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Tuesday, September 23, 2008

"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?.

    Posted by on Tuesday, September 23, 2008 at 10:17 AM in Economics, Financial System, Policy | Permalink  TrackBack (0)  Comments (96)


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