Bailout or bonanza? Part 1: what do you do?

September 29, 2008 | GSEs, Housing, Subprime, US News

Is the Treasury asset recapitalization program (TARP) a bailout for Wall Street, or a bonanza for taxpayers?



Wanna make a bet about it?


That depends on a critical question: Will Treasury pay too much or too little for the assets?



What, you think I know?  I just work here.


With the inevitability effect [Blog post on this subject to come – Ed.] kicking in, clouds of dust are obscuring the program’s plain lines.  That, plus the huge sums and headlines screaming BAILOUT, make it understandable that Joe Public might think we’re going to pay ‘too much’ – otherwise, why would Wall Street be rushing to do it?  As the New York Times quotes President Bush:

President Bush, in his weekly radio address, tried to sell the rescue plan to the American public, which, according to opinion polls, is deeply skeptical. “The rescue effort we’re negotiating is not aimed at Wall Street, it is aimed at your street,” Mr. Bush said.


Before we can take apart why this is almost certainly in the country’s interest – even if Treasury does overpay, this will undoubtedly be a gigantic lift for the economy, for reasons outlined below – we should examine the possibility of overpayment.  Just because Treasury is saving the global economy doesn’t mean we taxpayers should overpay for our salvation – we shouldn’t.  This post is about whether we will overpay in our rush to save the world financial system.



At least somebody gets the nature of the problem.


How we got here: the reduced Wall Street company.  As I’ve posted at great length before, during the heyday of twenty-first century securitization, Wall Street created new structured securities tranches – blends of slices from individual loans.  Through miracles of Monte Carlo simulations, the bankers were able to persuade what appear to have been all-too-gullible rating agencies to take a puree of Class C assets and find a Class AAA extract within.


Then things went wrong, went wrong, went wrong … and all of a sudden, nobody wanted the goods.  As Andy Kessler wrote in a cogent Wall Street Journal Op-Ed:


Here’s what’s happened so far. New technology like electronic trading meant that Wall Street’s bread-and-butter business of investment banking and trading stocks stopped making much money years ago. So investment banks took their enormous capital and at first packaged yield-enhanced, subprime mortgage loans into complex derivatives such as collateralized debt obligations (CDOs). Eventually and stupidly, these institutions owned them for themselves — lots of them, often at 30-to-1 leverage. The financial products were made “safe” by insurance products known as credit default swaps, a credit derivative from companies such as AIG. When housing turned down, the mortgages and derivatives were worth a lot less and no one would lend Wall Street money anymore.


Then the piling on started.



I think we can bid you down


Hedge funds could short financial stocks and then bid down the prices of CDOs stuck on Wall Street’s balance sheets. This was pretty easy to do in an illiquid market. Because of the Federal Accounting Standards Board’s mark-to-market 157 rule, Wall Street had to write off the lower value of these securities and raise more capital, diluting shareholders. So the stock prices would drop, which is what the shorts wanted in the first place. It was all legit.


So they all put it into their recycling bins.




Why Wall Street’s in a lather: liquidity and cash.  There came a moment when everybody on Wall Street held some of these assets, and nobody knew what they were worth.  All previous attempts to assess their value having failed, Wall Street did what Wall Street often does – it sought relief from its problem by selling the problem to somebody else.


So out on the curbs of Wall Street there blossomed, like blue-plastic mushrooms, buckets of goods to be recycled.  Thence came the problem: who buys recycling?


* Bring your heavy garden gloves, so you can sort it.

* Be prepared to hold on to it for a while.


Except that up and down Wall Street, nobody was in the recycling-hauling business, they were all in the recycling-dumping business.



Any recycled-asset buyers out there?


And thereby is the essence of a panic price-fall: even if it’s the most valuable thing in the world, a commodity drops in price when nobody’s buying it and everybody’s selling it.


Why this weighs on the banks: Vermeer or velvet-Elvis?  Banks – for that matter, any public company subject to Sarbanes-Oxley and FASB regulation – are under a duty to report their assets at fair value.  The concept of ‘fair value’ is easy to comprehend when assets are standardized and freely bought and sold every day.  When the assets trade infrequently, and when they’re very particular, what are they worth?


As an example, consider the paintings of Jan Vermeer.  In his entire life, we know of only 35 paintings that are indubitably his.  Each authentic Vermeer is a masterpiece.



This is a masterpiece


Suppose that your bank owned a Vermeer, and was carrying it on their books at a certain value.  You would be happy – it’s rare, it’s marvelous, and the collectors would line up around the block at Sotheby’s to buy it.  You loved it so much you put it into a huge wooden crate and stored it in your vault, with a big stamp labeled VERMEER.



“It’s under the care of top men.” 


“Top.  Men.”


Now suppose that a bulletin is issued suggesting that nearly all Vermeers in the world are fakes painted by a celebrated Elvis-on-velvet painter.



This isn’t a masterpiece


You want to sell.  Everybody wants to sell.  The Price of Vermeer-or-velvet-Elvis plummets.


Worse, every Vermeer-holder in the world suffers a massive writedown in the value of its Vermeers.  Once the panic spreads, nobody’s Vermeer is believed until it’s been professionally appraised.  All the appraisers, meanwhile, are overworked, and their confidence too is shaken.


If all the world’s Vermeers are fakes, then most of the world’s banks are bust.  No one will buy a claimed Vermeer because no one can afford to take the risk of being inauthentic.


Conversely, if you know all but two of those Vermeers were the real thing, you could make an absolute killing by buying all of them, now, when the price is so depressed.


Who’s got that kind of money?  Who’s got that patience and guts?


Enter the man whose name is on the money: Treasury Secretary Hank Paulson.



You mean I’ve got to decide this?


What we’re not doing: giving charity.  The Paulson doctrines require (1) preventing the Second Great Depression, and (2) doing as little as possible to achieve Job 1.  This program isn’t charity.  It may be imprudent, or optimistic, but it ain’t charity.



Donate your used CDO’s here


Under the Treasury plan, the Wall Street institutions will be able to sell – not borrow against, mind you – their recycling bins full of assets, for a price that is intended to reflect their real value.  As the New York Times puts it:


The core of the proposal, put forward a week ago by Treasury Secretary Henry M. Paulson Jr. remained intact: a plan for the government to purchase up to $700 billion in troubled assets from financial firms as a way to free their balance sheets of bad debts and to help restore a healthy flow of credit through the economy.


The ultimate cost of the plan to taxpayers is virtually impossible to know. Because the government would be purchasing assets of value — potentially worth much more than the government will pay for them — there is even a chance the rescue effort will eventually result in a profit for taxpayers.


Much more than a chance.  This is a classic Wall Street trade: if the assets are worth more than the Treasury pays, taxpayers make money.  If they are worth less, Treasury loses money.


The Paulson premises.  Beyond the Paulson doctrines, the TARP proposed by Secretary Paulson is predicated on several premises:


* These assets have an ‘intrinsic value’ – say, what a good evaluator would come up with provided there was plenty of rational money in the market.  (That is, they’re probably real paintings – if not Vermeers, then Jan Steens.)

* They have an ‘immediate trading price’ – what you’d get if you sold them tomorrow – which is grossly below intrinsic value, because the market’s acting irrationally.


Kessler again:


There is a saying on Wall Street that goes, “The market can stay irrational longer than you can stay solvent.”


Actually, he’s quoting John Maynard Keynes.



The young Keynes, by Duncan Grant


If Paulson’s premises are right, then Treasury can buy the assets for more than ‘fair market value’ and less than ‘intrinsic value.’


Fair market value, fair value, or some other value?  Most definitions of ‘fair market value’ use ‘immediate trading price’ as their measure, except for ‘distressed sales,’ which mean situations where the seller has a financial gun to his or her head.  The problem is the entire country is a distressed seller, which screws up the market, so it’s entirely possible to have immediate trading price (the usual best evidence for ‘fair market value’) much, much less than intrinsic value (which is what people use for ‘fair value’).


Why the country needs this move: the banks’ albatrosses.  Let’s go back to our bank with a newly questionable Vermeer.



Am I real?  Or am I a fake?


Originally, you bought it for (say) $7,000,000, but with the new revelations, you’ve written down its value to $4,500,000.  Your bank has had to book a $2,500,000 loss, even though it’s precisely the same painting it was before.  Additionally, you cannot tell for sure that $4,500,000 is the proper figure, so your auditors – burned by Enron or just plain cautious – require you to set aside 20% of the remaining value, $900,000, in cash, as a hedge against a further writedown. 


Thus you, the structured-asset buyer, trudge into the CFO’s office to tell him: “Boss, we took a two-point-five mill loss last month, and we have to set aside nine hundred kay as additional cash.”  The CFO looks at you and say, “if I need $3,400,000, I can start by eliminating your salary, can’t I?”


Meanwhile, along comes Paulson.



What should I offer for your questionable assets?


Paulson offers to buy the Vermeer, in its crate, for $4,250,000. 


What do you do?



“Shoot the hostage.”


[Continued tomorrow in Part 2.]



Comment from Eric Mauro
Date: September 30, 2008, 9:38 pm

If the securities were such a great buy then private buyers would be snapping them up.

Comment from Louis Buda
Date: October 1, 2008, 10:02 am

Some of those bonds (packaged collaterized debt) are good – The mortgages are being paid off.
The problem is trying to separate the good from the bad. This should be brought out in the
discussion, I believe.

Comment from endorendil
Date: October 1, 2008, 11:32 am

excellent explanation. Two things that bother me, though.

First, the Treasury will NOT be buying all fake Vermeers and real ones. It will be buying about 5% of them. Anyone who knows that they have a velvet Elvis will sell it to them. So they are llikely to end up with mostly Elvises. Because the sellers will be dumping their known bad assets first, they will depress prices. To the extent that they get away with it, they could actually depress prices for assets that ARE valuable.

Second, the banks will sit on 95% of the paintings after all this is over. If the Treasury does no more than buy at a price it thinks reasonable, then that will not achieve squat, as it does not form a basis for a re-evaluation of these paintings. After the bailout, the banks have not had a price discovery process, and so are in the same spot they were before. Minus 5%. If the selling process ends up depressing prices further (by making it look like there are more Elvises in each asset class than is really the case), they may be worse off. A lot worse…

The problem is that an illiquid instrument that depends on the health of the global economy as well as microscopic factors (the exact houses that form the collateral) can not be made liquid unless everyone agrees on a valuation model. Banks cannot agree on the valuation model anymore, and there may actually not be a reasonable model for the current economic circumstances. There is nothing Paulson can do about that. Or anyone else.