A number of readers have asked why I described the Paulson plan as "a plan to have a plan" when Bernanke says they want to use a reverse auction to price the securities.
A couple of reasons. First, because there are a lot of issues with reverse auctions. Bonds aren't stocks; there are a lot more of them, and they're much more idiosyncratic. The securities that the government is proposing to buy are even more complicated than ordinary bonds.
This means there's a gigantic asymmetrical information problem: the owners of these securities know much more about them than the Fed. And there isn't (obviously) a large liquid market for the Fed to check against. So the Fed is likely to overpay, because there won't be a lot of bidders in any one auction.
Second, because there are so many different securities, auctions will take a lot of time. The whole argument in favor of this bailout is that we don't really have a lot of time.
Third, the reverse auction arguably solves one problem--what are these securities worth?--by adding another: the aid isn't targeted to the institutions that necessarily need it, or can use it the best. It's targeted towards those who will bid the lowest. Maybe that will be institutions in distress. Or maybe it will be solvent firms looking to clean up their balance sheet.
Relatedly, using a price discovery mechanism means that the bailout may not give distressed firms enough capital. There's no point in buying distressed securities if the banks go bust anyway.
Thus, while reverse auctions may feature in the final plan, they're unsatisfactory, and probably will not be the primary vehicle for recapitalizing banks. So I still want to know: what's the plan?
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Maybe their idea is to have some deliberate ambiguity? That way market participants can't game it as easily, and will think twice about shorting any part of the credit markets, for fear that they'll end up on the wrong side of a $700 billion gorilla. That ambiguity itself, combined with the huge firepower, might be enough to lift the market for all debt securities somewhat.
I finally had someone explain to me what these insturments are. They are not even securities on full mortgages. The banks sliced up mortgages into securities on individual payments. You take a 30 year mortgage and sell the 360 payments in individual securities. Then bundle thousands of those securities in to larger offerings. It is the craziest thing I have ever heard of in my life.
I don't see how you could ever value these things properly. Even if they were full mortgages it would be difficult to value them because the value of a mortgage is a product of the value of the mrtogage, the probability of default, the priority of the lien and the resale value of the collateral. I don't see how you could value a bundled mortgage insturment letalone securities on individual payments.
How were these things ever legal? What idiot thought that it would be a good idea to buy them?
Fred makes a good point. Be too explicit, and people can game the system.
As well, other banks may go under simply because they are beyond help. The government aid should not be aimed towards them, but towards those banks that are bloodied. So this may not help WaMu, but it may help Wachovia (I've no idea which is weaker).
Apparently, some traders think that the Feds could clean up. But ultimately it comes down to a game of chicken. If a bank rejects a 50 cent on the dollar offer, and goes under, will anyone feel sorry for them?
Just want to say that during this whole bailout adventure, your blog has been indispensable to financial neophytes like myself who are just trying to get a rudimentary grasp of what's happening.
Thank you for writing it, it's a must read every day.
And John, is there a link to that explanation somewhere about the mortgages being sliced up into payments?
"If a bank rejects a 50 cent on the dollar offer, and goes under, will anyone feel sorry for them?"
Larry Kudlow is on National Review screaming that putting exectutive salary caps on banks that sell securities to the government will mean that no one will sell them. Well, if they can turn down the buyer of last resort, then they really don't need government help too much do they? Failure breeds supervision. If they are going to foist their bad paper off on the government, then there ought to be a lot of pain involved.
It's a very strange form of price discovery.
Price discovery is usually about creating a market or helping a market to funciton more efficiently so that it can clear, so that the market can determine the value or worth of some asset. Which in the case of MBSs or CDOs would normally the present discounted valuye of expefted future cash flows.
Paulson's price discovery is not about discovering this type of value or worth, it's about discovering the price at which banks can afford to offload the CDOs and MSBs while still maintaining some form of solvency on the balance sheets. It's not about best estimates of discounted future cash flows, it's about how low the banks can afford to go.
And how low the banks can afford to go in many instances is almost certainly more than the expected future cash flows. So it's really a straight subsidy to the banks under the cover of other bullshit.
Paulson's plan equates preserving a functioning financial system with preserving the actors and institutional arrangements of our current financial system. All of us have a big stake in the former, not so much in the latter.
No deal without equity!!
Thus, while reverse auctions may feature in the final plan, they're unsatisfactory, and probably will not be the primary vehicle for recapitalizing banks. So I still want to know: what's the plan?
If a firm finds that its balance sheet is out of whack, and that declining capital has put its operations at risk, it is perfectly free to let outsiders purchase equity in order to give itself an injection of capital.
Have these distressed financial institutions even tried that? I know you can say "nobody wants to buy their shares in their current state." Well, maybe, but, what that really sounds like is that they're not willing to price their equity sufficiently cheaply. Beggars can't be choosers.
Anyway, I continue to believe the easiest way out of this mess would be for the government to not get involved with the distressed assets in any way, shape or form. This situation is primarily one of damaged balance sheets, and damaged balance sheets simply need an injection of capital. If the private sector can't adequately undertake this task, then the government should take up the slack, in return for shares. And the government should be required to gradually divest itself of these shares in due course, based upon objective, agreed-upon-in-advance financial/economic criteria (ten quarters of annualized 2.5% GDP growth, etc.).
"This means there's a gigantic asymmetrical information problem: the owners of these securities know much more about them than the Fed."
That's why I suggested, in this comment that the government would be better off offering to buy only mortgages themselves, at a significant discount, and not the more complex securities derived from them:
Megan, I'm not sure I understand the third problem
"Third, the reverse auction arguably solves one problem--what are these securities worth?--by adding another: the aid isn't targeted to the institutions that necessarily need it, or can use it the best. It's targeted towards those who will bid the lowest. Maybe that will be institutions in distress. Or maybe it will be solvent firms looking to clean up their balance sheet."
In many posts, you've said that the bail out isn't, or shouldn't be directed at any institution, but rather at preserving the system, and keeping the credit markets from collapse. So, as tax payers, what do we care which banks fail and which go on, as long the the overall credit market continues to function? It seems that this is another take on the age old "Do you help the patient that needs help most, or the one that has the greatest chance of surviving?".
If anyone's interested, this is the post I wrote last month about those entrepreneurs in New Jersey and California who are buying distressed mortgages and, in some cases, writing them down and working out new terms with borrowers.
I think the problem with pricing these securities is not the device used to get the best valuation today. It's the uncertainty of what they will be worth tomorrow? These securities have to go at a discount to any sort of present valuation because their value will deteriorate if the economy worsens and the default rate increases.
I'm sure a smart investor is ready to buy these things, it's just a price no one wants to fetch for them. An auction isn't going to improve the situation. The winner of the auction will be the guy who overvalues the securities. Only until the future default rate is better known or until someone if finally willing to sell at deep discount will this thing stop. This will simply be passing the buck from one idiot to the next worst idiot.
What we need here is an orderly process to allow banks to liquidate enough assets to cure their liquidity ilks and fund operations. A process that will stave off mass liquidations and runs. Oh Wait, we already have that process. It's called a Chapter 11 restructuring.
There is too much discussion here about the mass cliff we're all going to run over and how the bailout is the ONLY option, and too little discussion about how a free market with proper govt intervention (think order, not force, or bailouts) would work.
Second, because there are so many different securities, auctions will take a lot of time. The whole argument in favor of this bailout is that we don't really have a lot of time.
Unless I have misunderstood him, he is disputing you on this point.
http://gregmankiw.blogspot.com/
"If a firm finds that its balance sheet is out of whack, and that declining capital has put its operations at risk, it is perfectly free to let outsiders purchase equity in order to give itself an injection of capital.
Have these distressed financial institutions even tried that?"
Umm, yes, Citigroup raised billions from Middle Eastern investors; UBS raised billions from Singapore and through a rights issue; Morgan Stanley, just last week, sold a 20% stake to Mitsubishi/UFJ; Barclays raised billions through a rights issue; as did RBS. Goldman is about to take something like a $5 billion injection from Warren Buffett. Perhaps speak when you know of which you speak.
As for those suggesting that these firms be restructured via bankruptcy. Umm, that's impossible because federal law requires financial institutions to be sold off in bankruptcy rather than restructured. Note how Lehman has been sold piecemeal to Barclays and Nomura rather than restructured.
The only choices here are, do something to help these banks, or some (many) of the banks will go bankrupt and have to have their assets sold off in a fire sale. There is no restructuring option.
I am not necessarily for this plan. In fact, I don't even know anyone in the financial industry who is "for it" morally. Most people think it's wrong on a very deep deep level. But, we're not going to get many solutions when it becomes amateur hour all over the country with every idiot thinking he knows what he's talking about. But then again, if it's amateur hour on the floor of the Senate then why not in the comments sections of this blog.
Megan, thank you for writing really interesting and insightful commentary on the crisis. You've been mostly right about the facts of the markets throughout.
Perhaps speak when you know of which you speak.
Um, Gene2, that was exactly my (rhetorical) point: we've seen significant private sector investment in financial institutions in the last couple of weeks, and we ought to try and let such investors carry as much of the recapitalization burden as possible.
"As for those suggesting that these firms be restructured via bankruptcy. Umm, that's impossible because federal law requires financial institutions to be sold off in bankruptcy rather than restructured. Note how Lehman has been sold piecemeal to Barclays and Nomura rather than restructured."
Why isn't changing that law on the table?
Much cheaper than a bailout, no? Decreases the risk of cascading failure from failing banks selling off the same assets that are held at other banks thereby depressing the book value of the assets of the other banks.
What's the argument in favor of this quirk? Is there one or is this another gift from the Roosevelt administration?
I don't think the reverse auction idea was ever meant to be taken so seriously. I think the plan was for Paulson to look for bargains with consideration for the needs of the seller and do deals like a cross between Warren Buffet and a Platonic philosopher king.
I guess that's the beauty of the House Repubs plan for insurance. You don't care what the price is, just the default rate. Once you know what the default rate is, you can price the insurance appropriately and the financial firms re-capitalize themselves. You turn these MBS' into a pre-refunded muni essentially with a minimum price of whatever the insurance payout is.
If a bond is trading at 20 cents, but it has a guaranteed payout of 80% the firm can now price it as a Level 2/3 asset(using FAS 157 speak) at 80 cents and take a current charge for the premiums or price it at 80 less the premiums. Since they were mark-to-marketing these assets at 20 cents the bank now has 60 cents on the dollar more in capitalization and they can avoid invoking covenants that require them to raise more capital, which is what brought AIG down and I'm guessing forced the FDIC to take over WaMu.
These firms still have cash, what is dragging them down is they have tons of realized/unrealized losses on their books. Fix the losses, and you fix the firms. Doesn't matter how you address the losses.
The one problem with the insurance idea is to keep it from growing into an unfunded entity with a trust fund that has already been spent.
"This means there's a gigantic asymmetrical information problem: the owners of these securities know much more about them than the Fed."
Are you sure about that?
Or, to put it another way, "what do they know that the Fed can't easily find out?"
When I want to sell you my car, I know a lot more about that car than you do, because I drive it every day, and you don't. But I don't understand what the holders of those securities can know about them that the Fed can't find out, in a reasonably quick time. Default rates? Does B of A even know who the mortgage holders are who underpin all the securities they're now responsible for?
I am reading that these securities are unique. Essentially, the Treasury would be offered a selection of uniquely bad paper at various prices by various banks with various needs. Should this process really be viewed as a mechanism for price discovery, or is it an opportunity for the Treasury to make some deals? Should we give the Treasury the discretion to do this?