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March 30, 2009

Progress report

Six months have come and gone now since the financial crisis went code red and TARP I was rolled out in response. It's natural to wonder, then, how the government is doing in responding to the problem.

Unfortunately, the answer has to be "not well."

Below are two excerpts. The first is from the very first blog post SMI put up about the Treasury bailout plan (last Sept 23). The second is from Jon Markman's latest column, written last week. See if you can find the common thread.

From the SMI Weblog last September:

But there are key details still being hammered out, and this leads us back to the baseball card story. The problem is that nobody knows exactly what these potentially bad loans should be priced at. The financial institutions have them "marked" at a certain price, but that price is almost certainly too high, as most of them would love to unload them but can't because there aren't any buyers at the prices these bad loans are supposedly currently "worth." Like my dad told me, it's not worth the value in the price guide if there isn't anybody willing to pay you that amount.
There is some recent precedent for what these loans are worth, as there have been some fire sales of late for similar assets. In most of these cases, the bad debt was sold for something like 20-30 cents on the dollar.

So there are basically three prices in play in the current discussions.

The "hold to maturity" price would be the highest. This price assumes the debt won't default and the payments will be made as scheduled for the loan's life. We all know this isn't happening. If it were, there'd be no current crisis.

The "mark to market" price is closer to reality, but still likely to be considerably inflated.

And then there's the "auction" price, or what those assets would bring if they were sold on the open market. It's not entirely true that there are no buyers for this stuff currently. There just aren't any buyers at the prices the financial institutions are willing to sell at. That's not necessarily them being unrealistic or greedy. It's a realization that if they sell at the lower prices an "auction" would bring, they would need to raise more capital in order to stay in business - and might not be able to do it.

The Treasury bailout plan is drawing a lot of heat from a broad range of critics, over a range of different issues. But probably the biggest one is this: what price is the government going to pay for these assets? The one that makes the most sense would seem to be the auction price. That way the taxpayer (government) takes on the least risk and has the potential to benefit as the crisis ends and at least some of these loans come up in value a bit.

Unfortunately, buying the bad debt at the auction price doesn't help the banks any. If they were willing to sell at that price, they could likely already sell the stuff now, as there are vultures out there willing to buy these assets at bargain bin prices (at least according to some reports). The banks are still stuck having to raise huge amounts of capital in that scenario, which most of them are unable to do.

From Jon Markman's column last week:

There are also questions over the quality of loans and securities the banks will put up for sale and the prices they will accept. There is already a very active market for these securities — the government isn't starting from scratch — but banks have been unwilling to let them go for what investors are willing to pay. If you assume most of these loans and securities started life being worth the equivalent of $100, most are now being carried on banks books at around $80. The government would be happy to buy them with its funny money at $80 as a sneaky way to recapitalize banks without nationalizing them, but real-money investors in recent months have been willing to pay only $25 to $35.
If all the loans were really bought at $35, experts tell me, most banks would have to take losses large enough to send them into bankruptcy. Not good. So using government-subsidized loans, BlackRock and its peers appear willing to pay around $40 to $50, but they can't pay much more because they still need to mark them up and sell them to clients at pension funds who know full well that the loans are superrisky. Don't forget that underlying each CDO and loan are hundreds of real, live homeowners who might lose their jobs next month and stop paying their mortgages. The more investors pay, the longer they will need to wait for a good return.

Presumably, the best securities will go first, so the most interesting juncture in this whole drama will come a few weeks after it starts, when fund managers balk at paying $50 and banks won't take the bids at $35. My guess is that if and when the auctions start to lock up, a lot of bank stocks are going to get hammered, and there will be renewed talk of nationalization.

Scary, huh? The central problem six months ago is still the problem vexing the government-sponsored solution today: What price to put on these toxic loans? Six months have gone by, yet we're really no closer to resolving this central problem.

Ultimately, I don't believe the government is going to be able to "fix" this issue with taxpayer money. I think it will eventually take "nationalizing" some of these banks (i.e., allowing them to go through a government-arranged bankruptcy where they continue to function and service customers while wiping out the shareholders and giving the bondholders a nasty haircut) in order to write-down their massive debts to zero.

While that's an ugly option, it's not any worse than saddling the productive citizens of the U.S. with massive additional tax burdens for decades to come as a result of issuing huge new amounts of debt. I'd argue that it's actually much more just and appropriate. But that's still politically too unpalatable, so we'll continue to spin our wheels and spend huge gobs of money shooting for a quick fix.