scenario 2, rather than giving the money away for free, the government demands 1/10th of the profits. Now, each investor in the private sector will get less than in scenario 1, they will only have $9,000 to distribute over the 9 shares rather than $10,000 like before - they no longer receive the benefit of the free government investment. I don't want to dwell on this since it detracts from the main point, but have I missed something? That's more than possible...)

I will try to update as I learn more.

Update: Krugman again (and it appears auctions will be used to try to reveal the hold to maturity price, but I still want more details):

Getting real - and letting the cat out of the bag: Whoa - it seems that Ben Bernanke ditched his prepared testimony and, instead, let the cat at least partly out of the bag.

I believe that under the Treasury program, auctions and other mechanisms could be devised that will give the market good information on what the hold-to-maturity price is for a large class of mortgage-related assets. If the Treasury bids for and then buys assets at a price close to the hold-to-maturity price, there will be substantial benefits.

First, banks will have a basis for valuing those assets and will not have to use fire sale prices. Their capital will not be unreasonably marked down ...

As I wrote earlier this morning, the whole "take these assets off the balance sheets" line is fundamentally disingenuous; the key question is what price Treasury pays for the assets. And here we have Bernanke effectively saying that it's going to pay above-market prices - prices that allegedly reflect "hold-to-maturity" value, but still more than private investors are willing to pay.

This should be read in the context of Brad Setser's calculations: he finds that if Treasury pays a price that seems appropriate given the poor quality of the assets, "The hit to the banks balance sheet might be too big" - the losses would be much larger than the amounts banks have already acknowledged, so that their capital position would be severely weakened.

So the plan only helps the financial situation if Treasury pays prices well above market - that is, if it is in effect injecting capital into financial firms, at taxpayers' expense.

What possible justification can there be for doing this without acquiring an equity stake?

No equity stake, no deal.

All I am saying above is that the design of the equity stake mechanism (there is more than one way to do this) should minimize any secondary effects, but as I said, this is of secondary importance.

Update: Let me try to give a defense of paying above current market prices (in a devil's advocate sense). For markets to function according to competitive ideals, full information must be available to all market participants. When information is lacking, or when it is asymmetric, the outcome is inefficient relative to the full information outcome.

The nature of these assets - their opacity as it has come to be called - makes full information unavailable. I'm not sure how asymmetric information is, people holding the assets don't know themselves whether a particular asset might blow up and lose it's value or not, but there is some degree of asymmetric information in these markets (a standard lemons problem).

This is market failure due to lack of full information, and asymmetric information to the extent it does exist, is depressing prices. The idea is for the government to hold the assets while the information is revealed, and then resell them later at closer to their full information price.

I think of bank asset portfolios as containing bombs, but nobody knows for sure where the bombs are hidden (though the banks may have a slightly better idea than outsiders). At somepoint, they will explode and cause big disruptions. The idea is for the government to gather up these assets, put them in the bomb containment chambers, and let the ones that are going to explode do so. This reveals the information that is lacking, the ones that don't blow up after a certain time period are just fine, and these will be sold at their "hold to maturity" prices.

The problem here is that not all assets are worth their hold to maturity value - some are going to blow up - so the entire stack is not worth (number of assets )*(hold to maturity value), it is worth (number of assets -number that blow up)*(hold to maturity values), and that means discounting each asset slightly below the hold to maturity value (on average since you don't know which will blow up). [I've assumed assets that blow up are valued at zero, and that all assets are identical a priori, but the formula can be easily adjusted to handle heterogeneity and a non-zero scrap value without changing the main point].

This value will be above (number of assets)*(today's market price), but it will be less than (number of assets )*(hold to maturity value), so it seems to me that the correct price (setting aside the need to recapitalize) is between the two values. Essentially, if all assets are valued at hold to maturity values, taxpayers will get stuck paying for the ones that blow up. For this, and the risk they are assuming overall, they need a stake in the outcome. [Update: I probably should have noted that this depends upon how hold to maturity is defined, i.e. the degree to which it incorporates the probability of default - this may already be accounted for in the definition - that's why I want to know how this will be calculated. I'm not completely happy with the example, but the point is simple - it's not clear this plan accounts for assets that default - it might but that's not clear yet - and if it doesn't, taxpayers will be on the hook for the assets that default.]

Update: Arnold Kling makes, essentially, the same point:

The fair price depends on the probability that you will default. If there is a 50 percent chance that you will default, the fair price is more like $50,000.

The probability that you will default depends on the distribution of possible paths of future home prices. Along paths of falling home prices, defaults are much more likely than along paths of stable or rising prices.

It's hard to know how home prices will behave, but right now if I were pricing the risk (something I used to do for a living, unlike the key decision-makers in this bailout), I would include a lot of paths where prices go down. That would make the "hold-to-maturity" prices of the mortgage securities, properly calculated, pretty low in many cases.

Update: Real Time Economics : How Will Troubled Assets Get Priced?.

Comments

[Grey Swan]

As Krugman notes, taxpayers need compensation for their participation in this.

What compensation? If Barney Frank has his way the rent to existing squaters will be lowered. Well, not lowered because these people aren't paying anything now.

It's too bad these sub prime loans weren't second homes at ski resorts or near the beach. At least the government could get some cold hard cash for a resale.

As it stands the Bary Frank plan of letting people who put nothing into the place they're living in takes forever and a day to get back any kind of money.

[Winslow R.]

krugman wrote: "There is no, repeat no justification for refusing to grant equity warrants that provide some taxpayer protection. This is, for me, an absolute deal or no-deal point. "

How about foreign corporations? We will have the U.S. owning the world's financial sector.

Do this thought experiment....

What is the world's financial capitalization and what is the world's total financial loss. My guess is the world's financial sector's capital is wiped out.

Why should the U.S. be bailing out foreign financial institutions when they are foreign based?

Why not just start a one world bank?

[esb]

Its clear to me that Bernanke wants to gift taxpayer funds to banks and others (GMAC, GE, perhaps even CAT, which also has a large vendor financing operation) with only "the promise of a better tomorrow" in return through this mechanism.

Now he cannot come right out and say this, hence the folderol.

If the banks are really in such a position that they simply cannot function without a gifting of funds then the solution is nationalization, in whole or in part through equity participation, sooner rather than later.

Krugman is quick on the draw and accurate with his aim.

[baileyman]

"value if held to maturity" as per Bernanke, this obviously means "par", you know, 100%. He's talking about paying the banks par.

[ampersand]

http://krugman.blogs.nytimes.com/2008/09/23/getting-real/

Krugman, updated

Getting real — and letting the cat out of the bag

Whoa — it seems that Ben Bernanke ditched his prepared testimony and, instead, let the cat at least partly out of the bag.

I believe that under the Treasury program, auctions and other mechanisms could be devised that will give the market good information on what the hold-to-maturity price is for a large class of mortgage-related assets. If the Treasury bids for and then buys assets at a price close to the hold-to-maturity price, there will be substantial benefits.

First, banks will have a basis for valuing those assets and will not have to use fire sale prices. Their capital will not be unreasonably marked down …

As I wrote earlier this morning, the whole “take these assets off the balance sheets” line is fundamentally disingenuous; the key question is what price Treasury pays for the assets. And here we have Bernanke effectively saying that it’s going to pay above-market prices — prices that allegedly reflect “hold-to-maturity” value, but still more than private investors are willing to pay.

[esb]

There was something really strange about the demeanor of the two men, especially Bernanke.

He continually would move his head in a circle, then close his eyes and grimace.

[esb]

Usually when Paulson was answering a question.

Something very odd here.

[Gavin]

One year after the credit crises started why are we talking about a fire sale price. Do people on this blog believe that the geniuses running hedge funds or on Wall Street cannot come up with a “hold to maturity price” after one year?

[hari]

Paulson is talking about *market mechanism* and Bernake is talking about *auction system* and that the taxpayer is on the *hook* any way now, Paulson says.

Taking the hearing into pespective, I've the keen feeling that this entire Plan is for hi street - the taxpayer will be holding the debt not the financial institutions that have diced and sliced the derivatives called CDS.

Will the Plan work?

At this point in time, there is no gurantee it will.

[ken melvin]

If the market is the best way to assign value - one might conclude these assets are worthless today, tomorrow and forever.

[Robert Waldmann]

The proposed transactions are free exchanges in which banks sell things to the treasury because they choose too. I see no reason for the treasury to pay one cent more than it has to. The normal rule in market transactions is the buyer pays as little as he she or it can.

I agree that it is necessary to recapitalize banks, but that can be done by buying equity.

Bernanke is arguing that the market price is unfair to banks.

He's risking expulsion from the economists guild.

[ndd]

Krugman has followed up with further thoughts on Bernanke's testimony:

His conclusion (and mine)::No equity stake? No deal!

My own extended thoughts:

I listened to Ben Bernanke's testimony before the Senate this morning. His theory is, there are 2 prices for securities right now: the fire sale price vs. the hold to maturity price. He says the treasury should buy above the fire sale price but below the hold to maturity price (even though he acknowledges that nobody knows what that is), and then resell at the hold to maturity price via auctions and other manners, hopefully in a way to "minimize losses" to taxpayers. He further says that in order to induce Wall Street to participate, there should be no punitive measures.

There are at least 4 problems with this theory:

(1) since nobody knows what the "hold to maturity" price is, there is not the slightest guarantee that the treasury purchase price will be below that price.

(2) if auctions are to be devised, why shouldn't the Congress hold onto the pursestrings and only promise the enabling funds once the auction system is set up by Treasury and approved by Congress or an oversight board?

(3) not the slightest justification has been offered as to why these auctions or other measures must be as massive as $700 billion, as opposed to $70 billion or even $7 billion. After all, the idea is simply to establish a market price based on "hold to maturity" which will free up liquidity among financiers.

(4) There is no excuse for refusing "punitive" measures such as taxpayer equity interest in the participants a la Sweden. It's the financiers who need the taxpayers, not the other way around. Bernanke's testimony makes clear that he regards the interests of Goldman Sachs and Morgan Stanley as being superior to the interests of the taxpayers

[max]

So, by having the government take a share of any upside, the result may be less willingness of the private sector to participate in recapitalization. That's not a deal breaker, not at all, taxpayers need a stake in any upside, but it is something to think about, and to try to minimize (all else equal). Or have I missed something here and this is not a problem?

(I have said this several places, but I'll say it again.) This is bank nationalization under another name; that is, the effects on the system are the same, but the CEOs and the shareholders keep their positions.

We DO have a need for a functioning deposit/lending system. So there are excellent reasons to do a deal.

But in business terms, if someone comes to me and says their company is bankrupt and they will have to liquidate at pennies on the dollar, whereas if I save them, I can keep them a going concern the employees won't suffer and eventually the business will be profitable, then at that point, I say, ok, sell yourselves to me. I do not screw around with a partial stake, I just buy the SOBs outright and skip the funny business.

max
['Surely economists can grasp this notion. Please?']

[Robinia]

It seems to me that Bernanke and Paulson are continuing to persue the basic false premise of this crisis: that by taking bad underwriting practice and overvalued toxic waste and sending it "away" ("remove assets from institutions' balance sheets"), all will be well. That is the very same game of musical chairs we have been playing, and it does not work. Splitting the risk among US taxpayers, with no compensation for taking that risk, will not make the risk "go away" although it may suffice to push it into a timeframe that NIMTOO ("not in my term of office") politicians can accept. If the US population is forced to swallow the errors of Wall St.'s profligate excess, they will lose and suffer, count on it, there is no free lunch. That makes such a "solution" profoundly unpatriotic.

The best plan actually starts with the house in determining value. The house value can be assessed, the gobbledygook alphabet-soup of derivatives can't. That is why the bailout should be focused mostly on the homeowner, not the financial institution. Institutions that didn't take on a lot of bad underwriting will be ok in the long run, those that did should be scrapped-- they had a bad business model, and the US taxpayer should not be taking hits to keep them going. Heck, even the IBs are recognizing that truth-- and, you might note, with very little disruption of markets as they change to a more reasonable business model. New, and better, leaner and nimbler, and, yes, more prudent, financial institutions will rise to the fore once the winds of creative destruction have blown through.

Bernanke's "hold to maturity" nonsense is nothing more than faith-based economics-- NPV by government fiat. We might just as well set a Soviet-style five-year plan for the finance sector. Correction, my friends, means that somebody-- lots of somebody-- was wrong. At base, the US housing and finance industry "was wrong" about endless cheap oil, permanent income increases among consumers, no more serious downturns in business cycles, no unintended consequences (negative externalities like pollution, global warming, cancer and diabetes) from industrial development, and no negative repercussions in "growing" the finance sector to represent a grossly disproportionate share of total US profits. And more. You can't make it go away, and foisting it on those least able to afford it will tank the country's future chances at prosperity.

Our democracy was built to assure each of us (citizens, not corporations) the chance to pursue happiness. Not to keep markets liquid or maintain corporate entities with a long history at all costs. Out with the old, the new is impatient to attend to real emergencies, like global warming. Which would you really rather have here in 2050, anyway: a livable earth, or a finance sector that was preserved at all costs in the classic, 1990s-boom configuration?

[Ken]

Call me stupid but it seems to me treasury isnt acting in the best interest of the people it is acting in what it sees as the best path to get credit moving again. To do that the higher the price it pays the looser the credit markets get.

When it comes to putting lipstick on a pig (sorry for the reference but i couldnt help it) none apply it better or more liberally than does the Federal Reserve and "Held to Maturity" is a bit bright for a pig. "Held to" assumes that there is some current stream coming from these assets. I have no idea what we are supposed to be buying but i would bet that many of the streams have long since dissipated!

Tell we the taxpayers the truth. be honest. we're very likley going to get screwed in this one. Its either that or watch the house of cards built by bad monetary policy and even worse fiscal policy crumble around our ears. To pretend there is a win lose choice is disingenuous

[Joseph Bee, DDS, MAGD]

No Fair! The financial industry has profited millions and billions. The Taxpayer takes the loser asset and holds to maturity with what gain?

The Institutions participating should pay into a fund to offset the losses over time. If this is viewed as "punitive" I am sorry but the losses should be recovered from the perpetrators.

This bail out can be placed into a separate fund / reserve in which all these institutions pay monthly premiums to offset the losses and risk now and moving forward for future behaviors.

The FDIC accepts insurance why not this debacle? By the way are the "newbies" allowed to dip into FDIC if they belly up. If they are aren't these solutions simply moving from one bucket to another?

[ob]

A thought after listening to Paulson argue against equity warrants:

If Treasury demands equity warrants accompanying all acquisition of assets sold in the auctions, only distressed banks will participate in the auction and there will not be sufficient competition for the auctions to provide adequate price-discovery for a liquid market to develop. The upshot is that the tax-payer risks losing more with equity warrants than without them.

A non-distressed bank willing and able to hold the assets until maturity will only participate in an auction where they stand to gain, i.e. if they value the asset as worth 50 cents on the dollar, they will only offer the asset in auction at a price above that evaluation – 51 cents. If equity warrants are required to insure the tax-payer against any subsequent loss on the asset, the bank in question will have no incentive to offer the asset at any price above 50 cents – for any eventual profit will be wiped out through the equity warrants.

Only distressed banks will be willing to sell such assets at below the hold-to-maturity value, because of the high value immediate liquidity has for them. So a bank which craves liquidity will offer an asset they value as worth 50 cents on a hold-to-maturity basis at 45 cents. However, if only distressed banks are participating in the auction, there will not be much competition. This, in a reverse auction, plays into the hands of the banks offering the assets, because they will be able to bid their assets at a price above their estimate of the hold-to-maturity value. If no one else is bidding they may be able to offload assets estimated at 50 cents at a price of 55 or 60 cents. Equity warrants may help to offset the tax-payer loss here, but remember that they provide for equity in a DISTRESSED bank.

In short, including equity warrants in the auction process to protect the tax-payer will have the perverse effect of ensuring that the tax-payer loses out in the end. He will end up paying above the best estimate of the hold-to-maturity value of the assets in question. Only by including non-distressed banks in the auction process will Treasury be able to ensure that the distressed banks gambling on the scarcity of assets on auction don’t overprice their bids. Only by ensuring high-competition auctions will Treasury be able to ensure that they get a price at or below fair-value.

There is a way around the problem, though. Treasury could demand the equivalent of a put-option on the assets in question – effectively a right to sell the successful bidder the assets back at a price, say, 10% below the bid price. This could insure against significant losses on any particular set of assets. And yet, if the other goal of the Paulson auction-plan is to clear up the banks' balance sheets to either free them to extend further credit to corporations and consumers or help them deleverage, having such an outstanding derivative commitment does not much help them do that.

None of this is to defend the Paulson plan per se. It merely serves to show that tacking equity warrants onto the auction plan does not help.

[Joseph Bee, DDS, MAGD]

To hold to maturity the government has a vested interest to encourage inflation to recover the losses of the failed assets. Hmmm!

[Joel]

It seems as if Paulson and Bernancke are still taking a pretty optimistic bet. They've been systematically overly optimistic for the last year (at least). I doubt the Congress is going to be willing to place such a one sided bet.

[Nicholas Weaver]

One comment: Dodd's plan seems to get this for free...

IF the treasury bought for less than the eventual sale price, tehy don't gain an equity stake. They only get an equity stake if it turns out that the treasury overpaid.

Thus if its liquidity: Treasury buys, sells later, all happy.

If its solvency but Brad DeLong is right: Treasury overprice buys, value goes up, sells later, all happy.

If its solvency but Krugman is right: Treasury overbuys price, value drops, sells later and exchanges for equity stake.

Oh, and I'll gladly run a big financial firm for $500K a year. I can't do a worse job than the yahoos already in charge...

[SanFranciscoJim]

There was something really strange about the demeanor of the two men, especially Bernanke.

He continually would move his head in a circle, then close his eyes and grimace.

Do you have a link to a youtube video of this or something? I would like to see it. The strain is probably starting to wear on the two of them.

[esb]

SFJ ...

The whole thing should be up on CNBC soon.

[Cynthia]

No one should lose sight of the fact that Hank Paulson represents crony capitalism at its worst. After all, he's a Goldman Guy and Treasury Secretary all rolled into one!

[sacman]

It's possible that the current market price is overly optimistic. The lower bound for the assets' eventual realized value is zero, not the assets' current market value.

[esb]

One problem here is that while Bernanke wants to keep the "system" working, Paulson wants his "familiars" to feed at the public trough, Dodd wants the taxpayers to own (in part) the banks and good 'ol Barney Frank just wants a Christmas tree.

[esb]

http://krugman.blogs.nytimes.com/
2008/09/23/good-ideas-and-lies/

Agree completely.

[Alex Tolley]

PK: "I mean, any bank that wants to remove toxic assets from its balance sheet can do it at a stroke — just declare them worthless, and poof! they’re gone."

But the problem isn't just vanilla assets like plain mortgages. There are the derivatives, particularly CDS's. These instruments have counter parties so a bank cannot unilaterally write down a CDS without dealing with the counter party. The difficulty of doing this with CDS's is suggested by the Wikipedia article on CDS's with showed that in 2006, 46% of CDS's had not been settled [a bit ambiguous- could be 46% of unsettled CDS's still not settled]. My guess is that the hugely leveraged nature of these instruments could wipe out either side of the transaction if there is a sudden discontinuity in the market, and this is part of the illiquidity equation that the FR is worried about.

Bank back offices always have a backlog of unsettled trades. Usually this is small. But the size of the CDS market could mean that the rapid attempt at settlement could result in much larger backlogs as counter party risk escalates.

[Worker]

Krugman is right. Equity is warranted, no pun intended.

Equally right is that the recipients of modifications should give up appreciation rights through a non-interest paying lien that would be discharged upon pay-off.

Restructure the payments, but leave 90% of the recovery upside up to the original loan amount to the taxpayers. 10 or 20% would encourage deferred maintenance. The sort of underwater buyers for the last 10 years have no need for home improvements- society will not benefit.

Alas, this is not even in the political discussion. Inability of our politicians to think more than 2 years into the future, plus Republican stupidity. They should counter the opposition populism on BK cramdowns and foreclosure moratoriums with this reasonable (and parallel to Krugman) proposal. It is sad they have become a party without a brain.

[Richard H. Serlin]

"If we reduce the future profitability of these firms at all (by that I mean the amount available to private investors), say by demanding a share of future profits for the government, that will make it harder for the firms to raise private capital since expected future profits will be lower. So, by having the government take a share of any upside, the result may be less willingness of the private sector to participate in recapitalization."

There's a relatively easy solution to this. As Paul Krugman and many other top economists recommend, the government just buys (takes over) the firms. Then credit will flow because the government does not have a problem comming up with money to loan out. When the bad assets are removed from the books and the firms are in order, then the government sells them back to the private market. This has been done successfully many times, and it allows the taxpayers to reap the benefits of the massive government cash infusion, rather than the firms existing shareholders and managers.

Why not just do this clearly better and more efficient solution? The same reason we don't do so many clearly better and more efficient solutions, simple-minded Republican ideology that's highly resistant and downright hostile to logic and evidence (see Columbia Economist Jeffery Sach's recent article, "Anti-Intellectualism" at: http://www.todayszaman.com/tz-web/detaylar.do?load=detay&link=154008&bolum=109). Republican ideology says government ownership of almost anything is bad. This has lead to massive inefficiency and complication in things from health care to student loans to the spiders web of extremely hard to monitor and control contractors and mercenaries in the military.

[Winslow R.]

If the government 'underpays' it pulls cash flow out of the economy and into the treasury, the same as raising taxes.

If the government keeps homeowners in houses they can barely afford it pulls cash flow out of the economy and into the treasury, the same as raising taxes.

If the government 'overpays' it pushes cash flow into the economy away from the treasury, the same as a tax cut for the financial sector.

[Worker]

I meant to add, republican's have become a party without a brain other than Bernanke and Paulson who are obvious too smart to succeed in the gotcha politics of appealing to ignorance and populist sentiment.

[Jesse]

A Modest Proposal. Show Us the Money

http://tinyurl.com/4zcrvd

[gc]

Has no one ever watched "It's a Wonderful Life"? It gets replayed every Xmas season. The likeable, older senile uncle (think Greenspan, Cox, Bush/McCain) loses the deposit. The younger, competent manager, played by Jimmy Stewart, (think Paulson, Bernanke) are able to do the right thing because all the savings and loan members (think us)pony up $5 and $10 here and there to cover the misplaced deposit. What's up with everyone? You're supposed to offer up little amounts with joy on your lips and tears in your eyes, and celebrate life's renewal. So just stop, stop it, with the cynical laughing, or you'll have us all end up in Potterville.

[Worker]

I would say that the Democratic default is equally stupid, that virtually any government hand-out is good.

Look at the beneficiaries of the cramdown proposals- subsidizing fraudulent McMansion buyers. Reading the Dodd bill, and knowing the Alt-A liar loan resets on the horizon, people who took out a million dollar loan on a $50k a year income will be the financial winners.

Their neighbors with the same income and a little commonsense.

How does that make sense, except within the framework of the current stupidity?

[anne]

http://krugman.blogs.nytimes.com/2008/09/23/good-ideas-and-lies/

September 23, 2008

Good Ideas and Lies
By Paul Krugman

Daniel Davies, in one of the great blog posts of this era, laid down * a key principle:

Good ideas do not need lots of lies told about them in order to gain public acceptance.

He was talking about the selling of the Iraq war, but it applies more generally.

So, this morning Hank Paulson told a whopper: **

"We gave you a simple, three-page legislative outline and I thought it would have been presumptuous for us on that outline to come up with an oversight mechanism. That’s the role of Congress, that’s something we’re going to work on together. So if any of you felt that I didn’t believe that we needed oversight: I believe we need oversight. We need oversight."

What the proposal actually did, *** of course, was explicitly rule out any oversight, plus grant immunity from future review:

"Sec. 8. Review.

"Decisions by the Secretary pursuant to the authority of this Act are non-reviewable and committed to agency discretion, and may not be reviewed by any court of law or any administrative agency."

I’m not playing gotcha here. This is telling: if Paulson can’t be honest about what he himself sent to Congress — if he not only made an incredible power grab, but is now engaged in black-is-white claims that he didn’t — there is no reason to trust him on anything related to his bailout plan.

* http://d-squareddigest.blogspot.com/2004_05_23_d-squareddigest_archive.html

** http://thinkprogress.org/2008/09/23/paulson-oversight/

*** http://www.nytimes.com/2008/09/21/business/21draftcnd.html

[anne]

http://krugman.blogs.nytimes.com/2008/09/23/getting-real/

September 23, 2008

Getting real — and letting the cat out of the bag
By Paul Krugman

Seeing it the same way: *

"What has become clear is that Treasury plans to purchase bad assets from banks at prices very near their original value. The risk to taxpayers under this program would be tremendous. If housing prices continue to fall, so will the value of the paper the government has purchased. Under this set of circumstances the public could be at risk for underwriting the great majority of the Treasury's purchases and never having a chance to recoup their investment.

"Buying troubled bank assets at above where they would be valued in a free market now and at a price which is near to the potential price when they mature is a great handout to the banks but undermines almost any chance that the Treasury will ever get any meaningful yield from the bailout.

"Taxpayers lose any chance of being made whole."

* http://www.247wallst.com/2008/09/paulson-plan-sh.html

[Joseph]

We know that one to two trillion dollars of housing equity has disappeared. It would be reasonable to assume that most of that must represent the difference between par, the original value of the assets and what they are worth now, their "hold to maturity value". Someone has to absorb the trillion dollar losses. Either the bailout buys the assets at par and taxpayers absorb the losses or the bailout buys the assets at "hold to maturity value" and the banks absorb the losses. In the latter case, the banks may be insolvent. So either the plan works by sticking it to the taxpayer, in which case Bernanke is being disingenuous about how much he's really going to pay, or else the plan buys the assets at real value and the plan fails.

[baileyman]

robinia says "That is why the bailout should be focused mostly on the homeowner, not the financial institution."

Right on!

What if Treasury rebated $50,000 in taxes to every individual taxpayer? People in trouble could pay down mortgages. Those who were flush might contribute theirs for the same purpose to others. Others might recapitalize banks. MBS might begin to magically work again. The total cost may be similar to what Paulson's plan will eventually cost.

[ob]

Richard Serlin (above) seems on the right track. Both with regard to the right solution - government taking an equity stake - and with regard to why the right solution is not on the table - republican 'free market' ideology. I don't understand why this is not openly discussed.

They should just drop the auction idea. The core problem is NOT falling house prices. It is the drying up of debt caused by the impairment of banks' balance sheets caused in turn by falling house prices. We don't need to buy up the junk weighing on the weakened balance sheet, we just need to strengthen the balance sheet by reinforcing the equity cushion. What is so complicated about that? Let the banks keep their damaged assets. Who cares? Somebody explain this insanity to me...

[Andrew]

What's interesting to me is that the "hold to maturity" argument was made by Bob Citron, the disgraced treasurer of Orange County following the massive failure of the county's portfolio in the mid 1990s.

I'm relying on my memory of Phillippe Jorion's book "Value At Risk" here. Citron built a highly leveraged, short duration portfolio of repos and derivatives. It was essentially an interest rate directional bet. When interest rates started to rise, the value of the portfolio fell. Citron argued that if the portfolio's assets were held to maturity, then face value losses would be avoided. What he missed was that the portfolio had to be marked to market (he had to roll over his repos).

If the US government ends up with apparently toxic securities, having sold treasuries to purchase them, it could of course in theory wait for these securities to appreciate - but it will have used a substantial amount of its borrowing capacity to acquire them, and the value received will be a market value.

[Bernard Yomtov]

If we reduce the future profitability of these firms at all (by that I mean the amount available to private investors), say by demanding a share of future profits for the government, that will make it harder for the firms to raise private capital since expected future profits will be lower. So, by having the government take a share of any upside, the result may be less willingness of the private sector to participate in recapitalization.

Why "harder?" More expensive for current shareholders, in that the price at which the firm sells equity will be lower, but why harder?

[Bruce Wilder]

My jaundiced view naturally focuses on the insistence of the financial industries lobbyists that the bankruptcy code should not be revised to allow bankruptcy judges to revise the terms of mortgages on primary residences. (People with a mortgage on a second home, of course, enjoy this option, already; funny how that works.)

Combine mark-to-maturity with debt peonage (and that's what the terms of many ARMs amount to, in the context of current bankruptcy law) and you have a pretty good idea of the vision of a just Republic, which men like Bernanke and our Treasury Secretary carry around.

I think many of the ideas put forth by liberals for mortgage re-structuring ("saving people's homes") are also wildly unrealistic, and reflect an unrealistic view of the economics of home ownership. As a guide to policy, the religious attachment to maximizing home ownership in this country makes no more sense at the margin, than chanting "jobs, jobs, jobs". Whatever.

We could assist a lot of people, within this hold-to-maturity framework, just by attaching provisions, which would let people live in foreclosed real estate, more or less rent-free. The same kinds of somewhat arcane arguments about the prospective value of MBS apply with considerable force to the idea of letting people live rent-free for a time. If the government is taking the long view on these assets -- and ultimately, most of these assets are houses -- then keeping them occupied and safe from vandalism only adds to their value. The cost is minimal -- and to families, which may have been struggling for months or years against high mortgage payments, the opportunity to rebuild cash savings, while living in a low-rent situation could be quite valuable. The houses are a sunk cost, and making use of them during the long interim adjustment of the housing market makes a good deal of sense.

Of course, don't expect such a proposal to make much headway against the demands of lobbyist armies. But, it is worth throwing out there, as something that makes a great deal of sense on its face.

[Bruce Wilder]

I wonder how "hold to maturity" is supposed to work, in relation to bundles of bad student loans or credit card debts.

Is this a kind of political alcemy, which will allow Fox News morons and Rush Limbaugh idiots to feel outrage? The government, it will be said, did not lose money on deadbeat banks; they lost money, when the Democrats let deadbeat ex-students and credit-card fraudsters walk away. Will that be the narrative?

[Bruce Wilder]

I had to ask. But, I see Worker has answered. Naturally.

[cas127]

Selling the "promise of a better tomorrow" (hold-to-maturity version).

Heck, if the rubes believe in Social Security's and Medicare's "long term viability" (a la Santa Clause) why wouldn't they believe that this is a break-even sorta blank check deal...

[Robinia]

Totally agree with this--

esb says...

http://krugman.blogs.nytimes.com/
2008/09/23/good-ideas-and-lies/

Agree completely.

I don't trust Paulson enough to make him our Dear Leader on into the future. I do trust the US population to adapt and adjust to new ways of structuring markets and finance. The hi-fi crew are still trying to say that they know better than we do, so, we should let them decide. That is simply not the case. They blew the world's trust that they know better. It will be far easier to rebuild trust in new ways of doing business than to patch up the old.

[robertdfeinman]

I thought you flunk eco 101 if you believe that assets have an inherent "value". Perhaps Bernanke has forgotten this lesson.

The value of a asset is exactly what gets set by an arms-length transaction. So if things are selling at "fire sale" prices then that's what they are worth (now).

Now if you want to provide capital to banks so that they can continue to lend out fresh money, then just say so. Provide them the cash and take whatever collateral you think appropriate in return. This can be a stake in the firm, directly, or via warrants, or the cash can just be in the form of an outright note.

Now what happens to the the assets that are being priced at fire sale prices? They can be kept off the market until the panic subsides - this is what happened with the Japanese real estate collapse. You do this by changing the reserve and reporting requirements that banks have to follow. The Japanese did this by inventing the "non performing loans" category. The US could do something similar.

There are two different issues here and they are being conflated. One is liquidity and the other is the balance sheet of banks. Liquidity failure can cause a depression, the balance sheet issue is just an accounting convention.

Not to get too far off the topic, but the real crunch is going to be in the market for imaginary assets which the hedge funds have been specializing in. This nonsense started when exchanges started offering to sell stock exchange indexes and it has gone on from there. This is pure gambling, aided by low margin requirements and there is no way to save these investments from collapse.

[Mike D]

1) Remember that a market with lemons discovers the price of the lemons efficiently.

2) Buying the distressed assets only increases bank capitalization to the extent to which the government pays more for the assets than the bank could otherwise get. Thus there's less than $1 of bank capital created per $1 of government purchases. (E.g. gov purchases an asset with market value of 50% of par for 80% of par -- 30% of par is added to bank capital, thus $0.375 of bank capital created per $1 of government purchases.)

Contrast that with a straight purchase of (say) cumulative preferred shares with a semi-punitive yield of 10-15%. That adds $1 of bank capital per $1 of government purchases.

Isn't the damage to bank capital the key thing here? Why shouldn't we attack that directly?

[anne]

http://blogs.wsj.com/washwire/2008/09/21/obama-might-keep-paulson-during-transition/

September 21, 2008

Obama Might Keep Paulson During Transition
By Nick Timiraos

Barack Obama said in an interview to air Sunday evening that he’d consider keeping Treasury Secretary Henry Paulson on a transition team given the intricate challenges facing the financial system right now.

“That doesn’t necessarily mean that he’d end up being the secretary Treasury, but I think it’s important for us to make sure that those who are currently in charge when it comes to the financial crisis and defense and intelligence, that they are deeply involved in the transition process,” Obama told CNBC’s John Harwood during an interview in Charlotte, N.C., on Sunday.

Both campaigns have already considered elements of their transition, and The Journal reported in July that the Obama campaign was considering asking Defense Secretary Robert Gates to stay on.

Asked about his confidence in the Wall Street rescue being hammered out by Treasury, Obama called for oversight and said Congress couldn’t give a “blank check.” The Illinois senator suggested that oversight could be appointed by Democrats, Republicans and the chairman of the Federal Reserve Bank.

[Oh.]

[a]

I'd just add that Bernanke has provided no evidence - none - that we are talking about fire sale prices of these assets. He could easily choose an example - here is an asset which the market values at x but which is obviously worth more than x. He doesn't do so. Why should we believe him, especially since he's been wrong about the dynamics of this crisis since day 1?

I'm just glad to see that Krugman is at last on the side of truth and justice.

[Bruce Wilder]

Robinia: "It will be far easier to rebuild trust in new ways of doing business than to patch up the old."

I so agree with this.

People react to events like this with habitual heuristics and tempermental inclinations. The base conservative and progressive impulses, stripped of self-interest and ideology, are nothing more than an inclination to either patch-and-muddle or try-something-new-and-muddle.

Ultimately, it is a choice between falling backward on to your butt, or forward onto your face.

Some people favor falling back. In its favor, we can say that we are well-padded, and, generally, we know what's back there, so we don't have to look, which is good, because we don't have eyes back there.

If we fall forward, we can see where we are going, and when it's over, and time to pick ourselves up, we're further along our path.

This is a case, where the progressive impulse is likely to be less costly. What's back there doesn't work, and isn't going to work, so patching it up is mostly going to turn out to be wasted effort.

Bernanke and Paulson are advocating throwing good money after bad, in the hope of filling in a giant hole. They are doing so with a sharp eye on the self-interest of an elite, but little concern evident for the future of the country or the interests of the mass of people. They contributed mightily to creating this mess, were surprised by it, and should not be particularly credible in proposing remedies. But, it might be a while before that insight becomes part of the general consensus.

[a]

"The value of a asset is exactly what gets set by an arms-length transaction. So if things are selling at "fire sale" prices then that's what they are worth (now)."

Well, assets - especially derivatives - can have two values. For instance, consider the value of an SP500 future. It has a market price. But it also has a theoretical price, based on the values of the constituent stocks, the interest rate, and repo. It's quite possible that the market price and the theoretical price are different, and in fact they often *are* different, which is why there are people work at arbitrating this difference (alas, because so many people do it, usually the two prices do not get much out of whack). But Bernanke has provided no evidence that there *is* a theoretical price for a single product which is out of whack from its market price. He, or someone else, should give it, so people can judge.

[a]

"If we reduce the future profitability of these firms at all (by that I mean the amount available to private investors), say by demanding a share of future profits for the government, that will make it harder for the firms to raise private capital since expected future profits will be lower. So, by having the government take a share of any upside, the result may be less willingness of the private sector to participate in recapitalization."

Just to continue (I think) the comment of Bernard Yomtov. Suppose the government nationalizes a firm, i.e. takes 100% of its equity. Which gives it 100% of future profits. It is impossible to raise private capital only if the government insists on keeping 100% of future profits. But obviously it doesn't - raising private capital means that the capital gets a stated percentage of the equity and thus a stated percentage of the profits. So nationalization does not make it harder to raise private capital, unless you suppose that private capital would not want to buy 20% of a firm when the other 80% is owned by a government (but this hasn't been the case in Europe).

[Andrew]

I think Bernanke is asserting that the value of an asset can be decomposed (simplistically) into an intrinsic value component (the stream of its future cash flows discounted at some appropriate rate), which we can term its yield to maturity value, and some liquidity discount component, marking the unwillingness of market participants to acquire an asset with low transparency.

The Fed/Treasury will forego some or all of this liquidity discount component, and will substitute liquid securities for illiquid ones with otherwise similar intrinsic values.

Jerome de Paris on Kos' site, BTW, argues that the real game is the recapitalization of the Fed, which gets to swap out its own toxic waste acquired through the ad hoc funding activities. Interesting thought.

[Robinia]

the real crunch is going to be in the market for imaginary assets which the hedge funds have been specializing in. This nonsense started when exchanges started offering to sell stock exchange indexes and it has gone on from there. This is pure gambling, aided by low margin requirements and there is no way to save these investments from collapse.

Amen. No TARP big enough to cover these exists. Numbers games are numbers games; most players lose most of the time. The sooner we zero these rackets out and get people honest work the better off we will be.

[Alan Reynolds is Correct]

Alan Reynolds wrote an article today "'Wall Street' No Longer Exists" (http://online.wsj.com/article/SB122212959612065505.html) that demonstrates that real financial institutions (not on Wall Street) are adequately capitalized, even now. Clearly the implication is that Paulson is attempting to panic Congress into giving him $700 billion for charitable donations to those malefactors who created the current problems.

"First of all, the financial storms over the past year have -- before last week -- been largely confined to securities markets and to interbank loans among commercial and investment banks. Bank loans to commercial and industrial business, real estate and consumers continued to expand nearly every month. Commercial and industrial loans exceeded $1.5 trillion this August, up from less than $1.2 trillion a year earlier. Real-estate loans exceeded $3.6 trillion, up from less than $3.4 trillion a year ago. Consumer loans were $845 billion, up from $737 billion. Credit standards are tougher, which is surely a good thing, but interest rates for creditworthy borrowers remain low.

The ongoing slow but steady availability of bank credit helps explain the much-remarked contrast between Wall Street and Main Street -- the shaky condition of exotic financial markets compared with relatively benign statistics for industrial production, retail sales, employment and the rest of the no housing economy. Most people go about their business without depending on investment banks or exotic varieties of commercial paper."

Given that this is obviously a Wall Street crisis, not a main street problem, it should be resolved on Wall Street without burdening the taxpayer at all. Nouriel Roubini calls this a "bailin" versus a "bailout". A number of authors (Luigi Zingales, Nouriel Roubini, Willem Buiter, John Hussman) have outlined plans for debt-to-equity swaps that would give Wall Street essentially infinite solvency overnight. Given that debt-to-equity swaps would restore solvency, restore moral hazard, enable real market pricing of assets, and cost the taxpayer nothing I see no compelling reason to give any further consideration to the Paulson plan.

[a]

Andrew - in your explanation there is no discount for the probability that a cash flow does not occur. Maybe that's what Bernanke wants; but if so, it's madness, from the point of view of the purchaser, since the problem with a lot of this paper is that there are promises of cash flows which in all likelihood will not materialize.

[ed_finnerty]

Could this be whats going on

The Feds bought AIG

AIG issued untold amounts of CDS's amounting to many multiples of the actual underlying intruments. If the underlying instruments defauld AIG must pay off. Essentially it issued trillions of dollars of naked puts.

The Fed/Treasury cannot let the underlying instruments default because they are the owner of AIG and they would need to default.

Does this make any sense ?

[Cynthia]

I'm also at a lose as to how Hank and Ben plan to price toxic assets, whether held to maturity or sold at a fire sale. My best guess is that they are looking for a happy medium between asset prices that are not too high, not too low -- Goldilocks prices, if you will. But Hank and Ben should be mindful that once the quants on Wall Street hit the unemployment line, they can hire them at rock-bottom prices to quantify such nebulous concepts as "hold to maturity" and "fire sale" prices.

[ed_finnerty]

In other words, it became an existential crisis when they bought AIG and its essential unlimited liability

[cas127]

Naming contest for proposed bailout accounting scheme:

Entry #1: "Mark to Mendacity"

[ndd]

I realize Prof. Thoma has this blog on his rss feed to the right, but you might possibly want to click on this link because a Japanese official says the bailout will require $5 Trillion.

[Dickeylee]

To be fair, has anybody asked Sarah! Sarah! Sarah! what she thinks about this? She's not taking any questions? Oh, well, never mind then.
How about Maverick? Has James Garner weighed in yet? Oh, he's dead? How long ago? He wasn't a POW?
Boy, you can't believe the MSM about anything anymore! Thank God Survivor's back on this week.

[baileyman]

ndd said: "a Japanese official says the bailout will require $5 Trillion."

Ha! That's MY number! 110m taxpayers at $46k (I rounded to $50k above), or 30% of 130m housing units at $220,000 2/3 encumbered at 90% LTV. A new consensus is forming...

[Alex Tolley]

ndd - why would Kenichii Ohmae, a business strategist, have enough expertise to determine the size of the bailout?

[donna]

I'll sell Ben my house for $2 million, too, but it's not worth it. Why should we do this bailout when the investment bankers aren't giving up their houses and yachts and all the toys they've bought?

Sorry you idiots have run out of greater fools to buy your bad loans, but it isn't my problem. I've been living within my means without ripping anyone off, silly me.

[ndd]

Alex Tolley:

I put that very question to him, but his response was, "Sumimasen ga, eigo o wakaremasen."

[acerimusdux]

Here's how you calculate "hold to maturity" value. To adjust for the probablility that some will default, you calculate the present value of those hold to maturity payments at a slightly higher discout rate. Now, since we wouldn't want to take advantage of distressed financial institutions that are having touble meeting their obligations and badly in need of cash, we wouldn't want to make that rate too high.

Wait a second, aren't these same banks we're talking about some of the largest issuers of credit cards in the country? Well, now maybe there's a model of how we should treat them in there somewhere. I mean, how do they treat us taxpayers when we have a bit of a cash flow problem and miss a payment?

Would a discount rate of 29% seem fair?

[skeptonomist]

I thought that a major aspect of the problem was that nobody knew what the "hold to maturity price" is - that is how much of the mass of loans is really bad. How is this going to be determined by an auction? How is Bernanke going to fool the market into bidding other than the current prices, which rightly include the uncertainty, when neither he nor the market knows what things are really worth?

[ken melvin]

Bunch fellows standing holding pokes which they say hold pigs (lipstick?) and Bernanke and Paulson can't wait to buy.

Yes, if maturity value is $100 and maturity is seven years hence, wouldn't be prudent to pay more than say $45, and, if there's a 50% chance they'll be worthless then wouldn't want to pay more than say $20, ...

If the NYSE can't assign a value then who in the hell can?

[ds]

this talk about mark-to-value is ridiculous because it assumes that the government is going to buy this paper off of banks and then simply hold it until matuirty. But if that is the case, the banks will have unloaded only a tiny share of their mortgage backed assets.

from what I know, the outstanding mortgage paper market is about 15T. Many analysts are calling for 500B to 1T in writedowns on this paper -- which is about an 5% writedown. If the government bought only 700B of this paper to hold to maturity, this would only take care of 700B * .05, or 37.5B in total writedowns that banks need to make. There would still be roughly 14T in securities held by the private sector.

The only way this bailout can work is if the government 'churns' through this paper -- i.e. the government will buy 700B worth of paper from the banks, sell it at a 5% discount, and net a 5% loss, or 663B in proceeds from the sale. The government will then take the 663B, buy more paper, sell it at a 5% discount, and do it again, up until it has run through the 700B the plan is allocated.

In order for the plan to work, it must help the banks cover the writedowns they will be forced to make, and since the MBS market is so highly leveraged, the government cannot take all of the MBS paper off the bank's hand at any one given time. This is basically how it works when you go to a casino -- you start out with, say, a thousand dollars, and make a whole bunch of bets. Along the way you win some and you lose some, but ultimately run down your thousand to zero. But if you look back, the total amount you wagered over the course of the night would be many many times the cash you started out with.

The administration doesn't want to make this clear, but churning through the MBS paper market is the only way the plan can work. That means that there is almost ZERO chance the tax payer can make any money out of this, and almost a 100 percent chance the taxpayer will ultimately lose the entire 700B cap amount.

[ken melvin]

If they know enough to have determined which assets are bad, i.e., need purchasing, then they know what these assets are. Thye need to share this with congress and the public.

[Andrew]

a: you wrote at 2:08pm, in response to my 2:02pm "in your explanation there is no discount for the probability that a cash flow does not occur. Maybe that's what Bernanke wants; but if so, it's madness, from the point of view of the purchaser, since the problem with a lot of this paper is that there are promises of cash flows which in all likelihood will not materialize."

Although I don't get into probability weighting future cash flows in my original post, I don't disagree with you.

Market participants will have a view on the default rate of the underlying securities. If we have a fairly simple structure like a mortgage backed security, then in normal times assigning a discounted value to the future stream of payments from the mortgages, including those that prepay and those that default, is bread and butter stuff to a trading desk. Once we get into CDOs and CDO squareds etc it becomes a trickier proposition (AAA rating notwithstanding), but obviously it's still one our financial wizards felt they were up to.

As just about everyone has noticed, though, these ain't normal times. And the heck with trading any kind of long dated security with hard to price risk - a lot of the short term stuff is frozen. And it's partly frozen 'cos if you buy it, you may not be able to sell it again. This is what bernake/Paulson are proposing to do - to act as that old standbuy, buyer of last resort.

So in my view (although I didn't spell it out in the first post) the hold-to-maturity idea is consistent with some form of default/blow-up haircut, but it sets (through taxpayers' largesse) the liquidity discount to zero.

[skeptonomist]

If Bernanke meant par, he would not be talking about an auction, which would introduce uncertainty of its own and waste time and money if the price were known otherwise.

There seems to be a general assumption in a lot of this discussion that the "hold to maturity" price, and by that I mean the price including the future defaults, not par, would be higher than the current price. So, have all those of you who think this way been out buying this stuff from the investment banks? You should be if you really believe yourselves. How much of those millions that Paulson earned as CEO of Goldman Sachs would he like to sink into its paper (of course he's not actually allowed to, but he is allowed to bail them out. We'll excuse Bernanke as he presumably did not make millions on his salary as a professor.)

[skeptonomist]

re: Obama Might Keep Paulson During Transition
quoted by Anne

Evidently Paulson is going to be given most of the authority that he asks for, so if he succeeds there would be some reason to keep him on (or in that case maybe Paulson will just be declared dictator and it will be his decision whether or not to employ Obama).

But how could Obama or anybody now think that Paulson is the man to be in charge? As CEO of Goldman Sachs he led it to the point of begging for help from the "government" (i.e. Paulson himself now), and as Treasury Secretary he denied the problem until he demanded dictatorial powers for himself. What more would somebody have to do to show the lack of skills and knowledge which will be needed in this crisis? Just what are Paulson's winning qualities which leads him to be so highly esteemed - his arrogance?

[gordon]

Prof. Krugman: '"Removing these assets from institutions' balance sheets" what an evasive phrase'.

WSJ economics blog (quoted in the post):"...Mr. Bernanke essentially argued that [setting a fire-sale price] would hurt markets even further..."

There's another evasive phrase - "hurting markets". What markets? There is no market for these CDOs, they're valueless. What that phrase means is "hurting the existing financial system" or, even more precisely, "hurting Wall St."

Ever since the panic created by the collapse of Bear Stearns, there has been no attempt to look beyond the existing, deeply flawed, financial system by those attempting to resolve this crisis. The "take it or leave it" way the Paulson/Bernanke plan has been presented actually makes it look as though the powers that be in the US are as anxious to prevent discussion of alternatives as they are to prevent bank failures.

[gordon]

cas127, existing descriptions of mark-to-model pricing should be automatically entered in your competition, shouldn't they? Including W.Buffett's "mark-to-myth" and the Wikipedia's alternative name for them, "mark-to-guess".

[Roger Chittum]

Just reading some of the comments here provides a basis for estimating that the problem could be bigger than the US government can handle. Potentially $5 trillion in bad real estate loans, for starters. Then there is the whole hedge fund black box of unknown huge size and risk. Since these shadow banks undoubtedly have counterparties in the visible financial system, their failures cannot be contained and ignored. Isn’t it possible that Paulson is not just trying to protect the wealth and status of his peers (for whom I have no sympathy), and is not prevented by a laissez faire ideology from officially nationalizing failing financial institutions, but that he is actually and reasonably scared to death?

If the Tarp Team were motivated but such a fear, what actions would it be proposing now?
Wouldn’t it try to slow down the rate of asset value deterioration enough to allow time for capital infusions from private wealth and sovereign wealth funds. For example, (i) stop short sales to partially disarm the bears, (ii) arrange for transactions that substantiate higher valuations for troubled assets (maybe you could do this with only $700 billion) or in some other way circumvent the mark-to-market rules so that troubled institutions can carry trash at higher values, (iii) by whatever means are available get cash or cash equivalents into firms that can be saved, and (iv) keep interest rates low to try to guide housing prices into a soft landing. Is this why Bernanke’s eyes were loose in his head?

[LJR]

I think you'd be a lot more understandable if you'd drop "asymmetric information" gibberish for "uncertainty." The problem is that there are a lot of very complicated contracts out there that probably CAN'T be evaluated with any accuracy. The problem is the same as that of trying to write a program that will analyze another program and determine if it every reaches a termination. Can't be done. The unfortunate aspect of our situation is that we can't analyze our way out of it. We'll have to guess. Right now the bid and ask are so far apart that the market is frozen.

Benny and Hanky have the right idea. Someone has to step in and set some prices to provide a starting point for more sales. It seems clear they'll set prices highly advantageous to their masters - the financial institutions.

I see a real psychology problem here. If B&H Inc. bid too high the market players will just sit back and let them buy until their funds are exhausted. The smart investors aren't going to be suckered into buying assets at "maturity pricing." They could be doing that today.

If the reverse auction format is used there is apparently an "apples and oranges" problem. These complicated contracts have been cobbled together on an almost ad hoc basis. Most were traded OTC and no standards have been imposed. How in the world can an auction work under those conditions. It's not like bidding on a '72 Chevy Shortbed.

And how does one factor in things like CDS's that were purchased as part of the deal to offset risk? Does the government get the (probably worthless) swaps right along with the RMBS (or whatever)?

How, for instance, would you do a reverse auction of art works? My Leonardo against your Vermeer? I don't think so.

Suppose H&B Inc. gets a bunch of VSF's (very smart fellows) to analyze prior to making a bid. I wonder just how many people out there are qualified to make a decent seat of the pants evaluation of these kinds of instruments. Not very many I'd guess.

Suppose H&B Inc. are bidding on a chunk taken from a middle tier tranch of a CDO that consists primarily of RMBS. The risk of the tranche was calculated by Moodys (for example) and they didn't do a very good job. The tranche below is failing. The CDO was written so that when the lowest tranche fails the AAA senior tranche holders can force a sale. How does the government even guess what a particular chunk of the middle tranche is worth?

What I'm blathering about here is that these contracts make the savings and loan debacle look a cakewalk. If the government just takes the "maturity" value and discounts a bit for risk there's a good chance it will dramatically overpay in real terms.

Bad idea.

My idea is very simple. Let the system fail if it's going to. Sure, it will be painful. But let's give the free market people a chance to show that their system really works. Let's hold their feet to the fire even if we, the common people, get burned a bit too. In the end we will be rid of the parasites for a few years. If we let them bail themselves out by knuckling under to their threats of calamity we'll still be under their tyrannical thumb when the dust settles.

[ken melvin]

Easy to get teh impression that the sub-primes exposed something much worse. Anyone have an idea of what the unmentionables are?

[Mario Lemeaux]

Of course the CDS market is the REAL trouble!

There is NO transparency. It transcends borders & countries. It infects every financial institution on the planet, and NO ONE has any idea what contracts exist where. The global Derivatives market is $455 trillion!

Why do you thing the banks are "frozen" right now. They are trying to sort out all the exposure to CDS involving Fannie, Freddie, & Lehman. I assume the British have conceded that it will take until 2009 to sort out all these swaps, since their stock market is partially diabled until then!

And yes, we have significant exposure going forward with the AIG equity stake. It means, a significant failure in the CDS market will cause unknown (massive) losses for AIG (Fed). No one knows what this exposure is!!!

All along the Feds have tried to protect the CDS from blowing up (i.e. Bear Stearns) ... and now they want to flush the system with $600B in an attempt to make the CDS problem go away. The CDS market as it stands now is inherently flawed. It is blatantly disfunctional, and cannot work going forward.

No matter how much money you throw at a problem, or divert from the real problem (CDS), if the design is inherently broken (CDS), it will still be broken when the money is gone!

The ISDA (International Swaps & Derivatives Association) announced its plan to help settle credit derivatives trades involving a Canadian forest products company, Tembec Industries in October 2008. The 2008 Tembec CDS Protocol will permit cash settlement of credit derivatives based on a price established at an auction!

I wonder how Fannie, Freddie, and Lehman's derivatives will settle out in October using the same CDS settlement protcol!

I would cautiously submit that this is the REAL "smoking gun" or "dead corpse" that the FEDS are attempting to cover up ... and their urgency is driven by a desire to appropriate $600 billion before the world finds out how broken the CDS market is!

Mario

[Mark]

Anne: "So, this morning Hank Paulson told a whopper"

Sec. 8 refers to two of the three branches of government. "Administrative agency" refers to the executive branch. "Court of law" refers to the judicial branch. The legislative branch is Congress. Therefore, Sec. 8 does not rule out congressional oversight.

[free lunch]

The idea of crowding out the private sector is just a valid for the MBS as it is for equity.

[BJ Feng]

According to speculation, Lehman was allowed to fail because their net CDS positions were small. All that had to be done was get counterparties together to cancel out positions. But AIG had a massive net position because they kept on writing CDS but purchased very little to hedge their own holdings.

Now why would anyone write a CDS and then purchase a CDS from another company to offset that? Remember that there is no clearinghouse or central market. I could sell you a CDS on Citigroup for $500,000 a year to cover $10,000,000, and then turn around and buy one from UBS for $450,000 a year. I just made $50,000! But I still have two CDS, though my net position is zero.

If UBS folds though, I didn't make $50,000. Instead, I'm on the hook to pay out $10,000,000 if Citigroup folds. Just that exposure alone could force me to fold, which would cause a payout event for my CDS securities. Worse, those who bought protection from me would have to write off that protection. Maybe they fold causing another CDS payout event. You see how it can get out of hand.

If Paulson and Bernanke are being interpreted correctly, I really don't like the plan. There are many ways to get the complex stuff off of the balance sheets without giving a huge handout. I expected their plan to be more like their recent "bailouts" which were favorable for the taxpayer, and only marginally favorable for the bailed out company (they're not bankrupt at least).

It seems to me that either Paulson and Bernanke don't know exactly what they are going to do yet, or they don't want to say what they are going to do in case they have to change tactics in midstream or to give others time to prepare. The details were VERY vague.

I think it might be a combination of both, but I'm leaning toward the second option. If you are going to do something, you don't want people to be able to game your procedure in advance. You don't want US banks to start buying crap from around the world because they can make a profit selling it to Uncle Sam. So you keep the details close to the vest so that banks don't know what will be included and what the terms will be.

[Outtanames999]

Prices are a funny thing. When there are no buyers, there can be no price. But the minute there is a price that can be identified, a price can be set. It's all psychological. When you have a price that some buyer is willing to pay, and you have a transaction in which that buyer actually did pay that price, then you have established a reference price.

All the Fed has to do is buy a few tranches of bad loans and presto! the prices they pay become the reference price. At that point, speculation becomes moot and due to draconian mark to market rules, all identical assets immediately are compelled to be revalued at the reference price. That is, all assets IN ALL PORTFOLIOS world wide. Bang! Aseet values are reset and liquidity returns.

And all the Fed has to do is buy a few tranches of a carefully calibrated selection of bad loans (e.g. 30/60/90 days past due, 3/6/12 months in foreclosure, etc.) and all like assets in the market are priced accordingly.

It might cost the Fed $1 or $2 billion at most to achieve this. If the market balks, then the Fed goes back to the well and buys $1 or $2 billion more. With a total of $700 billion at its disposal, even the shorts will capitulate even if the Fed never spends another dime beyond the first couple of billion. The mere threat will be sufficient.

[Detlef]

Outtanames999 said:

Prices are a funny thing. When there are no buyers, there can be no price. But the minute there is a price that can be identified, a price can be set. It's all psychological. When you have a price that some buyer is willing to pay, and you have a transaction in which that buyer actually did pay that price, then you have established a reference price.

But you have that already. Merrill Lynch in late July sold a $30 billion package of CDOs for 22 cents on the dollar. There is your reference price. It´s just that other banks don´t like that price. :)

The Treasury could buy a roughly similar package for 70 cents on the dollar. That still wouldn´t make it the market price because private investors wouldn´t buy at that price.

[asia]

Outtanames999 says...

Prices are a funny thing.
===============
Not funny as the way you think. They are not trendy jeans, that if some celebrity buys it at $1000, people will flock to buy them at the same price.

Financial product is special: the price is determined by future cash flow. If the product does not generate enough cash flow, no one will buy it at high price. With high default rate and falling housing prices, it is not surprising that people are not buying at high prices (sure, they don't have the money either).

Anyone over paid will collect millions of loss in a few months.

[James]

Warren Buffett says the government should buy at fire sale prices.

[Jack]

Instead of seeking warrants as compensation to taxpayers, why not require the Treasury to compensate taxpayers (excluding those taxpayers whose mortgages are in foreclosure) with dividends payable directly to taxpayers, perhaps on a quarterly or semi-annual basis? Paying dividends directly to taxpayers both stimulates consumer demand and minimizes the possibility that government misallocates the funds derived from warrants.

[Matt]

It seems to me that much of the criticism of the plan completely ignores much of the value that the taxpayers would, in effect, be buying. The whole point is that unfreezing the credit markets will have the effect of shortening the duration and intensity of the economic downturn, thereby benefiting all of us, not just the banks.

The aim is not, and should not be, to get a monetary return on our investment, or even to "break even" in a purely monetary sense, as if this were an arms length transaction between two private parties. Krugman's mistake is analogizing the U.S. Government to a private white knight.

The aim should be to structure the price in such a way as to unfreeze the credit markets at the least possible cost to the tax payer. If that allows the taxpayers to recoup the investment, great, but it will definitely cost more than current market values--that is the whole point. I'm not necessarily against the federal government taking an equity position, but we should not require "upside" participation rights at the expense of the ultimate goal of economic stimulus.

[asia]

Matt says...

we should not require "upside" participation rights at the expense of the ultimate goal of economic stimulus.
=========================
But this is not happening, is it? Do you see any danger that taking the equity position will cost us the ultimate goal of economic stimulus?

Please argue that when it is reality, not just in your mind.

[BJ Feng]

"Instead of seeking warrants as compensation to taxpayers, why not require the Treasury to compensate taxpayers (excluding those taxpayers whose mortgages are in foreclosure) with dividends payable directly to taxpayers, perhaps on a quarterly or semi-annual basis?"

Because the party in control of Congress views any money returned to taxpayers as a "cost". Therefore a scheme to pay taxpayers for the risk they take would be attacked as a huge "cost" and unaffordable. However, new plans to use that money for various pet projects would be welcomed without any mention as to the cost.

[Steve]

The key thing here though is that the hold to maturity losses modelled by S&P ($437bn) are pretty close to the mark-to-market writedowns projected.

In other words, the notion of “markups” to come as the markets recover is flawed.

http://ftalphaville.ft.com/blog/2008/09/18/16080/a-rising-tide-of-writedowns/

Global Financial Institutions Eye Another Wave Of Write-Downs As U.S. Housing Woes Spread

A Hold-To-Maturity Estimate Assesses Economic Value In an effort to better estimate the loss in underlying economic value of MBS, we apply a hold-to-maturity approach to all nonprime segments of MBS. Our hold-to-maturity estimate of ultimate losses for the wider range of MBS is $437 billion--and $482 billion including leveraged loans (see table 10). Table 10 All Nonprime MBS Segments: Estimated Losses On A Hold-To-Maturity Basis (Bil. $) ABS CDOs 264 Subprime RMBS outside of ABS CDOs 69 CES 37 Alt-A RMBS outside of ABS CDOs 40 CMBS 14 HELOC RMBS 13 Total 437 Leveraged loans 45 Total including leveraged loans 482 Source: Standard & Poor's.
Date: 2008-09-17 | Similar pages

[Peter Principle]

I think the idea that a public capitalization would prevent private participation is kind of a red herring. Every major nationalization of a banking system I know of has involved the government taking some sort of stake (common, prefered, warrants, senior debt, etc.) in exchange for taking the bad assets on to its own balance sheet. And all of them have ultimately resulted in those stakes being sold back into the private sector. That's when private investors get their bite of the apple.

I mean if Sweden can do it I assume the Capitalist Motherland can too.

Part of me wonders if Fed/Treasury's reluctance to dilute the existing shareholders isn't really about trying not to screw the SWFS that financed the first (failed) recapitalization last year. AFter all, we may need those guys again.

[Lafayette]

It ain't broke, it's stuck

Krugman: Now, if the price Treasury pays is very low - anything comparable to what financial institutions are able to sell the stuff for now - it's going to do nothing for confidence and capital. If the price is high, confidence and capital will improve - but taxpayers may well take a big loss.

Confidence will improve if the TW is OFF their books. That alone will suffice, I submit, to kick-start the credit wheel.

Furthermore, it is not at all obvious that "taxpayers will take a big loss". Past experience in both Japan and Sweden indicates that residual value was unlocked and forthcoming from the TW to the national treasury -- but after a considerable wait.

No one really thinks that reflating $700B capital into Wall Street investment banks is Really & Truly Necessary to get the Credit Wheel rolling again. Maybe as much as $400B will do. (Some investors owning mortgage SIVs may want to wait till the housing market comes back, which will off itself change the TW into solvent assets.) The wheel is stuck and the objective is to get it turning again. It ain't broke, it's stuck. We must comprehend that difference.

(My point: Banks will not lend, even if they can, because there is no trust that the money lent, even overnight, will be returned if bankruptcy were declared. )

Any loan should be also secured however by corporate equity as well. The industry needs government supervisors on the Board to assure that Further Regulatory Measures, which will be certainly forthcoming to regulate the industry, are also observed.

This industry deserves tutelage for its callous negligence.

The premise of the Paulson plan - though never stated bluntly - is that these assets are hugely underpriced, so that Uncle Sam can buy them at prices that help the financial industry a lot, without big losses for taxpayers. Are you prepared to bet $700 billion on that premise?

That may indeed be true. If most of the toxic waste was allowed for new construction. If not, the old housing can be contributed to the community, knocked down and rebuilt as social housing (or, more likely, just resold for reconstruction).

If most of it was allowed for new construction, then the residual price is still that which would be determined by its replacement value. This value is determined by how much would it cost if the property burnt entirely and was rebuilt.

That replacement value is MUCH, MUCH less than its retail price. Presuming that property prices have reduced by 30% from its last transaction retail price, the cost of replacement is probably at only 50% of the last transaction retail price (since land value is included in the property's title). It is, I submit, foolish to think that this panic will drive them lower than replacement value.

Meaning this: If anyone is expecting a fire-sale below that replacement price, the time has probably come and gone. Housing stocks are in the phase of price consolidation, at lower values, yes, but the threat of them going any further is not that great. Most are already at or just below replacement value.

What we don't know, with any exactitude, is how long it will take to deplete the TW by reselling it.