Illiquidity and Insolvency

Someone asked how the bailout is supposed to work:

I'd say it this way, there are two problems.

1. Financial firms are stuck holding securities they can't sell and can't borrow against. Since these firms borrow short and lend long, that's a killer. The problem is that there are hidden bombs in their asset portfolios, and nobody knows which securities will blow up (so everyone tries to get rid of their securities causing prices to fall rapidly [and this leads to the "paradox of deleveraging", see Krugman's description]). By having the government trade for these frozen assets (some of which are perfectly fine) and replace them with safe, low risk or risk free assets, the firms ought to be able to sell the assets and/or borrow against them again (since there will now be buyers willing to take them), prices will stabilize, and credit will resume flowing.

That's an illiquidity problem. It's caused by toxic assets, the hidden ones freeze up the whole system since nobody wants to end up with them. Why give up cash unless the interest rate is really, really high, too high?

2. The other problem is solvency. Now, some people think that if you solve the illiquidity problem, that's enough, it will allow the firms to borrow within the private sector (perhaps internationally) and recapitalize themselves.

Others think the solvency problem can only be solved with additional injections of safe assets - say cash or bonds - solving the illiquidity problem alone won't be enough.

I don't want to take chances, so I say (1) get rid of the toxic stuff, that helps the liquidity problems and gets credit markets moving again (they froze up severely after Lehman was allowed to collapse, that was a mistake), (2) add additional capital to help with solvency, this is extra insurance in case freeing up credit markets by solving the liquidity problem isn't enough by itself, and (3) give taxpayers a stake in all of this for their troubles. The exact form of that stake isn't as important as the fact that they have one.

Comments

[esb]

"The exact form of that stake isn't as important as the fact that they have one"

More important is that the stake be of sufficient or proper size.

Most important is that Hank Paulson have no role in setting the size(s) of the stake(s).

He is just too close socially to those largest potential beneficiaries of his plans.

Its only human nature to try to help out the guys one private dock "up and down" from the "cottage" on Long Island Sound.

[Paul]

I agree. Equity in the companies is the only way that the taxpayer won't get screwed (too much). That way if (when) we overpay, the taxpayer will share the company's benefit. Also, if liquidity is the issue, then the banks should be obligated to repurchase the assets that the US buys at a later time (with a risk/insurance premium). Hey, maybe the assets will increase and the banks will profit from that, as the arguement goes...

Another problem that no one is talking about is "too big to fail." If this is the case, then shouldn't we breakup some of these companies before this happens again in 2 years? Anyway, I suspect that the real issue, even with the biggest of them, is not too big, but too interconnected to fail. They have created a complex mess of financial instruments so no one knows what happens if you yank the thread. Will it just break off, or will the whole shirt come undone? JPMorgan has assets of $1.8 Trillion, but derivative contract in the HUNDREDS of TRILLIONS. How stable can a comapnay like that be?

[Paul]

That is I agree with esb:
"More important is that the stake be of sufficient or proper size.'

[a]

"it will allow the firms to borrow within the private sector (perhaps internationally) and recapitalize themselves."

Borrowing doesn't recapitalize. Equity does.

[Blissex]

«Financial firms are stuck holding securities they can't sell and can't borrow against. Since these firms borrow short and lend long, that's a killer.»

The problem here is that this is dissembling. If those securities cannot be sold or borrowed against, their value is ZERO. If you cannot sell your car, its value is ZERO. If you cannot sell your navel lint, its value is ZERO.

«The problem is that there are hidden bombs in their asset portfolios, and nobody knows which securities will blow up»

This is another major piece of prevarication, because there are two very different types of securities: the underlying mortgages, and then the securities whose value depends on those mortgages.

Among these securities are the shares, bonds and CDSes of the companies holding those mortgages, backed by their capital. There are enough losses to wipe out the capital of the entire financial system, and this means that the shares, bonds, and CDSes sold by the companies holding those mortages are claims against bankrupt companies.

Sure, while there are enough bad assets to wipe out the capital, but not all assets are bad, so probably there would be some asset recovery, but that probably would be in the 20-40 cents on the dollar range for bondholders and nothing for shares.

But everybody knows for certain at least one thing then: that the shares of companies in the financial system are worth ZERO. There is no way to equivocate and say "nobody know which securities will blow up": everybody knows that at the very least shares have already blown up.

Also, all but the super-senior tranches of CDOs have clearly blown up too, and their value is ZERO, and everybody knows that for certain.

Also, it is certain that even the super-senior tranches of CDOs have blown up, the only uncertainty is just how much.

«(so everyone tries to get rid of their securities causing prices to fall rapidly»

To a level that reflects faithfully the fact that those securities are IOUs from bankrupt issuers.

«and this leads to the "paradox of deleveraging", see Krugman's description]).»

But it is not a paradox -- it is how markets work.

If there is a gigantic oversupply of bad stuff that nobody wants, its price is going to collapse, and drag down the whole market. Perhaps below long term fair value for the ", but that is entirely in the eye of the beholder (or vulture funds).

«By having the government trade for these frozen assets (some of which are perfectly fine)»

This phrase shows clearly the dissembling: as written, it looks like that the problem is that the assets are frozen, but the problem is really that most of those assets are not "fine", as it is implicitly acknowledged.

«and replace them with safe, low risk or risk free assets,»

Ands this is the prevarication that follows the dissembling: since the previous phrase focuses on the "frozen" and not the far more important "fine" side of the story, the argument here is to replace all frozen assets with safe ones, not just the few that are "fine".

This is the Paulson/Bernanke technique for pretending that all there is a liquidity problem ("frozen") when the real issue is solvency (only some are "fine").

And their solution is to make sure all assets everywhere become "fine" again by covering the losses for free.

Also, there is a slight problem with the notion of «risk free assets», because the only practical ones, Treasury-issued cash or bonds, are denominated in dollars, and thus subject to enormous inflation and currency risks.

And this matters a great deal because while the Treasury will assume the credit risk, ultimately the inflation and currency risk will be borne by those who will lend money to the Treasury to carry out the bailout. Will they accept to generously cover that risk?

«The other problem is solvency. [ ... ] (3) give taxpayers a stake in all of this for their troubles. The exact form of that stake isn't as important as the fact that they have one.»

But the form of the stake matters a great deal, because it determines whether those companies and their management, refilled with taxpayer-guaranteed cash, will have an incentive to create another series of bubbles, as it happened after the S&L crisis, or not. Does it end here or not? The shape of that stake will determine that.

The USA have to decide whether they want a financial system that is safer but with less innovation and lower rewards to management, or very risky but with a a great deal of innovation and very large rewards to management. Guess who wins...

[BJ Feng]

The thing about "too big to fail" is that it usually only applies to financial firms. And financial firms often fail in an financial crisis type environment when other financial firms are also very weak. If it were just one or two financial firms in trouble, then others could be relied upon to carve up the failing firms, but in a time of financial firm weakness, there are just too many bad firms and too few firms strong enough to absorb them.

Mandating a breakup of the largest firms will hurt more than it will help. The reason for the recent bailouts is that the firms in question posed a threat to others thanks to the weakened position of all financial firms. In ordinary times, most institutions would have been able to write off a large, one-time loss from holding AIG credit default swaps let's say. But in these times, that could force bankruptcy. Even if you make firms smaller, cross holdings and weakness would still force the government to intervene. But without big firms, we don't have the possibility of a private sector buyout like with BOA and Merrill. Only a firm large as BOA could swallow a Merrill with all of its bad assets.

My idea might be to create some sort of bailout fund that banks and institutions would pay into in good times. That fund would be used to buy bad assets in times of trouble, but the existence of such a fund could create lax attitudes towards risk.

What is clear is that institutions should no longer be able to create SIVs, which are quasi-independent entities designed to hold assets off of the balance sheet. If institutions make a commitment to fund these SIVs, then they have to be recognized as part of the overall risk of the institution. I believe this will be changed in the near future.

If Paulson holds to past actions, he will also ask for a stake in firms who sell debt to the government. We'll see, but that's a sensible requirement.

[bakho]

Have the Treasury and the Fed EVER admitted the existence of a housing bubble?

Dean Baker notes the numerous times Paulson has NOT acknowledged a housing bubble.

http://www.prospect.org/csnc/blogs/beat_the_press_archive?month=09&year=2008&base_name=paulson_missed_the_bubble_and

Maybe the Bush administration is working with less than full information? This should not be possible. In the Bush administration (we did not know people were drowning in New Orleans) anything seems possible.

Is it possible that they still do not understand the housing bubble?

[paine]

"How ironic would it be if the unbridled push toward free market capitalism brought about ... dictatorship via economic chaos "

" ironic " ???
perhaps "lapidary"
gets to the core meaning of this knee jerk boiler plate

what ystem have we ben operating here these past 30 years
and who's called the shots ???
so now they want to keep calling em
ironic ???
hardly
that te play must get more force filled
more state induced
even more gun barrel ish

a surprise ???
given the reagan coup
the feeling of irony here
among whole people oriented commentators
is the irony

uncle ronnie ..pinochet with a hollywood rewrite

[paine]

zero equity funds that pay a risk premium on their portfolio
that outghta be the model entity
to replace these hyper geared
exiguously equitized
high wire acts
btw
such gigantic freak shows
will spontaneous re emerge
if equity plays re enter the model

if the only arbitage rents that flow out of these
loans to loaners who loan to loaners who loan to ...

that paasses back up the chain
"final net earnings "
like a bucket brigade with sieves for pails ....

i submit public equity stakes
will only get re privatized
as the game boards and the play re heat

hair grows back
so
not a hair cut a scalping

[ken melvin]

First - a look at which of these firms are worth saving. Otherwise, 'tis like bailing a leaky boat or pouring sand in a rat hole.

[paine]

too big to fail
really has nothing to do with the problem
the total system wide equity versus the total potential losses
that's the problem
whether its in one big firm or
fairly evenly distributed in ten thousand little firms
the problem is the possibilty of inadequate equity
and thus lender losses
imagine if by an invisible hand
the equity in every firm would always be
exactly emough
to cover all potential losses to that firm
then lenders could and would lend to them
but would folks buy equity issues by thm ???

not if losses of unknow proportions
still hung over them

ask yourself this

if transparency is voluntary
as free private firms insist is their right
how is it in the interests of insiders
to obscure on their balance sheet
their real financial prospects and conditions

to throw
a partial light or if the odds favor
non timely revelations
why not throw even a boldly blatantly
false light
on conditions
how does a market
filled with a zillion
little firms
hit with a crsis
differ in consequences
that a market with only one big firm
if the little firms act like a school of fish

if all the toxic shit was in one or a few big firms ??
it would be easy
for a public authority
backed by the redit of the whole society
to intervene effectively

take it over
clean out the gunk
and move on
voila fred and fanny

but
if every firm of many has some unknown amount of gunk ???

to big to fail only means
the market might turn radioactive if the big firm fails
and all the others will face a panic day
of senseless reckoning
all at once

[swells]

B J FENG, good post. As regards SIVs? What government programs are analogs for these? Are those programs, for lack of a better term, Government SIVs. Do these government SIVs exist for the same reason the non-government SIVs existed; i.e., to get things off the balance sheet and thereby hide the true extent of the risks they pose?

This is just the beginning folks.

[paine]

we have equity because
those who play equity games
gain "return"
by leveraging off debt players

we only tolerate equity as a society
because it provides a class of players
that in times of crisis
play the involuntary role of risk buffer

there are better risk buffers folks
for credit flow systems

end the equity rip off game

ps
of ourse
even equity is a sucker play
relatively speaking

there's another deeper
more decisive rip off

the skim
from the passive equity players
by the sifted few insiders

and sifted few insiders
would exist in pure debt funds as well

[Re-liquefied Reputations]

After re-liquefying/recapitalizing, will these institutions be able to securitize future loans for resale to foreigners? Will foreigners be suspicious that any future loans brokered by the errant institutions may contain toxic waste also? New private mortgages are essentially unmarketable. Only full faith and credit guaranteed mortgages can be marketed overseas now. What makes you think that the old institutions which have destroyed their reputations will be trusted again? At least for a long time.

Something more drastic may be needed. Strict credit regulations may be enough to restore foreign confidence in new privately brokered loans. If not, something like new institutions arising, with impeccable reputations. Alternatively, something like complete gov takeover, and full faith and credit guarantees of all new loans (mortgages, credit cards, business loans, etc...)

We can't reasonably expect to continue marketing private loans with credit standards that vary markedly from the rest of the world. Not after this fiasco. We may even need standards that are higher than the rest of the world to restore trust.

[openmouthedfool]

Can one of the smart commenters here explain to me, please, if a $200K mortgage (approx US median home price) is worth say $450K over 30 years, $700 billion = 1.5 million mortgages, so better than 1 of every 2 people, man, woman, and child, in this country owes on a mortgage?

[robertdfeinman]

I don't believe it, that the "toxic" waste is mortgage securities. Firms have been taking write downs as mortgages went into default for over a year now. I doubt there is still a huge amount still on the books.

There may be a fear of future mortgage failures, but that's just a potential, not reality.

The real "toxic" waste are all the highly leveraged derivative products that have been created that have nothing to do with home buyers. By creating a catch phrase that the clueless pundit class can latch onto the underlying issues get hidden.

What the financial firms want is to be covered for their rampant speculation based upon 3% margin requirements. Paulson has a $100 million conflict of interest in keeping Goldman Sachs afloat. Allowing two of the big competitors to fail only made his stake more secure.

Then today these firms turn themselves into "banks" and get to tap the retail deposit market.

Unless someone can show otherwise, I say this is all about helping Paulson and his cronies hold on to their millions. This also explains his desire to avoid any judicial or congressional oversight once given the keys to the treasury.

Can we stop talking about "toxic waste" and get some clarity as to what sorts of liabilities we are really talking about? AIG was writing insurance on the possibility of firms failing, that's like taking out insurance if you bet on the wrong horse in a race. With "insurance" firm didn't have to do due diligence and could market anything.

Words do matter, and in this case the propaganda machine has already won the battle over rationality with its combination of "crisis" and toxic waste. Nothing good will come out of this, unless you are a plutocrat.

[Alex Tolley]

openmouthedfool - there are ~ 100M households in the US, so your # is 1.5% of households, a far cry from 1/2 the population owing on mortgages.

[Alex Tolley]

rdf: Most mortgages are not in default (yet). Your assumption is that mortgages in the poor risk tranches are all in default. Not so. I also understand that mortgages were broken up into different pieces to serve different customer requirements, and some of these slices may be underwater to the point of 0 value.

[paine]

i think bob f
has the bull by the horn here

how much more adjustment is yet to happen ??

the house lot bubble burst
a year ago
how long will it ake and how much more is left to absorb

does the vast inverted v hierarchy
of synthetic securities
still face huge further devaluations

what more
if left to its own devices
is yet to happen
inside that hideous freak of a financial structure ???

have the towers all fallen ???

or will many more follow ????

maybe the frights are now
encouraged
by the wall street types
begging for a "refill"
at the public pump ????

my take....

nope

the fuckers are still sinking
and the prospect of uncle's pumps so far
ain't nearly enough

btw
we're goin down with em folks

[robertdfeinman]

AT:
Let's suppose that all the mortgages in a given tranche are in default and that the homes are all worth less than the outstanding loan. The homes still have a residual value and in a normal foreclosure procedure the bank would get back a substantial fraction of its loan by selling the property.

That these mortgages have been resold to others doesn't affect this basic underlying fact.

What is different is that the banks have been short of capital so that they have been selling the property too quickly and taking big loses because they can't afford to dispose of them in an orderly fashion. This has caused an overshoot on the low side.

A real resolution of the housing (not banking) squeeze could be any combination of allowing people to stay in their homes while renegotiating their loans, or shifting to renter status, or trading a share of future equity gains, when they sell, to the banks for low or no payments now.

In addition a mortgage purchasing federal entity could be set up to buy up the mortgages under these conditions. This would help dig out the banks who originated the loans, but would not bail out the speculators who have been trading in anything that they could create as market and "innovative" financial products.

Ponzi had an "innovative" financial product too.

[Gavin]

Mark Thoma seems to have already decided that allowing Lehman to fail is a mistake. I think history will judge whether it was a good idea. To solve this crises the leverage that financial companies use must be reduced. This is likely to lead to a smaller financial sector which is only possible if some banks go out of business. With attitudes like Mark Thoma's it is unlikely that the Treasury will allow any more banks to fail with the $700 billion bailout.

We will continue to be stuck with the excess capacity.

[Alex Tolley]

rdf: "What is different is that the banks have been short of capital so that they have been selling the property too quickly and taking big loses because they can't afford to dispose of them in an orderly fashion. This has caused an overshoot on the low side."

Even prior to the financial meltdown, there was ~ 8 months of housing inventory. Clearly there was excess supply already. Panic selling miay well have exacerbated the price decline for some properties, but I don't see any orderly solution that can work itself out quickly. While I think the idea of helping the homeowner should be done (we could end up with a lot of foreclosed homes causing unnecessary pain), but any small haircut in the value of the loans will wipe out the bank's capital due to the high leverage ratios. So I think you are arguing that the 'toxic waste' still has some residual asset value, rather than zero. But that assumes that the 'securities' in question are attached to the underlying asset. They may well be more like options or AIGs insurance - valued only to fact that the mortgages even exist, but with no asset backing at all.

[paine]

"a mortgage purchasing federal entity could be set up to buy up the mortgages under these conditions. This would help dig out the banks who originated the loans, but would not bail out the speculators "

correcto

but its all abut hi fi here bob as u well know

curing eeble suffering is only a last resort expedient
if direct tower troll bail outs
aren't enough
recall
the dilemma
if it don't stop

the walk away threat might suddenly multiply

just how long how slowly and how far
are lot values going to fall
if say 30% of the housing stock
is owned
by folks with under water equity ...
anything might trigger a walk way graze
like the dust bowl
farm abandonments of the 30's

handle this allwrong
and this time next year
McCainvilles might
start to pop up
like bavarian mushrooms

[paine]

"This is likely to lead to a smaller financial sector "

oh great pundit

what in hell does this mean
specifically

smaller hi fi firm count

smaller total value of outstanding loans

society wide
portfolio value shrink
of bonds and equity

lower security trading velocity

lower hi fi sector share of national income

inquiring dip shits want to know

[paine]

as to lot value bottom

the "natural" household income
to mortgage ratio (ie our proxy for
capitalized ground rent )
indicates
the long run trend ratio
is something not far from 50% below
this cycle's peak ...

and we over shoot it to boot ....

[paine]

bob and one other chap
are at opposite ends here

one wants a public equity buy in
and the other
a public mortgage buy up

shared good intentions are obviously
not enough
to settle on a plan

[baileyman]

"(3) give taxpayers a stake in all of this for their troubles."

Taxpayers should TAKE a stake. Something on the order of 90% in most cases.