Bailout dilemma: How hard to squeeze the banks on loans?
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How much should the Treasury pay banks to take bad mortgages off their books? Eighty cents on the dollar? Fifty cents? Ten cents?
Just asking the question exposes the real nightmare of the Bush administration’s $700-billion financial-system bailout proposal: The government will be trying to decide on the true value of myriad loans and securities whose worth remains a mystery to the Wall Street rocket scientists who created them.
Testifying before the Senate on Tuesday, Federal Reserve Chairman Ben S. Bernanke made the case for paying the banks more than what a normal buyer would in this situation -- assuming that a normal buyer would pay as little as possible, to minimize his risk.
Bernanke presumably will make the same argument when he and Treasury Secretary Henry M. Paulson testify before a House panel today.
Bernanke asserts that it would do no good to hurt the banks more than they’ve already been hurt by the real estate bust, if the goal is to climb out of this mess sooner than later.
At least he’s being honest: This bailout program is all about getting the most cash possible to the banks, relieving them of lemon loans they made or bought, and thereby getting lenders to lend again -- or so the government hopes.
As the new owner of some gigantic number of troubled loans, the government also would be in a position to order loan modifications that could forestall foreclosures. If that shrinks the glut of homes on the market, it could brake the decline in prices. And if people begin to believe the bottom has been reached in housing, confidence in the economy and the financial system should improve.
This may be a great plan for current homeowners. But if you’re a renter -- and you believe that housing prices should fall further -- the proposed bailout is the worst kind of market interference. The government would be setting an artificial clearing price for distressed mortgage assets instead of letting the market decide.
Is Bernanke all wet? Writing on the Economist’s View website, Mark Thoma played devil’s advocate in backing the Fed chief’s argument for paying banks close to ‘hold-to-maturity’ prices for their assets -- prices that (hopefully) reflect how much of a loan is likely to be repaid in time -- instead of fire-sale prices of the moment. It’s a bit wonkish, but I like his main points:
For markets to function according to competitive ideals, full information must be available to all market participants. When information is lacking, or when it is asymmetric, the outcome is inefficient relative to the full information outcome. The nature of these assets -- their opacity as it has come to be called -- makes full information unavailable. . . . This is market failure due to lack of full information, and asymmetric information to the extent it does exist, is depressing prices. The idea is for the government to hold the assets while the information is revealed, and then resell them later at closer to their full information price. I think of bank asset portfolios as containing bombs, but nobody knows for sure where the bombs are hidden (though the banks may have a slightly better idea than outsiders). At some point, they will explode and cause big disruptions. The idea is for the government to gather up these assets, put them in the bomb-containment chambers, and let the ones that are going to explode do so. This reveals the information that is lacking, the ones that don’t blow up after a certain time period are just fine, and these will be sold at their ‘hold-to-maturity’ prices.
But how to arrive at fair ‘hold-to-maturity’ prices for Treasury to pay for this stuff? For one, the government (and its advisors) will have to be very good at estimating the recovery values of homes already in default or those likely to end up in default. Yet this is something the marketplace itself is having a terrible time figuring out.
If the Treasury overpays for loans, the final taxpayer bill for this bailout will rise.
Economist Arnold Kling on Econlog.com says the risk of further home price declines argues for conservative ‘hold-to-maturity’ prices in valuing bad loans:
The probability that you will default depends on the distribution of possible paths of future home prices. Along paths of falling home prices, defaults are much more likely than along paths of stable or rising prices. It’s hard to know how home prices will behave, but right now if I were pricing the risk (something I used to do for a living, unlike the key decision-makers in this bailout), I would include a lot of paths where prices go down. That would make the ‘hold-to-maturity’ prices of the mortgage securities, properly calculated, pretty low in many cases. I sure hope that Bernanke and Paulson know what business they’re getting into. Part of me thinks they don’t know. Part of me thinks they don’t even care. They’re so desperate to try to make the mess go away that they don’t think little details matter.
Finally, New York Times columnist Paul Krugman seems to back Bernanke’s idea for paying better-than-fire-sale prices for the debt, but wants something more in return for relieving the banks of their dreck. He suggests that the government take ownership stakes in the banks, which might one day be sold at a gain for taxpayers:
If the price Treasury pays is very low -- anything comparable to what financial institutions are able to sell the stuff for now -- it’s going to do nothing for confidence and capital. If the price is high, confidence and capital will improve, but taxpayers may well take a big loss. The premise of the Paulson plan, though never stated bluntly, is that these assets are hugely underpriced, so that Uncle Sam can buy them at prices that help the financial industry a lot, without big losses for taxpayers. Are you prepared to bet $700 billion on that premise? But how can we help the financial situation without making that bet? By taking an equity stake. That way, if it turns out that the feds are pumping money in at above-fair prices, at least they get ownership, just as a private white knight would have. There is no, repeat no justification for refusing to grant equity warrants that provide some taxpayer protection. This is, for me, an absolute deal or no-deal point.
Except that taking equity stakes in hundreds or thousands of banks, brokerages and other financial institutions on behalf of taxpayers seems like a bureacratic nightmare in and of itself.
But maybe it’s inevitable that government involvement in capital markets on the scale the Bush administration proposes can’t help but lead to much more of the same. Wall Street brought this on itself.