Tuesday, September 23, 2008

The Bailout Plan - Fleshing out some Detail

I dropped in on the TV coverage of Senate Banking Cmte. hearing with Treasury's Paulson, Fed. Reserve's Bernanke, SEC's Cox, and OFHEO's Lockhart. The dialogue concerned the administration's bailout/stabilization plan and its details, effects, benefits, pitfalls.

I previously spoke out vehemently against this type of action, feeling it to be an unjust socialization of the risks taken by entities almost completely beyond taxpayers' influence, and an affront to free market capitalism.

While my foundational opinion hasn't changed, paying close attention to the hearing, the discussion has brought me to understand how the plan might help. There exists a crucial linchpin in this that will determine if this risk socialization effort ultimately becomes a taxpayer burden: the fundamental value of various securitized assets backed by mortgage debt and the requirement that these exotic securities be market-to-market.

Before I start a wordy train of infinite digression, I've heared some financial pundits talk about simple spension of the mark-to-market requirement for valuing these exotic securities as a relief from this crisis. Bernanke's argument is that this will not enhance, but likely erode confidence in their true worth.

I cannot say if a solution involving suspension of mark-to-market requirements would be better or worse in the end, but my inclination is that it would only be of help on a very short timeframe. But since housing is not likely to bottom soon, Bernanke's notion sounds logical to me. It could be at the heart of why no formal exchange was ever created to trade these exotic products in a standardized way. Late stage in the boom there was likely a desire to conceal risk.

The overall scope of this issue is truly vast, but I feel like I now have a grasp of it in toto.

The bailout plan is only one portion of the total issue, and centers around the problem of asset valuation really in a system which grew more clever (innovative) than its mechanisms of regulation could comprehend and feedback into. The real "innovation" was the disconnection of risk from reward, and I feel that while government policy was not directly responsible for the market's action, its policy ultimately distorted the market, and from their the market behaved perfectly normally, in its own self-interest.

As I understand it many of the big Wall St. firms presently under fire hold vast quantities of complex securities whose value is ultimately tied for the most part to real estate.

As the credit boom neared its apex, to keep the wheels turning and make more credit available to the real estate speculators and the general public, firms began to take their debt piles and issue security shares backed by the future value of their pile of debt. As time went by, firms purchasing those securities began lumping them all together and issuing their own securities backed by the value of the securities they had bought. This process of abstracting the original debt fed on itself for many levels and caused leverage by holders to expand, while at each step turning the window on the the original debt and its condition increasingly opaque.

The securities became too abstract to value directly (a clear warning), but with an understanding that they were ultimately backed by real estate (going gangbusters) investors were willing to assent to their represented worth without question.

A modest economic slowdown just slows the growth of real-estate early-on, but this is enough to trigger some minor mortgage delinquencies, and some begin to wonder if the securities they hold will pay off as promised, since payoff is predicated on the boom continuing.

The financial firms holding the securities need to value them on their balance sheets so we all can know the total value of the firms' assets. This is a normal and critical part of determining how much firms can lend, or their ability to make good on their own debt to other firms, or to secure new credit.

In a case like that of AIG, as an insurance company claims are paid by company assets and a certain minimum ratio must be maintained to assure that ability.

If AIG had spent too much of its revenue from premiums on exotic debt securities (in the hopes of gaining a high return and higher net worth) and those securities are now in doubt, would it still be able to make good on policy claims?

With the housing slowdown, the market for the exotic securities dried up as buyers began to realize they might not be buying sure things and their true value was too opaque to assess.

When demand dries up, prices must fall. This is bad for the affected firms, which have to mark-to-market these pieces of paper of increasingly unknown real worth. If firms marked-to-market, the balance sheets would accordingly show a now much lower worth. This would affect operations as it is this worth which guarantees their obligations to others. An effective margin-call is the result.

The Federal Reserve earlier pumped money into these firms in direct and indirect ways, shoring up their balance sheets for the short term and preventing a need to mark-to-market until liquidity returned.

The hope was that housing would rapidly turn back around, and the implied values of the exotic securities would be sufficient to bring back buyers (like soverign wealth funds and hedge funds).

With bids in the market to mark against, balance sheets would reinflate, short-term Fed debt could be repaid, and life would again be grand.

This did not happen, because housing continued to fall and begain causing trickle effects in the broader economy (as too many of us unwisely overspend against the over-appraised value of our homes).

The bailout plan then seeks to create a somewhat contrived market for the exotic securities. To work, it must buy these things off firms above present "fire-sale" prices. This is so because the fire-sale price is what firms have to mark-to-market against now, and is too little to prevent insolvency for too many firms.

Bernanke today spoke of a "hold-to-maturity" price for the exotics. This price would be the true value when all the debt backing the security is paid and foreclosed losses deducted. This value will remain in flux as it is still unclear how much foreclosure will ultimately occurr, and how many folks will dutifully pay their mortgage.

His idea that current fire-sale prices clearly don't reflect the exotics' intrinsic worth, but are a result of the difficulty in discovering their present valueas they are too abstracted from the original debt.

By using some mechanism to pay a middle price (TBD, but a reverse auction, in which firms wanting to sell submit bids and Treasury sweeps all at a specified bid, has been suggested), a market will spring into existence with a fair price to mark against. Balance sheets re-inflate for all those firms not selling, and the solvency problem is eased. In the Treasury, a buyer for the exotics is always at hand if a firm should encounter a need to sell to raise cash later.

The novel hope is by doing this the Treasury will cause a secondary market to soon be spurred for these exotics, whereupon further future sellers can get a better price. Fast forward and as the debt underlying the exotics matures and default risk eases, this market for these exotics will be liquid enough that private buyers will want to purchase the exotics which Treasury has accumulated.

Treasury trickles them back out, and the gov't pockets any profits on the sales (which if present, will certainly fund gov't programs and not be used to reduce the tax burden on the public).

However... all this presumes that the slowing in the underlying real economy and specifically housing begin to level off soon.

My previous comments still stand on the measure, however. The Treasury would, in setting up a contrived market to buy these exotics, make us all stakeholders in essentially a huge new hedge fund. Much money would be spent to buy the exotics. A fair buy means that it would all come back to the Treasury later, and taxpayers would be out nothing. We could possibly even see a gain.

But, if Treasury pays too much (and this price is so very hard to know, again due to the opaque nature of these securities), we are all on the hook for the losses. Tax hikes could result, but more likely in my view, the Federal Reserve would just print sufficient money to make up the difference, depressing the value of the dollar and its buying power.

The resulting additional inflation would be the tax on me and you for your neighbor who fancied himself a big-shot property speculator, or simply made some bad choices and bought a home he couldn't really afford in the first place. Would that make you feel good? Risk was transferred from the dealmakers to you.

The counterargument is that doing nothing at this stage would be far worse. Too many financial firms bought up too much exotic mortgage derived securities and the failure of these firms would translate into an inability to lend to even legitimate business and personal interests, bringing the economy to a halt...period. Jim Cramer even suggests that failure to act as the administration now has, would have meant your local Bank's ATM wouldn't spit out any cash when you slide your card to access your savings or checking.

Excesses beget these exotic mortgage-backed securities. They were inherently less liquid and more risky because no ordered market existed on which to foster their transparent exchange.


I'm listening to these points. But I remain skeptically open-minded about it. This doomsday scenario could be accurate (and sad if so), in which case what real choice do we have but to go along and hope for the best in the execution of the bailout.

I do not believe the characterization, however, that this problem was a showcase of the failure of free markets. An argument for something "less-free" for the good of all of us.

Freedom and risk go hand-in-hand. The most freedom entails the highest risk, but the greatest opportunity for the greatest reward. The principle that free markets are self regulating stems from the notion that fear of too much risk will keep decisions in some rational bounds.

This crisis did not result from a free, deregulated, market. The housing industry is at the core of all this, and at the core of housing is Fannie Mae and Freddie Mac. Through the practices of these two government-backed entities, risk became disconnected from reward. As housing became frothy in the bubble's final stages, folks entered into deals to continue to lend aggressively to ever lower-income and higher-risk buyers at ever lower rates, with the notion that if it all went south, the government would back them up. The scope of the problem became "too big to fail."

Conservative pundits will blame liberal Democrat policies for the mismanagement of Fannie and Freddie and also for the overabundance of cash generated by a Federal Reserve under Alan Greenspan which kept interest rates too low for too long. I believe there is stock in these arguments, but blame does not rest solely there.

The Bush administration also deserves some blame for its part in also leaning on Fannie and Freddie to keep the cash flowing to lenders. The President himself has spoken about his great desire to great an "ownership society" and promoting expansion of low-rate mortgage options to help more Americans get credit to buy homes.

These housing markets were not free to begin with, but manipulated with considered government policy. Some may argue to great benefit: making homes affordable to more Americans through the greater availability of credit. Bzzt! Wrong. Homes were not made more affordable. The policy manipulation only caused more credit availability, which lowered monthly payments enough to get risky people to buy in. Homes only became more expensive, inflated, as these extra risky buyers (and well-heeled speculators) drove up demand. All fueled and driven by easy access to credit.

In believing in a government backstop, risk became blunted by policy, leading to outsized risks being taken, and it's that which we are reeling from now. Capitalism, hijacked.

In a free market, Adam Smith style, risk and reward are closely linked. You only take on as much as you can handle, because you know there is no safety net for you, no government backstop. The risky low-income home seeker earning $30K annually probably cannot afford a $250,000 home. As a financial firm, if I cannot afford the consequences of his default, I judge him too risky and don't make the loan.

But in our manipulated market, Fannie and Freddie, spurred on by Clinton and Bush, and also by their management (keen on inflating revenue figures to secure bonus pay) was always there to buy the shaky loans in exchange for cash now for more lending. Originating lenders turned into mere brokers for Fannie and Freddie, profitting on the deal getting done, rather than on the future value of the loan. This is one element of how the risk became disconnected.

Just keep this in mind when you evaluate your government leadership. Subsidy, whether outright, through a well-intentioned government program, or in the form of a special deal for a favor, distorts free markets.

Free markets do work. Distorted markets do not. Socialism creates the most distorted of all markets by moving the majority of wealth to the government for patronage according to its own self-interest. In so doing, it can not only disconnect the risk-reward relationship, it also removes the fundamental incentive to productive work. Why try harder, why risk, if your reward will be confiscated and distributed amongst those who haven't risked?

In needing regulation, what we really need are standards which are enforced. Government regulation reduces efficiency and capital will naturally flow toward the most efficient market. But standardization can foster efficiency by creating a level playing field in which all the actors know what to expect and can have assurance in the parties which whom they trade.

Any regulation to come out of this crisis should be viewed in this respect. We need to remove the levers of subsidy which distort an otherwise free market, and then foster standards which promote confidence among the parties, and assure a measure of smooth and efficient trade. That's all.

If you're still reading... *whew*


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