Whether this $700B blank check for the treasury is bad, really bad, or a disaster depends a great deal on the price paid for the excess securities. If nominal price is paid, it’s a complete disaster, essentially giving money to the outer-reaches of the economy engaged in multiple levels of speculation with other peoples’ savings at the expense of its core, the working-consuming-taxpayer.
If a deep discount is paid, it’s more fair, but then the banks will come back for more relief as their insolvent balance sheets invite lower levels of saving, “bank runs,” and the like.
If the price varies from bank to bank or asset-backed-security-pool to pool, then claims of favoritism, unfairness, or lack of zeal will be levied. If after taking on all of these bad assets, syndicates rebuy them from the Treasury at an additional discount citing the lack of liquidity in the market, the taxpayer will have gotten fleeced both coming and going.
But the price is everything, and the price Paulson (or his successor) will pay is completely unknown. The Economist had a useful piece on this:
One of the big myths currently circulating is that banks simply cannot unload these bad assets. In reality, however, there is still plenty of interest if banks are willing to reduce the price low enough. At the end of July, Merrill Lynch liquidated US$30.6bn of asset-backed collateralised debt obligations for US$6.7bn — a discount of 78%.
Most other banks have been reluctant to accept such a steep discount. This unwillingness puts Treasury in a difficult position. Mr Paulson could demand a big discount, which would help protect taxpayers from overpaying on assets that already have a limited market. However, if banks were forced to sell at fire-sale prices, they would suffer a sharp increase in their writedowns, causing them to seek even more capital, which would defeat the plan’s initial purpose.
Instead, Mr Paulson seems intent on paying fair-market values for these troubled assets, noting that any punitive discounts would limit the participation of financial institutions. But it’s not clear what the fair value of these illiquid assets really is. There is a very real danger that Mr Paulson will overpay for these troubled assets just to help recapitalise the beleaguered banks. This could force taxpayers to hold billions of dollars of assets to maturity or try and resell them — either of which has the potential to generate huge losses, especially as long as the housing crisis continues.
The fear of contraction is creating additional inflationary pressure, which will, in turn, create more bad investments, excessive expansion, cheap money, declining US credit, and an eventual meltdown of the currency, whether in hyperinflation, deflation, or some kind of supply shock combination of both remains to be seen.
That McCain and Obama both see this as a tail of heros and villains where hidden piggy banks of money in the form of executive compensation can sort this all out is the most worrisome feature of all. The money is not there, and our collective national lifestyle of “leverage,” low savings, high consumption, high levels of debt, generous government programs, “wars of choice,” mass immigration, cheap labor, multi-trillion dollar debts, trade imbalances, resource profligacy, a mania for toys, and an overall absence of any national economic policy is the cause. Everyone who bought a house thinking he could flip it for 150-300% of its purchase price before the ARM kicked in bears some of the blame, as too do the race hustlers, liar loan liars, vacation-taking second mortgagors, and everyone in between. Worst of all, our President who said “spend as an act of patriotism” during a time of war, while ignoring the impending solvency impact of entitlement spending, showed a complete absence of foresight of leadership.
No one giving this kind of speech, however, will get very far in a democratic regime. It’s so much easier to blame a few fat cats, or a few greedy Wall Streeters–and greedy they were!–but their greed is an epiphenomenon of an unbalanced economy fueled by a culture of rank speculation, leverage, and get-rich-quick scheming.
Subscribe To This Feed
You hit the nail on the head toward the end of this piece: there are no politically palatable solutions. No politician can win (or govern) under principles of austerity. It is a race to the bottom, who can promise more, and defer the Reckoning.
The Dollar will fail. It may not be this year, or even this decade, but it will be in my lifetime. There are no collective actions that can be organized, and the only control you have over your destiny is individual action: buy tangibles, trust only “sound money” like gold/silver, own a gun, stockpile food, avoid variable rate debt.
I can’t tell you whether the Reckoning will be apocalyptic (i.e., electric grid collapse, total societal breakdown, lack of readily purchasable food/heat, etc.), or chronic and low grade (i.e., periodic civil disturbance, extended high unemployment, shortage, etc.) If it’s #1 rather than #2, we’re all screwed.
Chris,
How right you are! I don’t trust Treasury, the Congress or the Federal Reserve to make the right decisions. Neither of the candidates have the courage to address the country and tell them the truth. I don’t expect President Bush to do the right thing either. I wonder, if Obama wins, how his supporters will react when they find out that the programs they want will not be possible. I wonder, if McCain wins, if those who caused this mess (like Phil Gramm) will be in place to continue the pillage.
PessimistMonkey is right. The dollar will fail; and it will be an awful day of reckoning! Although many farms failed during the Great Depression; most people lived in small towns and rural areas. The majority owned (at the least) a small patch of yard where a garden could be established and a small chicken coop could be kept. Can you imagine our densely populated cities without electricty and no food being trucked into them?
I expect better of The Economist than to conflate “fair market value” with “book value.” The fact that Merrill Lynch had to sell off its securities at a 78% discount indicates that the entire problem is the discrepancy between book value — what Paulson apparently wants to pay — and market value — what the banks refuse to accept, because to do so would subject them to punishment in the stock market.
I think that everyone needs to take a deep breath instead of panicking about the imminent collapse of American society and libeling Phil Gramm.
Leif, there’s no conflation of the concepts. Under FAS157, banks are required to account for their CMBS assets at market; I know of no financial institutions (including Merrill) that were carrying their CMBS at “book”. The question indeed is what is “market” for hard-to-value assets like structured products, hung LBO bridge loans, etc. that don’t trade on an exchange, that have already been heavily impaired/marked down in prior quarters, and where determination of true value is more art than science. The Economist was making the point that Lone Star’s purchase of CMBS from Merrill was at 22 cents of face, not that Merrill was carrying the assets at face.
By the way, the “worst case” sales, such as Lone Star’s heavily discounted purchase of CMBS assets from Merrill, was even worse than the media reports. Merrill financed most of the Lone Star purchase on a non-recourse facility. I think Lone Star put in only 25% of equity, thus getting an enormous option at a cheap price; the benefit to Merrill was strictly one of accounting, since it still holds most of the downside risk on this asset, but can account for it as if this exposure has been “sold.”
Actually, I think the best case scenario would be for Treasury to buy them at a discount, and then to take a $100-200 billion loss selling them off to private bidders at an even steeper discount.
That way we wouldn’t have a massive government bureaucracy controlling half the housing market for too long and the damage would be more than painful enough to teach us a lesson without being too debilitating. And if treasury does initially buy at a solid discount, the pain will be shared between taxpayers and the overseas investors who bought these securities in the first place.
Of course I don’t have any idea what the securities would actually clear at, so maybe that’s just wishful thinking.
Monkey: Thanks for the accounting pointers. Please substitute “face” for “book” throughout the rest of my earlier comment, and I think the content (and the argument) are the same.
I agree wholeheartedly with the difficulty of determining market value of these peculiar assets — which is why we should, in fact, let the market set the value by seeing how steep of a discount these assets must take to be salable, not by having Hank Paulson and a group of Very Important People decide that, for instance, 78.22% of face represents an “appropriate” amount of taxpayer money to spend socializing the financial sector.
I think we all understand the concept of “market value.” I agree with the commenters above who argue that the market value of an asset is whatever buyers in a market agree to pay for it. It’s the word “fair” which is problematic, suggesting that there is some intrinsically fair price for an asset. To the extent that “fair” means anything in this context, it seems to me that it would have to refer to buyers and sellers in a non-coercive market, i.e. one is not dealing with something like an organized crime syndicate applying pressure in illegal ways. Or a entity violating monoploy or restrain-of-trade legislation.
So longers as buyers and sellers can choose whether or not to strike deals, without illegal coercion of other sorts, I suspect you’d have to say that the price they reach is “fair.” Or at least, I guess a free-marketer would.
The public has lots of reasons to be angry about this. But a systemic economic collapse probably won’t assuage their (our) anger. One does get the sense that those who more or less run our national affairs are more circus ringmasters than sober accounts.
But perhaps that’s a reflection of our society as well. Descent into decadence is not an easy trend to reverse.
100 percent on point. You should be a Wall St. J. columnist. The best post I’ve read.