Is the Market an Accurate Pricing Mechanism? Paulson Doesn't Think So

In recent weeks the Treasury has taken a series of actions which have shaken the foundation of our free market economy, and have brought into question the market's ability to accurately price securities.  Recently, Treasury Secretary Henry Paulson has temporarily banned short selling of over 800 stocks, and has announced plans to start a $700 bailout fund which would potentially value distressed assets above their market value.  Through these actions, Paulson has brought about accusations that the market is seriously hindered in its ability to price assets.

The most dramatic action by the Treasury Department thus far has been their temporary ban of 799 financial stocks (the list has now been expanded to include over 800 stocks).  Short selling is a vital part of our financial markets and allows for accurate price discovery as markets price in risk.  Secretary Paulson decided that in order to stabilize financial markets and to prevent additional large institutions from failing, all short selling of these securities should be banned temporarily.  By restricting short selling, the market prices of stocks are artificially inflated.

Numerous studies have been conducted examining the effect of restricting short selling, and have concluded that price discovery is distorted; recently, an extensive study was conducted which concluded that the restrictions led to overvalued conditions in stocks which were selectively banned on the Hong Kong market. 

Additionally, Secretary Paulson has announced his support for purchasing mortgage-backed securities for ailing financial institutions at inflated prices above market value.  The most direct way to price these assets, and to compensate the banks for selling the distressed assets, is by valuing them at the bank's carrying value, or the value at which they currently hold them. 

Bernanke and Paulson on the other hand, believe that these prices are artificially depressed due to a lack of liquidity in the markets, and have suggested that the government fund should purchase the securities at "hold-to-maturity" prices, or at an estimated future value.  However, this argument is counterintuitive, as one would expect that banks would price these assets above their believed fair-value, rather than below. 

The most accurate way to price securities currently is through our financial markets.  I am far from a proponent of Burton Malkeil's Random Walk theory that markets are efficient, but in the long-run financial markets are efficient at pricing risk and value (even though large inefficiencies in individual securities can exist for extended periods of time).  On CNBC this week, Warren Buffett was interviewed by Becky Quick, where he agreed that the best way to price these assets is through mark-to-market.  The following is an excerpt from the interview transcript:

Buffett: … they shouldn't pay any attention to the cost of these instruments to the selling institutions.  They shouldn't pay any attention to the carrying value.  In fact, one thing you might do, is if someone wants to sell a hundred billion of these instruments to the Treasury, let them sell two or three billion in the market and then have the Treasury match that, for what they pay. 

However, the Treasury Department must offer some incentives to have banks deposit their illiquid mortgage-backed assets into the new bailout fund.  The most important and clear incentive is that banks will be able to remove these toxic assets from their balance sheet and improve their capital ratios.  Above that, the Treasury must also be sure not to discourage banks from selling their assets by implementing executive pay caps for participating institutions. 

It is important to realize that it is not necessary for the Treasury to pay banks above market value for their illiquid assets, as this would put an unwarranted premium on the financial industries assets, and put further taxpayer capital at risk. 

Comments

[JohnKing:]

Paulson is just trying to save his hide.

Illiquid assets aren't assets at all, its a misnomer.

How so many are fooled by Wall Streets alpha predator Paulson is beyond me.

2008 Sep 25 02:07 AM

[User 269421:]

I think we are in what George Soros calls a self-reinforcing downtrend. In a stable market, pricing is fair. But in the extremes of a self-reinforcing downtrend where there is no liquidity, the price is not reasonable and fair by any measure except that it is what the unstable market produces. If you want to call that accurate, then go ahead. But you need to distinguish between a stable market and the extremes of an unstable, self-reinforcing trend.

2008 Sep 25 03:30 AM