Thursday, September 25, 2008

The Bailout

The news of the week has been the proposed Federal (or Paulson) Bailout, with $700 billion being the price tag associated with it. Let me state at the outset that there is a crisis looming over many financial service firms and drastic action is unavoidable. So, is this bailout the solution?
1. The price tag on the bailout is a little misleading. The $700 billion is what the government will pay to buy mortgage backed securities off banks, but the net cost will be lower. In fact, if everyone goes back to paying their mortgages on time, the Federal Government will make money on the deal. It is very unlikely that this optimistic scenario will unfold. What is far more likely is that there will be defaults, and how much this bailout will cost us will depend upon how quickly housing recovers.
2. There are two keys to making this not a "bailout". The first is to pay fair value (See below) for these mortgage backed securities, rather than an optimistic value or face value. This fair value may still be a bargain for banks that face the problems of having to mark these securities to market every period. To the extent that liquidity has dried up in this market, these securities may well have to written down below fair value. The second is for taxpayers to get something in return for taking these problem securities off the books. I would use the Buffett model (from his Goldman acquisition) and ask for warrants or equity to compensate for at least a portion of the difference between the fair value and the current value (which will reflect the illiquidity).
(What is fair value? It is the present value of the cumulative cashflows on these mortgage backed securities, discounted back at a rate that realistically reflects default risk. This will be well below face value, since these securities were misvalued using default risk estimates that we too low.)
3. I know that the zeal for punitive measures is strong and that people want to punish the bankers who have put us in this position. While I will not defend sloppy valuations and poor oversight, I also believe that there is plenty of blame to go around. In fact, anyone who bought a house in the last 5 years and traded up, using a cheap mortgage to fund the move, participated in the benefits of the boom. I am not eager to seek out these homeowners and punish them either.
4. Regulation is not the answer. After all, this problem was created by a patchwork of regulations that left loopholes to be exploited. What we need is a consistent regulatory environment that covers all types of risky assets, rather than different regulatory environments for real estate, mortgage backed securities,  corporate bonds and equities. In fact, I think trying to regulate trading and restrict risk taking in a global marketplace is akin to trying to stop unauthorized downloads of movies on the internet... A waste of time and money!
I think that the bailout will not end the troubles at banks, but it is a solution to the liquidity crisis that is haunting this market. 

7 comments:

Sudeep said...

I am one of your former students.Welcome and thank you for starting this blog! Two points:

1. In general more regulation may not be the answer, but what to you think of CDOs? They are simply an insurance product by another name. If you believe that insurance should be regulated via capital reserve adequacy and other constraints, then no reason to argue that folks who underwrite CDOs be under similar constraints.

2. If the $700bn is to provide liquidity, why don't the feds offer to insure these securities for their face value at maturity instead of ponying up cash and buying them at a fair/market value? Won't the backing by the govt. be enough to bring liquidity?

Lee said...

Much better to buy equity than pay above market price for assests no one knows how to value.

Sudeep said...

Correction to above comment:
a. CDS and not CDO.

evileconboy said...

The question is, just what is a reasonable default rate? We have no long-term experience with some of these products, whether it be the 5/1 ARM or the 3/1 ARM, or the Option ARM or whatever. These product frankly don't have a data set for defaults since they are so new and no one has any idea how notoriously prodigal Americans are going to manage their payment shock when their ARMS reset.

Let the market decide what these securities are worth-- it already is--- without the government's piggy bank to guarantee liquidity. After all, the debt holders signed up for liquidity risk. Let them bear it. I don't see the government rushing in to add liquidity to the housing market or the used car market or the corporate bond market for that matter.

And if the banks need more equity, let the government inject it and wipe out the morons that put us in this situation in the first place, and the people who bought their stock.

The risk of the Paulson plan is that the government will overpay for trash-- not to mention create a moral hazard for the future (the Bernanke-Paulson MBS put?) -- is to great to rush this through.

And while we're at it, perhaps we should add regulation to the package since it will never get through the Senate in any other way. CDS and other derivatives should be on exchanges where proper collateral setting is enforced.

njn said...

I am thinking that bailout may not be the long term solution. The problem emerged because of lack of maintenance of self discipline on the part of financial instituion and ineffective application of stringent rules on the part of regulatory authority. Moreover, they makes the government to assume more role rather than the less but effective role.

Ando said...

Someone explain how GS and MS et al. going under is going to really hurt mainstreet? Heaven forbid the old boy networks of NYC and DC go down. Maybe the South is rising again (BoA/Wachovia) To me it seems that commercial banks are still doing okay. Liquidity? Yeah maybe noone wants to lend to overleveraged bulge but that doesn't mean commercial banks aren't willing to lend, albeit tighter underwriting. Let's not forget there was a point in time that people actually had to put some of their own equity up when lending.

mpc said...

I saw this comment on Bloomberg news (9/23):
``Accounting rules require banks to value many assets at something close to a very low fire-sale price rather than the hold-to-maturity price,'' Bernanke said in testimony to the Senate Banking Committee today. ``If the Treasury bids for and then buys assets at a price close to the hold-to-maturity price, there will be substantial benefits.''
Does that sound like trades at the end of the day to anyone else?