While we have focused on the fact that the Treasury bailout plan, which with some tweaks, is moving towards approval. is a covert and inefficient recapitalization of the banking system, other observers see another goal for the plan. The contend that its main purpose is to circumvent mark-to-market accounting.
The belief is that mark to market accounting has worsened the credit mess, since in a stressed market, those prices will be less than fundamental value. With arcane paper that is hard to value even in a good market, where prices of liquid instruments are volatile, and the underlying credit quality is deteriorating, I’m not certain that view is correct. The consensus at the time of the Bear Stearns deal was the the Fed’s $29 billion subsidy was a huge coup for Morgan and left it well compensated. Yet proving how hard it is to estimate values correctly, Jamie Dimon is now apparently saying often that he wishes he had not done the deal. Admittedly, Bear had a big portfolio that JP Morgan could not inspect in detail, but the general principle holds.
So rather than follow the course of action that has been shown to work in Sweden and to a lesser degree in the US S&L crisis, namely, let asset prices fall, strip out bad assets and sell them, combine and recapitalize the good pieces, and sell those to the public too, we have clearly decided to go down the Japan path, of maintaining phony asset prices to keep institutions that would otherwise fail alive. The Japan approach proved to be vastly more costly than taking the short-term (considerable) economic pain, but we don’t do pain in the US.
And perhaps more important, since no one is fooled by this ruse, expect whatever benefits this plan delivers to be short-lived, How comfortable will investors be with buying stock and bonds of banks if they know the accounts are rubbish?
From James Saft at Reuters, “Hold-to-Maturity is the new Mark-to-Myth“:
Paulson and Bernanke’s ‘Hold-to-Maturity’ plan is really just the new ‘Mark-to-Myth’, and even its heroic proportions are not likely to paper over solvency problems in the banking system.
The Federal Reserve Chairman told lawmakers the plan to spend $700 billion to buy up bad assets would allow banks to avoid unloading loans at fire sale prices….
“Now what the hell is a ‘held-to-maturity’ price, and how in the world can an auction or ‘other mechanism’ be devised that gives the market a good idea of ‘hold-to-maturity’ prices — since there is no such thing?” economist Thomas Lawler, a former Fannie Mae portfolio manager and founder of Virginia-based Lawler Economic & Housing Consulting, wrote in a note to clients.
“Of course, everyone knew what he meant: ‘held-to-maturity’ means ‘above market.'”
The hope, presumably, is that the subsidy given by buying up debt for more than it will fetch on the open market will be enough to prop banks and attract new investors.
If it is a subsidy, what not call it one?
And though $700 billion is a lot of money, it is not enough to wipe the slate clean and leave banks with workable balance sheets; the plan only works if that $700 billion, which equates to far less in terms of capital relief, is leveraged by attracting new money from outsiders now sitting on the sidelines.
But I find it hard to credit that the sovereign wealth funds of the world, having already been burned though their disastrous investments in banking last year and this, will feel that a price arrived at through what promises to be an opaque process gives them the confidence to buy in now.
“It is hubris to say they are going to set the prices and everyone will just mark to market their assets accordingly,” said Tim Brunne, a credit strategist at Unicredit in Munich.
One possibility being discussed is a reverse auction, where banks will compete to sell bonds to the government. Given that private label securities are often unique, that may be a very difficult process to do in a competitive and transparent way. And seeing as how the purpose of the exercise is in part establishing a mark for banks to use on their portfolios, there is scope for collusion….
Banking is a confidence game, even if done soberly and responsibly. But this plan, because it fails to meet the issue of insolvent and failing institutions head on, is not likely to work.
Ed Harrison at Credit Writedowns has come to the same conclusion:
The crux of the edict is that companies must mark to market. However, marking to market is considered to be very pro-cyclical, meaning it overstates assets on the balance sheet when the economy is in an upswing and it understates asset value during downturns like the present one. Given the market panic, it is probable that many assets have been marked down far below their ultimate fair value….
Yves here. Given that Meredith Whitney in her research has shown that banks are using housing market decline assumption in their valuations that she sees as unrealistic (save Bank of America, which has been aggressive and is not too far behind reality) and the nearly 80% loss that Merrill took on its sale of what was formerly $30 billion of CDOs (and that price had previously been written down), I don’t see that that view is necessarily accurate. Bank have gone to considerable lengths to finesse their accounting within the new rules. In fact I wonder whether the real reason for the extreme urgency to get this bill passed was to have it in place before year end (quarterly statements are unaudited, and accountant might force enough companies to make more conservative valuations so as to create considerably more worry when full year financials were released).
In my opinion, this may explain the hidden agenda behind his plan: Paulson wants to revalue assets on all banks’ balance sheets in order to stem the tide of writedowns.
Under Paulson’s Economic Patriot Act, taxpayers will be on the hook only if these assets the Treasury plans to buy are overvalued. They might even see a gain if they are undervalued. Paulson is clearly betting that the assets are undervalued.
But even if they are overvalued and more writedowns are likely, Paulson certainly believes he can prop up asset prices, at least temporarily. This buys banks time. Time is an valuable asset here because:
1. it may give banks enough time to consolidate the industry
2. it may allow banks to earn their way out of trouble due to the steepness of the yield curve
3. it may give Congress enough time to come up with a new, better plan once the new President comes into office in 2009.
I don’t buy 3. at all. With this large a bill in place (and the bureaucracy that will be created to deal with it), there are zero odds it will be undone, and it is so large that any additional program will be rounding error. But Harrison is no fan:
Again, I don’t like his plan and I don’t like the tactics the Bush Administration is using to promote it smack of fear mongering – hence, my designation of this as the Economic Patriot Act.
Update 3:10 PM: Reader Rob via e-mail pointed out that the plan could backfire:
f the auction process yields prices below level 2 & level 3 marks, it becomes a neutron bomb for institutions that don’t get the first acceptance of an offer from the Treasury.
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I understand that the explosion in the OIS spread is a reflection of the fear banks have for each others solvency. And it makes sense that it exploded right after the bankruptcy of LEH–it was not the bankruptcy per se, IMO, but the that $110b of senior LEH debt went from trading .95 to .12 in a matter of days that concentrated the market’s attention. If you include the less senior debt that is trading at essentially zero, LEH had $110b hole in its balance sheet. And just days before this, the market was being told and was believing that the $10b disposition of Neuberger was going to solve their funding problems.
Now is there a precedent in this history of bankruptcy–excluding cases of accounting fraud–where bonds collapsed like this once a bankruptcy court opened up the books? I’m thinking the answer is ‘no.’ Which then makes you re-evaluate the premise that there wasn’t fraud at LEH in marking the value of their assets.
Now extrapolate this reasoning across the entire banking system and, voila, you have the seizure of the interbank lending market.
Now this leads me to the question: if the OIS spread represents eminently legitimate fears of inaccurate marks on banks books, how is a commitment from the treasury to buy hundreds of billions of distressed assets from the banks any assurance to a counterparty that that bank will not still become insolvent. Obviously it helps on the margin, but the staggering hole in LEH’s balance sheet that was revealed after bankruptcy creates profound fears about the true solvency of C or UBS. Until the market is convinced they are solvent–and TARP does not do this–the OIS spread will remain elevated and lending will remain frozen.
Alright, take your shots–what is wrong with this reasoning?
Dan
SIFMA & FASB need shut down TODAY! The fraud has to stop and we need accountability to restore confidence!
Good banks here that understand GAAP accounting: http://www.bauerfinancial.com/btc_ratings.asp
banks will syndicate and make sure joe sixpack is screwed big time.
From the ‘Colbert Report’
We have to make the most important, irrevokable financial decision ever and we should do it inn a state of panic’.
Well just ya quiet down y’all we have the Enron Team in place to run every darn thing for ya just don’t ya worry yaselfs one little bit you know we can handle this kinda thing, weve dun dun it before.
I’ve come to the conclusion that this is a massive helicopter drop, and the Fed does not care what they get in return. They just want an excuse to give the banks a load of liquidity and hope to kick in the 10x multiplier and defer the coming collapse.
That was more clear to me from Bernanke’s testimony. They really don’t care. Its a giveaway.
And like true Third World warlords, the banks will take the humanitarian relief and a hefty cut off the top up front, and then dole it out with the maximum corruption. That’s the little fly in the ointment for Ben’s concept.
Paulson is just a pigman, and Bush is paying off his supporters on the way out of town.
The boundary of this plan is the dollar obviously. Except more airdrops.
Ben was fair in a way. He warned us up front.
Make that “expect more airdrops”
Thats what I get for commenting while squaring up positions. :)
Dan,
Your reasoning is sound.
If I could add a minor point, I think the only incremental lending that will occur after the bailout will be secured lending to banks using such funds to purchase TARP-qualified assets from institutions (hedge funds, foreigners) without access to the TARP facility. High return, low risk quasi-arbitrage.
This raises the interesting accounting issue of the identical security being marked at [potentially] $0.10 on the dollar at the TARP-excluded hedge fund, but $0.80 on the dollar by the purchasing bank (with TARP access).
Seems corrupt, Dan.
What do you think of my reasoning?
The demand for mark-to-mkt pricing is part of the problem.
I drafted CDOs most of this decade and they were never meant to trade in the secondary market. They were crafted, rather, by buyers and bankers working in tandem, to solve specific buyer-related problems.
(See “What is a CDO — I mean really” at http://www.newcombat.net.)
A middle ground between the Tsy plan and Free Market mythology would be price controls — only on the wounded mortgage bonds that Tsy is now preparing to buy.
The wounded bonds stay on the bank books at Tsy-specified prices based on current trailing three- or six-month performance for the various segments of the wounded MSB universe.
Ie, how much interest are they actually paying and how much principal are they actually losing?
Thus Tsy does a lot of spreadsheeting, but doesn’t lay out cash. Adjusts the controlled prices each quarter based again on trailing performance.
This cures the legitimate current Market Liquidity problem, which has been the largest element in the horrendous writedowns of the MBS on the bank books the past year.
But the risk of future performance of the wounded bonds is retained by the banks, not transferred to Tsy.
AND — take note. Price controls would NOT covertly rescue FASB 157 violators. But the Tsy plan will.
That is, such violators — holding MSB on their books at marks elevated above current (non) market prices — will be in effect selling those non-compliant marks to Tsy for cash.
This latter I think is the dirty little secret of the plan that Boom Boom and Hammerin’ Hank have not discussed.
But — for those banks etc in compliance — the current plan is not based on myth, I believe. The myth was that there EVER WAS supposed to be a market for these instruments.
There was not. They were not really “bonds.” They were problem solvers for particular clients.
The problem, in other words, is that the current crisis has for 14 months demanded that hundreds of billions worth of these instruments suddenly trade efficiently in public to produce “price discovery” for ancillary (political?) purposes.
In any case — price controls would be a better solution I believe.
They would leave the bank’s responsible for future performance, but with transparent (re MBS), slightly juiced (other than FASB violators) and stabilized balance sheets.
And short sellers would find it much harder to mount rumor campaigns in that environment.
Then across two or three years the wounded bonds would wind down, probably as Boom Boom says, throwing off more interest and returning more principal than current (non) mkt values imply.
And if across those years, the performance-based controlled prices got marked back down, even to today’s levels, then that’s as it should be. Most banks would weather the storm.
And Tsy would not be on the hook for performance.
BBC World TV
The world is facing possibly its worst financial crisis since the 1920s.
It has seen the collapse or takeover of a number of world famous financial institutions and now the US government is debating a $700bn bail-out plan.
BBC News is chairing a debate called World Economy on the Brink? to discuss the origins of the crisis, consider who might be to blame and look at possible solutions.
The discussion will be chaired by Andrew Neil and will feature leading members of the financial world including:
George Magnus, senior economic adviser, UBS
Ken Courtis, former vice chairman of Goldman Sachs, Asia
Terry Smith, chief executive, Tullett Prebon, an inter-dealer broker
Jim Chanos, founder and president of Kynikos Associates, a dedicated short-selling hedge fund
and BBC business editor Robert Peston.
http://news.bbc.co.uk/1/hi/business/7635388.stm
Note: Ken Courtis, former vice chairman of Goldman Sachs, Asia reckons this will turn out to be a $4 trillion affair! I agree.
The relative growth of financial and property sectors in US GDP to other sectors is a clue to the size of the correction coming.
Everything has become part of the secondary market and that is not something which we now have any control over but that must change.
Matthew Dubuque
From Jennifer Hughes’ OUTSTANDING Accounting feature at the FT of today:
“Bernanke is right to resist calls to soften fair-value rules”
http://tinyurl.com/3u6xr7
PLEASE READ IT CAREFULLY AND THOROUGHLY before jumping to false conclusions.
This famed accounting expert applauds Bernanke’s decisive stand yesterday SUPPORTING mark to market.
SHOULD THE OPINION OF ONE OF THE WORLD’S MOST RESPECTED ACCOUNTANTS ON THIS SUBJECT BE IGNORED?
I don’t think so. Read the fine print. Get the big picture.
Matthew Dubuque
mdubuque@yahoo.com
If McCain gets in, this leads to a replay of the depression. We had all better hope it’s Obama. We MIGHT have a chance, then.
If not, I guess at least the Republicans will avoid the blame and their party might survive to screw us another day. I see this entire action as the last, biggest theft by the Bush administration.
This may be an analogy, then again, maybe not.
As Mr. Lame Duck Bush said a few months ago, Wall Street got drunk and they have been active in an orgy which has gone on for many years; maybe this is a non-stop party, maybe tradition, maybe cultural, maybe pathological, who can friggn say?
If we put this party into perspective and all the players, cops, judges and associated regulatory participants, we can thus suggest that there was collusion and corruption in this system.
Hence, as the party grew in size, it became more chaotic and more abusive.
Thus, if we take this system, where the party was being played and suggest that wall street is like a machine, maybe we can also say wall street is akin to a nuclear reactor.
Ask yourselves then, if we should have the same drunks return to the control rooms!
Re: The Chernobyl disaster was a nuclear reactor accident in the Chernobyl Nuclear Power Plant in the Soviet Union. It was the worst nuclear power plant accident in history and the only instance so far of level 7 on the International Nuclear Event Scale, resulting in a severe release of radioactivity into the environment following a massive power excursion which destroyed the reactor. Two people died in the initial steam explosion, but most deaths from the accident were attributed to fallout.
Re: http://en.wikipedia.org/wiki/Chernobyl_disaster
Wake up America!!!!
We have to find out why Lehman was allowed to go down. The further out we get the more questions about the late summer of 2008 will come forward.
There had to have been a better way to deal with Freddie Mac and Fannie Mae.
Matthew,
1. When I spoke of mkt mythology, I did not intend to imply FASB and similar should be lifted. They should not.
2. But for the FASB violators out there, the Tsy plan WILL make them whole — by trading cash for non-compliant marks.
Ie, the plan is to execute a one-time backdoor voiding of FASB for those institutions currently non-compliant.
These non-compliant banks won’t have their balance sheet juiced (since their MBS are already marked near guesstimate “Hold to Maturity” levels).
But they will get cash in exchange for those elevated marks. That’s the covert rescue of bad players no one is talking about.
So I’m against the Tsy plan for that reason and, more importantly, because it puts Tsy on the hook for future performance of the wounded bonds.
I’m for, rather, recognizing that no market has existed for 14 months for these bonds. And that in such a world Mark-to-Market has nothing to work on.
Ie, the MBS market is broken. Humpty Dumpty.
Thus the need for price controls (as outlined in comment 9 above) on the MBS currently on the books.
It is both simplistic and easy to blame the current situation on President Bush. The problem remains that junk paper can be written today just as easily as it was written in the past. Right now there remains no effective oversight and the oversight that is in place is not being used and enforced because it is seen as just too much work and the product mistakes become perpetuated.
There is absolutely nothing wrong with the current MBS rules so long as everyone is honest.
How much government do some people need?
But Lewis,
The alternative is a $700 billion governmental bond trading operation — one of the largest on the planet. Extremely risky business.
No “rule” or legal changes are required, broad strokes.
Rather: the quarantine of the wounded MBS currently on the institutions’ books — with price controls that keep the gov’t out of the MBS trading business, while stabilizing the wounded banks.
William here in Massachusetts we have two rules for the Registrar of Deeds that must be followed:
1. All instruments must be clear and readable.
2. The provenance is beyond dispute.
The first is enforced but the second never is.
Now we wake up in September 2008 and Freddie and Fannie are gone, Lehman closes the doors, Merrill Lynch takes a hike, GS MS are now banking away and its all Bush’s fault.
I am slightly against the PP if you have not notice.
There never would have been wounded MBS’s if there were proper instrument inspection and as for bank’s they have to do their own in house research and not rely on some lawyer or title searcher.
It is not impossible to go back on all of that junk paper and track it back to those who committed the fraud and hang it on them. Let them pay not us. That is the bottom line which no one wants to get because being irreponsible paid so well.
allegedly banks are still hiding 1 trillion of losses in their balance sheets under category 2 and 3.They have recognized till now 0,5 trillions. I guess assets under category 2 and 3 are near par value, fair value, price to maturity or whatever you call it so there will be no big gain. So banks are mainly selling those loans already written off the balance sheet to the treasury generating a big profit and capitalizing and at the same time those assets under categories 2 and 3 magically have a certain and fair value near par!!
Hi Lewis,
I’m in sympathy with everything you say.
On one point: the instruments that comprise, eg, a CDO — a dozen or so contracts — are as clear as any other finance paper, I should think.
What has proven less than clear is the modelling (spreadsheets) that both the bankers and rating agencies use to predict the performance of the tranches under various stresses.
Good luck to them; no investor in their right mind wuold totally trust the valuation of a seller (whatever item they may be selling), more so when they are so far off the line of rationality. By marking to myth, they are only encouraging more fear, scepticism and ultimately speculation of the savage kind.If no one enters the market for those assets, they’ll be forced to continually mark down till some sort of consensus is reached and it won’t be pretty, the -ve volatility will be the penalty exacted upon them- would anyone enter a store and buy items that they know are going to be sold in the Not-FireSale-sale next day /week /month?
I’m not sure I’d call Treasury’s program Mark-to-Myth accounting as Yves does, I think a lot of people maintain FAS 157 drives mark-to-myth in the current environment which is illiquid and subject to extrapolating vulture pricing. Rather than the tail (accounting) wagging the dog (the auction process, or more broadly, the economy) I think it may be worth considering if the tail needs adjusting, since it was created on an explicit theoretical presumption of active markets with willing buyers and sellers and non-distressed sales, rather than forcing the dog to chase its tail.