While we have focused on the fact that the Treasury bailout plan, which with some tweaks, is moving towards approval. is a covert and inefficient recapitalization of the banking system, other observers see another goal for the plan. The contend that its main purpose is to circumvent mark-to-market accounting.
The belief is that mark to market accounting has worsened the credit mess, since in a stressed market, those prices will be less than fundamental value. With arcane paper that is hard to value even in a good market, where prices of liquid instruments are volatile, and the underlying credit quality is deteriorating, I’m not certain that view is correct. The consensus at the time of the Bear Stearns deal was the the Fed’s $29 billion subsidy was a huge coup for Morgan and left it well compensated. Yet proving how hard it is to estimate values correctly, Jamie Dimon is now apparently saying often that he wishes he had not done the deal. Admittedly, Bear had a big portfolio that JP Morgan could not inspect in detail, but the general principle holds.
So rather than follow the course of action that has been shown to work in Sweden and to a lesser degree in the US S&L crisis, namely, let asset prices fall, strip out bad assets and sell them, combine and recapitalize the good pieces, and sell those to the public too, we have clearly decided to go down the Japan path, of maintaining phony asset prices to keep institutions that would otherwise fail alive. The Japan approach proved to be vastly more costly than taking the short-term (considerable) economic pain, but we don’t do pain in the US.
And perhaps more important, since no one is fooled by this ruse, expect whatever benefits this plan delivers to be short-lived, How comfortable will investors be with buying stock and bonds of banks if they know the accounts are rubbish?
From James Saft at Reuters, “Hold-to-Maturity is the new Mark-to-Myth“:
Paulson and Bernanke’s ‘Hold-to-Maturity’ plan is really just the new ‘Mark-to-Myth’, and even its heroic proportions are not likely to paper over solvency problems in the banking system.The Federal Reserve Chairman told lawmakers the plan to spend $700 billion to buy up bad assets would allow banks to avoid unloading loans at fire sale prices….
“Now what the hell is a ‘held-to-maturity’ price, and how in the world can an auction or ‘other mechanism’ be devised that gives the market a good idea of ‘hold-to-maturity’ prices — since there is no such thing?” economist Thomas Lawler, a former Fannie Mae portfolio manager and founder of Virginia-based Lawler Economic & Housing Consulting, wrote in a note to clients.
“Of course, everyone knew what he meant: ‘held-to-maturity’ means ‘above market.’”
The hope, presumably, is that the subsidy given by buying up debt for more than it will fetch on the open market will be enough to prop banks and attract new investors.
If it is a subsidy, what not call it one?
And though $700 billion is a lot of money, it is not enough to wipe the slate clean and leave banks with workable balance sheets; the plan only works if that $700 billion, which equates to far less in terms of capital relief, is leveraged by attracting new money from outsiders now sitting on the sidelines.
But I find it hard to credit that the sovereign wealth funds of the world, having already been burned though their disastrous investments in banking last year and this, will feel that a price arrived at through what promises to be an opaque process gives them the confidence to buy in now.
“It is hubris to say they are going to set the prices and everyone will just mark to market their assets accordingly,” said Tim Brunne, a credit strategist at Unicredit in Munich.
One possibility being discussed is a reverse auction, where banks will compete to sell bonds to the government. Given that private label securities are often unique, that may be a very difficult process to do in a competitive and transparent way. And seeing as how the purpose of the exercise is in part establishing a mark for banks to use on their portfolios, there is scope for collusion….
Banking is a confidence game, even if done soberly and responsibly. But this plan, because it fails to meet the issue of insolvent and failing institutions head on, is not likely to work.
Ed Harrison at Credit Writedowns has come to the same conclusion:
The crux of the edict is that companies must mark to market. However, marking to market is considered to be very pro-cyclical, meaning it overstates assets on the balance sheet when the economy is in an upswing and it understates asset value during downturns like the present one. Given the market panic, it is probable that many assets have been marked down far below their ultimate fair value….
Yves here. Given that Meredith Whitney in her research has shown that banks are using housing market decline assumption in their valuations that she sees as unrealistic (save Bank of America, which has been aggressive and is not too far behind reality) and the nearly 80% loss that Merrill took on its sale of what was formerly $30 billion of CDOs (and that price had previously been written down), I don’t see that that view is necessarily accurate. Bank have gone to considerable lengths to finesse their accounting within the new rules. In fact I wonder whether the real reason for the extreme urgency to get this bill passed was to have it in place before year end (quarterly statements are unaudited, and accountant might force enough companies to make more conservative valuations so as to create considerably more worry when full year financials were released).
In my opinion, this may explain the hidden agenda behind his plan: Paulson wants to revalue assets on all banks’ balance sheets in order to stem the tide of writedowns.Under Paulson’s Economic Patriot Act, taxpayers will be on the hook only if these assets the Treasury plans to buy are overvalued. They might even see a gain if they are undervalued. Paulson is clearly betting that the assets are undervalued.
But even if they are overvalued and more writedowns are likely, Paulson certainly believes he can prop up asset prices, at least temporarily. This buys banks time. Time is an valuable asset here because:
1. it may give banks enough time to consolidate the industry
2. it may allow banks to earn their way out of trouble due to the steepness of the yield curve
3. it may give Congress enough time to come up with a new, better plan once the new President comes into office in 2009.
I don’t buy 3. at all. With this large a bill in place (and the bureaucracy that will be created to deal with it), there are zero odds it will be undone, and it is so large that any additional program will be rounding error. But Harrison is no fan:
Again, I don’t like his plan and I don’t like the tactics the Bush Administration is using to promote it smack of fear mongering – hence, my designation of this as the Economic Patriot Act.
Update 3:10 PM: Reader Rob via e-mail pointed out that the plan could backfire:
f the auction process yields prices below level 2 & level 3 marks, it becomes a neutron bomb for institutions that don’t get the first acceptance of an offer from the Treasury.
doc holiday 
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I understand that the explosion in the OIS spread is a reflection of the fear banks have for each others solvency. And it makes sense that it exploded right after the bankruptcy of LEH–it was not the bankruptcy per se, IMO, but the that $110b of senior LEH debt went from trading .95 to .12 in a matter of days that concentrated the market’s attention. If you include the less senior debt that is trading at essentially zero, LEH had $110b hole in its balance sheet. And just days before this, the market was being told and was believing that the $10b disposition of Neuberger was going to solve their funding problems.
Now is there a precedent in this history of bankruptcy–excluding cases of accounting fraud–where bonds collapsed like this once a bankruptcy court opened up the books? I’m thinking the answer is ‘no.’ Which then makes you re-evaluate the premise that there wasn’t fraud at LEH in marking the value of their assets.
Now extrapolate this reasoning across the entire banking system and, voila, you have the seizure of the interbank lending market.
Now this leads me to the question: if the OIS spread represents eminently legitimate fears of inaccurate marks on banks books, how is a commitment from the treasury to buy hundreds of billions of distressed assets from the banks any assurance to a counterparty that that bank will not still become insolvent. Obviously it helps on the margin, but the staggering hole in LEH’s balance sheet that was revealed after bankruptcy creates profound fears about the true solvency of C or UBS. Until the market is convinced they are solvent–and TARP does not do this–the OIS spread will remain elevated and lending will remain frozen.
Alright, take your shots–what is wrong with this reasoning?
Dan