Vikas Bajaj of the New York Times is an able reporter and I have often enjoyed his work. I was therefore taken aback when I read his article, “Plan’s Basic Mystery: What’s All This Stuff Worth?” since it misleads readers as to the intent and thrust of the so-called Troubled Asset Relief Program.
This is part of a disturbing pattern in the mainstream media as far as the plan is concerned. Despite the considerable diversity of opinion and political orientation among economists, the criticism of the plan among economists has been widespread, verging on unanimity (with Alan Blinder a notable outlier). Yet the press has treated the plan with vastly more deference than it deserves.
How did this come about? Perhaps select members of the media got a version of the scary talk that Paulson gave to the Congressional leadership behind closed doors. But that still does not explain the obfuscation of how the plan will work.
In a nutshell, the article seeks to explain why a lot of the assets likely to be bought by the program are hard to value, and does a good job on that front. Fair enough. But get a load of the premise:
A big concern in Washington — and among many ordinary Americans — is that the difficulty in valuing these assets could result in the government’s buying them for more than they will ever be worth, a step that would benefit financial institutions at taxpayers’ expense….
A big challenge for Treasury officials will be deciding whether to buy the troubled investments near the values at which the banks hold them on their books. That would help minimize losses for financial institutions. Driving a hard bargain, however, would protect taxpayers.
Huh? How can Bajaj not understand what this program is about? First, it is going to pay above, in fact considerably above, current market prices for the illiquid (frankly, often dud) assets. There is no point to this exercise otherwise. The banks are free to sell now at market price, but they aren’t willing to. Hence the government is stepping in, paying over the mark.
This is a feature of the program, not a bug. The financial firms most assuredly do not want price discovery at current levels, and paying above market serves as a back door recapitalization of the banking system. But the operation is badly flawed, since it’s the companies with a high proportion of assets for which the Treasury overpays most who benefit most. That given priority to those with the biggest exposures, when not all of them may be worth saving, and within that group, the level of subsidy will likely be arbitrary, since the degree of overpayment will vary from asset to asset.
If you doubt my take on this, consider this Bloomberg article, “Paulson, Bernanke Put Bank Aid Ahead of Best Deal “:
Treasury Secretary Henry Paulson and Federal Reserve Chairman Ben S. Bernanke have signaled that their priority is shoring up the nation’s banks even if it means they don’t get taxpayers the cheapest prices for the devalued assets the government buys.
“I am not advocating that the government intentionally overpay,” Bernanke told the Joint Economic Committee today, in response to a question from U.S. Rep. Jim Saxton, a New Jersey Republican.
At the same time, Bernanke also repeated his view that the government won’t pay “fire-sale prices” for the mainly mortgage-related securities Paulson aims to buy in a proposed $700 billion rescue. Officials want to set a long-term value on assets, holding them until they mature or markets improve.
If you believe the last statement, I have a bridge I’d like to sell you. Henry Blodgett reads the intent of the program the same way (boldface his):
Bernanke and Paulson want to pay a phantom “hold-to-maturity” price that is above the prices at which the banks are currently valuing their trash assets. The logic is that the banks’ carrying value is somehow artificially depressed by a lack of liquidity. (This logic is weak: If anything, the banks are trying to conceal how badly off they are by overstating the value of the assets).
In the vast majority of markets in the US, real estate has not bottomed. The last serious real estate recession in the US, in the late 1980s-early 1990s, was 15 quarters peak to trough. The high point in the cycle just passed was third quarter 2006, so by that standard, we are a bit more than half way through. Similarly, for housing to return to long-standing historical relationships to income and rental prices means the peak to trough fall nationwide would be about 35%. Other indicators also point to a 35-40% decline. And that assumes that prices do not fall below “fair” value, which often happens in a bear market. Commercial real estate may not fall as far, but is much earlier in its trajectory. Corporate defaults have only started to rise, but some distressed debt experts forecast that they could go as high as 16%. LBO loan paper will fall much further in value as defaults rise. So across the board, there is every reason to expect pricing of debt to worsen appreciably.
The hold to maturity idea is bunk. With a national price decline of 35-40% for housing, a very high percentage will be in negative equity territory. And do you think banks will unload the loans that are likely to be good? Hell no, they’ll get rid of their worst dreck. If the Treasury winds up with any assets that pay 100% at maturity, it was a mistake.
Another not-trivial detail: many structured credits, particularly collateralized debt obligations, have what is called high embedded leverage. That is, a small fall in cash flow (due to defaults) has a disproportionate effect on value. That’s why some tranches were downgraded directly from AAA to CCC (super junk) in a single downgrade. A change of that magnitude is simpl unheard of in corporate bonds. So a small increase in defaults or delinquencies can trash this paper.And delinquencies ARE increasing.
And that gets us to the next fantasy, or misrepresentation, namely, that the Treasury will buy these dud assets, and somehow, miraculously, be bailed out by an improving market.
First, as we discussed above, things are going to get a lot worse before they get any better. For housing in particular, once it reverts to the mean, there is no reason to think it will bounce back to an unsustainable price level.
Second, the Treasury isn’t simply buying paper at above market prices. It will be buying it at price high than the banks are carrying it on their books. Remember, that’s a requirement. No bank will take a writedown. That would lead to a reduction in equity.
And despite the requirement that banks mark assets to market, the reason that so many of these markets are illiquid is that banks do not want the prices for assets to be discovered, since it would force them to mark their positions accordingly and take further writedowns. Look at Merrill’s sale of its AAA CDOs. The price was 22 cents on the dollar (actually, the cash portion was a mere 5 cents, the rest was contingent) . Note that Merrill’s had previously written down that paper. But in this program, Merrill would sell it only for its current book value, which for the CDO would have been a huge premium to the 22 cent market price. Otherwise, it would hang on to it and offload some other paper it could sell for at least its current carrying value.
So with book values in some cases above where the market would really be, banks having an incentive to offload their most mis-marked paper, and prices of risky credit instruments just about certain to fall further, the odds of Treasury showing a profit look to be sheer fantasy.