Bailouts Are Painful - And Should Be 17 comments
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I’m starting out this post with two stories, to try to help illustrate my position on the bailout.
Not so long ago I did some consulting for a financial institution that held the single-A tranches of several trust preferred CDOs that had CMBS, REIT debt, and a lot of junior debt from bank, mortgage, and housing related names. They wanted to know where I would market the bonds at year end 2007. I created a really complex simulation model with regime-switching for credit migration, to simulate how creditworthy the underlying bonds would be.
These bonds were on the cusp; the value of the bonds would vary a lot depending on the assumptions used. The bonds below the single-As in the securitization were all likely to eventually default. All they are worth is the value of interest they will get paid before the securitization shuts them off, plus the warrant value if things improved dramatically. The bonds above the single-As were very likely money good. Losses to the AA and AAA bonds were a remote possibility.
After estimating likely cash flow streams, I tried to estimate where a single-B bond would trade in that environment; that is, if it would trade. I estimated that it would need a 20% annualized return, leading to a dollar price around $35 on a par of $100. The bank pushed back in two ways, suggesting that my discount rate was too high, suggesting that I use 10% (price $65), and they trotted out another analysis from one of the subsidiaries of the rating agencies that was incredibly lightweight, suggesting a price of $85.
Now, did these beasties ever trade? Rarely. But they had traded two months earlier between $25-30, and at year end there was one unusual trade, for which I will give you a fictionalized version of how I think it happened:
Bond Owner: I need a bid for my bonds; you brought this deal to the market. Bid on my bonds.
Investment Banker: There is no market for those bonds; no one knows what they are worth. No one is bidding for them in this environment.
BO: You have a moral obligation to bid on my bonds; you brought the deal to market.
IB: So what, at this point almost no investment bank is willing to honor that.
BO: (begging) Look, I’ll take anything, anything, offer me a cruddy “back bid.” I just need to sell these to realize a tax loss.
IB: (long pause, feeling disgusted, and wanting to tell the guy to go away through a too low bid) Okay then, I’ll offer you $5.
BO: (Happy) Done. Sir, you have those bonds at $5!
IB: Done. (Ugh, what will the risk control desk say?…)
What did I tell my client? I said that I would tell them what my model yielded under their assumptions, but that my recommendation was that they mark them at $35.
Okay, so what’s the right price? $5, $35, $65, $85, $100. The bank marked them down to $75, average of the 10% discount rate and the rating agency’s view, because they could not take the full hit.
Now apply this lesson to the current bailout, and what do we learn?
- The hold-to-maturity price mentioned by Bernanke is the $75, a value that has no basis in fact. They don’t want to have the bank take losses.
- The price that a clever investor would pay if he could buy-and-hold is below $35. Where? Not sure, things have gotten worse since my analysis.
- The security is worth at least $10, if it pays interest for three years (highly likely).
- The investment bank that bought the bonds can’t re-sell them.
- Most bond owners ignore the $5 trade, and ignore the $25-30 trades also. They mark the bonds much higher, because they can’t take the losses. They are eating an elephant. How do you eat an elephant? One bite at a time. They can’t take a full loss this year, but will use flexible accounting rules to take those losses over the next three years.
- A clever bailout would start sucking in these bonds in the teens, quietly. We’re not doing that, but that is what Buffet would do, and maybe Bill Gross.
- But these bonds are unique, as are most credit sensitive bonds. The idea of holding reverse auctions is ridiculous, because I have given you one example, and there are hundreds of thousands, maybe a few million different bond tranches to evaluate. Only the originally AAA-rated tranches have any size to them. For any party, even PIMCO, to say that they can come up with the proper pricing for all of them is ludicrous, regardless of whether we go for the panic price, theoretical current “fair price,” or the price at which it is on the bank’s books.
- This also discourages banks from taking writedowns. Why write down, when the government will pay you book value? Or at least, the lowest book value that is common….
Well, that’s one story. Here’s one more: As a bond manager, I would occasionally come up with unusual theses that would translate into inquiries after unusual assets. in late 2002, I began buying floating rate trust preferred securities. Junior debt — not as safe as senior debt, but because they were floating rate, they did not have the same call provisions as the fixed rate securities. There could be a lot of profit if the credit market rallied. So, I started buying slowly, because it is not a thick market, using three brokers to mask my actions.
By the time I reached 90% of my goal, two things happened. First, the chief investment officer called to ask what I was doing buying such low yielding securities. My reply was that I was earning more than a 5-year senior bank bond, and that it improved the asset-liability match for our insurance client. He said that he didn’t want much more of them, and I said that I wanted $20 million more. He agreed, and we were done. Second, one of the three brokers, the one that I used the least, called me and said that their bank thought there was a buyer in the market, and that prices would rise from here. I asked what they had left in inventory, and he named a few names that I did not have so much of. I bought those bonds, and then (after a few weeks) the market repriced dramatically tighter, i.e., higher prices. We never cleared less than a 10% gain on any of those bonds, which is a “home run” in bond terms.
Here’s my point: the Treasury, should it do the bailout, will find it hard to determine the proper prices for the bonds they want to buy. Why?
- High prices bail out the banks.
- Low prices protect taxpayers.
- No one knows the correct price.
- Anyone with a large amount of money to invest will artificially inflate the market, unless they are very careful.
The negotiations have broken down, and it is for a good reason. There is little agreement over what costs the taxpayers should bear for matters that they had little say in creating.
With respect to the central question, “Will the Bailout work?” my answer is no. The assets are too fragmented, and the policy goals too uncertain to make the deal work.
We will see what happens today. The Cantor plan may play some role in this, trying to restructure the bill as a reactive bill through an insurance mechanism, while making it sound proactive. That is preferable to me, because I think that the next administration would take time to analyze the best options, rather than let an unaccountable lame duck President and Congress set the tone. If bailouts are needed because of systemic risk before then, let them be done on a one-off basis. We don’t need a systemic solution now.
What is the crisis at present? It is mainly in the short-term lending markets. That’s not good, because they are big markets, but on the other hand, the percentage losses aren’t large. Again, I would call Congress to oppose the bailout, in order to let the next President and Congress consider the measure. Until then, I would do one-off bailouts, like those done for AIG and Fannie (FNM) and Freddie (FRE).
That may not be optimal policy, and it might be messy, but it might minimize cost to the taxpayers, while causing those that would sell off liabilities to the government to think twice. Bailouts should be painful.
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This article has 17 comments:
When this crisis started, plenty of financial institutios needed cash. So, they went to the smart money. Of course they would have loved to sell the snart money their distressed assets at a reasonable price. But, the smart money being smart money said no and instead traded their cash for a slice of equity.
You see, the smart money knows nothing about esoteric mortgage backed derivatives and other assets. Even a great price, they figured, it's going to cost a fortune to manage these things. Whatever upside in price there is, will be evaporated by the management cost of these equities from now until it's a good yime to sell. "Thanks, but no thanks" they told the financial institutions. We;ll buy a piece of your equity and let you manage these assets. You have the know-how, people and structure to do it cheaper than us.
Why can't our government behave more like the smart money? Yes, the financial institutions need a $700B financial infusion lest the entire system collapse. Yes, it is in the best interest of the taxpayers to give them this infusion. So, let's do it. But, wait a minute, why do we have to take these assets that not even the financial institutions understand in return for our money? Let's change the accounting rules so they don't have to price them in their books at distressed prices and let's take instead some interest or equity for our $700B.
X years from now, these mortgage backed assets will be worth more than today. Who will be able to cutody them in the meantime at a lower cost? The financial institutions, or the federal government? Who eill be able to sell them at a better time and at a higher price? The financial institutions, or the federal government?
Dear fed: Please give the banks the money, just don't trade it for a complex financial instrument you don't understand and will spend a fortune managing. Buy stock or a CD, sit down and wait. After all, that is what politicians do best and at a lesser expense. No?
Bush said that "failing to approve it would risk DIRE consequences for the economy and most Americans". Notice Bush did not elaborate what the DIRE consequences will be.
Bush went on to say "Without IMMEDIATE action by Congress, America could slip into a financial panic, and a DISTRESSING SCENARIO would unfold," Seems to me our President is the one who is screaming fire by publicly predicting American's will "panic". The distressing scenario is the ultra rich Wall Street and Washington gang stands to lose lots money by the stock market continuing to contract to its proper place.
Bush said as he worked to resurrect the unpopular bailout package. "Our ENTIRE economy is in DANGER." In danger of what? I mean Wall Street has already flipped trillions of dollars of bad paper on the global market. Why does this create "danger" for the American economy? Someone other than Uncle Sam will simply buy this distressed debt at a discount from its current holders. The selling party will take a loss and that will be that. Where’s the danger to the American Economy? How will using the public trough to buy distressed debt prevent the financial Armageddon that is now being prophesied by our incredibly smart President?
Seems to me that Wall Street and Washington have once again decided to use fear to sell us another line of B.S. in the same way they fooled many people into buying the WMD story or Y2K. Americans should see through this B.S. and be outraged with our politicians who pass the “bailout bill”.
When you look at the rapacious terms that Buffet got from Goldman Sachs, supposedly one of the strongest, it is very clear to see who Wall Street sees as the sucker at this poker table, the TAXPAYER.
There was no bailout announcement during the failures of Lehman, Freddie, Fannie, AIG etc. But when Goldman started to drop toward $100 per share there was the bailout idea / announcement by Hank Paulson / George Bush. Why did the bailout come at this time? It is because Paulson owns $500 million of Goldman stock. If you were going to lose that kind of cash you would bow down / get on one knee to whomever you thought could save your ass!!! In fact, some of you may have done a lot more for Nancy!
Excellent article. I might argue with individual points but the overall logic is impecible. I am repeating below something I did in a comment to another article. (I don't normally do this, but it is so directly applicable to your article that I am making an exception.)
I have a couple of analogies that have some applicability to the current crisis.
1. In triage, first you stop the bleeding and then apply the sutures.
2. If a person with clogged arteries is having a heart attack, you first clear the arteries. Only then is it productive to address the causes, such as diet and lifestyle.
I am not in a position to provide the best road map for the current finacial crisis, but I will examine what is proposed by "experts" in the sense of the two analogies. If what is proposed can stabilize the patient, it should be evaluated. If what is proposed is aimed at the underlying causes, it should be postponed until actions are taken to be sure the patient doesn't die on the table before surgery starts.
Check out this article from the New York Times Sept 2003. Its actually an article about what had been unfolding since 2002.
query.nytimes.com/gst/...
Could someone please educate me? If $700B really is enough to restore confidence and solvency, why does it have to be fed into the system via purchases of multiple heterogeneous and difficult-to-price MBSs? Why can't it be fed in on an as-needed, case-by-case basis by way of Treasury purchases of newly issued convertible preferred shares? As for foreign banks holding toxic US stuff - nobody in the States forced them to buy it, so it would be up to their home governments to recapitalise them.
Not a free market solution, of course, but this market stopped being remotely free months ago.
This is not going away any time soon.
for Reviving the Economy
by Stan Muse
The Federal Reserve is out of Federal Funds rate options and now the Congress is about to pass legislation which will be the largest bailout bill in the history of the world. Fannie Mae and Freddie Mac are now penny stocks with perhaps over 1000 bank failures yet to come. The American taxpayer will be told that they and their children will be writing big checks to rescue the Wall Street crooks and congressmen that caused all the problems, while receiving nothing in return.
Anyone who has been following recent congressional hearings knows by now that this is unacceptable to Main Street, the voters who will be firing their congressmen for turning the USA into a socialist country. It is also widely believed that this bailout bill may not be embraced by Wall Street because of its onerous terms even if passed. Finally, it will not provide sufficient liquidity for improving the rest of the economy.
A much more effective and fairer way to end our economic crisis is easily attainable. To state it simply, all Congress has to do is to pass a Mortgage Investment bill which allows individuals a one-time option to use some of the funds in their IRAs to pay off their mortgage balance in full, without any penalty, interest, or taxes for doing so. In return, individuals choosing to exercise this option give up their mortgage interest tax deduction for life. This bill could be passed quickly and independently of any other economy-related legislation currently being debated, or included in the current bill. Individuals choosing this option would need sufficient IRA funds to pay mortgage balance in full. The actual payment to the individual’s mortgage company would be done by the IRA managing institution to avoid fraud.
As one senator recently stated, ‘for most people their home is their IRA’. For many others, their 401-K plans hold many trillions of dollars, much of which by now is parked in money market funds or T-bills as mine is. If these IRA funds could be released to pay off mortgages, we could possibly avert, or at least significantly shorten, the economic recession we now find ourselves in. In fact, no other bailout legislation may even be necessary, although more regulatory legislation is certainly needed.
I asked Allan Meltzer, Arthur Segel, and Ellen Zentner to review this proposal and received some positive responses. Ellen said it seemed to be fool-proof and better than a reverse mortgage. In fact, it is a no-brainer for the homeowner with a large 401-K balance, and for the government. The only people who might object, as Ellen stated, are the bankers who want to keep homeowners dependant on them, especially those in the upper-income group. But even the bankers can not want the government to own a large stake in their business for a multitude of reasons.
It makes sense to allow people to use their IRA money, which they earned, to invest in the best and safest investment they could ever make, their home. Presumably they will need a place to live in retirement on a fixed income. It makes no sense for someone with more than enough IRA funds to cover their mortgage balance to loose their home because they lost their job and can not pay their mortgage. It also makes sense because it is not some form of government bailout which rewards the bad behavior of mortgage companies and unqualified borrowers. Instead, it rewards the good behavior of those who have saved and invested in the economy
If only 5 million people chose this option, for an average of only $200,000 each, the result would be $1 Trillion in paid-off mortgages, providing liquidity to the mortgage industry. By executing the option, an individual’s annual mortgage payment would become disposable income to put back into the economy or back into IRA accounts. To the individual, the effect is the same as lowering taxes. If only 5 Million people were able to put back $20,000 per year into the economy, the result would be a $100 Billion per year stimulus package for many years to come.
In my case, with $800K in IRAs and a secure pension, I would increase disposable income by $1600 per month while reducing the IRA balance by only $160K, but saving over $120K in future interest payments. I could retire, which I can not afford to now, and leave my six figure job to someone else. I could also quickly replenish the IRA money used to pay off my mortgage with the extra income.
Adding a further provision to delay receiving Social Security payments for a year in order to exercise the option would be a baby step towards privatization of Social Security. Anyone financially able to exercise the option should be able to delay the payments. For every 5 million people choosing the option, approximately $100 Billion would remain in the Social Security fund. This could fix our problems with Social Security for good.
Some of the benefits of this plan would be to:
• Immediately increase an individual’s or married couple’s disposable income by tens of thousands of dollars each year while enabling them to become debt free, helping families to stay together
• Save homeowners hundreds of thousands of dollars in mortgage interest payments
• Encourage individual IRA savings by many who have never saved
• Allow many people to retire earlier than they otherwise could
• Create demand for housing, reducing inventory, and stopping the decline in home prices
• Stimulate the overall economy, creating and saving jobs
• Not cost the government anything, and actually Increase federal, state, and local tax revenues by eliminating individual mortgage interest tax deductions, without raising tax rates
• Force the banks to sell their good loan assets to cover their bad loan losses, instead of forcing the taxpayer to buy their worst loans, and increase liquidity for new loans to those who need them
• Allow the free market economy to work through the crisis rather than resorting to socialism
• Not increase the national debt nor the money supply as a bailout would do and contribute to inflation
• Allow the individual home owner to the freedom to become their own banker with the money they earn, reducing America’s dependence on bankers, and changing America from renters and borrowers to homeowners and savers
The merits of this simple plan, the Mortgage Investment bill, for saving the economy, instead of trillions of dollars for a Wall Street bailout which will socialize the finance industry, are obvious and would benefit everyone involved. The individual gets more disposable income and a chance to live debt free, the capital markets get needed liquidity, the government collects more taxes and collects them sooner at the expense of the bankers, the housing market gets more demand, and the general economy gets a much needed boost for the next few years.
Democrats should like this plan because they can claim that it lets the wealthy pay for this mess. Republicans should like it because it increases disposable income, which has the same effect the same lowering taxes. The average voter should like it because it addresses all segments of the economy with a huge economic stimulus package, not just Wall Street, and costs nothing while helping to pay off the national debt and potentially fixing Social Security.