Monday, September 29, 2008

initial thoughts on the bailout

it appears the politicians in washington have finally pulled together some kind of mortgage bailout measure. it is late, so I must be brief, but I want to go on record doubting it will succeed.

quite simply, the bill treats only the symptom and not the cause of the problem. it allows the government to spend up to $700 billion buying toxic mortgages securities from banks ... it also restricts executive pay at banks that participate.

not surprisingly, the pay issue has received a lot of attention. one thing I am more concerned about is how much the government will pay for these bonds. on one hand, if they pay what appears to be the market price for them, it won't help. after all, why have a government program if it's going to pay the same price as the market?

instead, it seems they would have to pay some kind of price above the 10-15 cents on the dollar these things now trade for. this is a roundabout way to inject capital and solvency back into banks. given how far it is from the main objective, it makes me doubt it will work. if they want to get capital into the banks, they should focus on doing that.

on the other hand, if they want to prop up prices of anything, it should be the prices of houses, not mortgage-backed securities. after all, they continue to plunge -- especially given the huge supply exceeding 10 months currently for sale.

you can throw as much money at mortgage-backed securities as you like, but if houses continue to lose value, it will accomplish nothing. furthermore, there is good reason for these securities to trade so cheap. not only are they backed by bad collateral -- houses -- but they are also very hetergenous, with many different features and structures. hank paulson seems to have been an M&A guy, so he probably doesn't understand how people price credit: the more complexity, the cheaper the price. this is why things like ABS and sinking-fund debt always yielded more than straight corporate bonds. plain-vanilla corporates mainly have very similar characteristics in terms of maturity, covenants and callability. these mortgage bonds do not.

unlike corporates, they were never meant to be traded. they were meant to be tucked away and to generate cash flow (some of the cynics might argue their main purpose was really just to get priced, locking in fees for everyone from the loan officer to the investment bank to the rating agencies... some cynics might argue they were never meant to actually pay interest and principal.)

so, you have these securities that are hard to price and were never meant to trade. and you throw them into a market at the very worst time. how is it possible they'll be worth anything more than 10-15 cents on the dollar?

I say this is like trying to extinguish a fire by pumping water through an empty hose uphill. the money will go everywhere but the fire.

some optimists might say the bailout program will restore confidence to banks, which will restore the banking and mortgage system. fat chance of that. credit investors already know that hundreds of billions of debt needs to be repriced and come to market over the next 1-3 years -- across the spectrum of corporates and commercial mortgage backed securities. they know we're entering a recession and default rates are moving higher. $700 billion will do little to prop up the broader credit market. companies will still go bankrupt and home prices will continue to fall.

again, this is an indirect way to prop up prices. sometimes indirect methods of controlling prices work. the fed, for instances, uses interest rates to calm inflation. this tends to work, but it has a long time lag. furthermore, rate hikes have had an established track record at slowing the economy and pushing down rates since volcker's hawkish moves in the early 1980s.

this highlights at least 2 problems for the bailout. first, even if this program works, we don't have time to wait for it to creep through the banking system and make loan officers loosen standards (fat chance of that as well.)

secondly, this has no established track record. we just hope it will work.

as a general believer in free markets, I hate having to look back to FDR for wisdom.. but it's worth looking to the New Deal's agriculture policies. food prices plunged in the late 1920s, making it impossible for farmers to pay their debts, which accelerated the collapse of the banking system at the time.

the government's solution was much simpler: subsidize prices and burn excess grain. their goal was to keep prices up... we should be doing the same now. if henry paulson was around in 1930, he would have been injecting capital into the accounts of commodity traders.

I think we need to focus on supporting home prices and preventing foreclosures. bush and paulson should be meeting with governors and telling them to have their sheriffs suspend foreclosures. we should be subsidizing people whose mortgages are resetting, sharing some of the pain and also forcing the bond investors to take pre-determined, clear-cut haircuts. in some cases, the government should find ways to raze forecloses houses and take some of the inventory off the market.

I would also suggest some programs to find other uses for these houses, if possible. can they be converted into local health-clinics, for instance? while I'm on the subject, I'll add I think we'll eventually need to do something like that to deal with the looming excess supply of retail-related commercial real-estate. many of those big megastores could probably be converted into manufacturing space, which would generate jobs rather than helping to siphon cash off from our economy to help build the middle class in places like china and indonesia.

that's what I would call real leadership. it's not what we're getting from these clowns.

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