Saturday, September 20, 2008

At What Price?

I'm forgoing the usual restaurant review because there is a pressing question I want to raise about the mother of all bailouts, announced at $800 billion but almost certainly going to cost far more than that: what's the price? It's a question passed over almost entirely by the financial journalists, who are proving that they know no more (and probably a good deal less) about the financial markets than they know about their favorite baseball teams. So far they have repeated breathlessly that Treasury is asking for $800 billion of your and my money to buy mortgage-backed securities from banks, and that this will prevent the financial system from collapsing. But what price will they pay?

In my previous posts, I told the story of how poor lending practices led to mortgage-backed securities which led to major investment banks going bankrupt. The situation today is something like this (the numbers are obviously illustrative, but they reflect the basic facts). Some big bank has $190 in loans and "$200" in assets, which means it has $10 in capital. Of those "$200" in assets, $140 is in "normal" assets that are considered reasonably safe, and "$60" is in mortgage-backed securities. I say "$60" because there is virtually no market for mortgage-backed securities, so the bank is guessing (hoping?) that they are worth $60. Originally those securities were worth $100, but they've already been written down multiple times to $60. However, if the bank absolutely had to sell them on the market today, it would probably only get $20. (In July, Merrill Lynch - remember them? - sold $30 billion of mortgage-backed securities for 22 cents on the dollar.) The problem is that those $190 in loans are coming due, and no one is willing to roll over the loans or lend new money, because no one believes that the assets are really worth $200. And without new loans, the bank will go bankrupt. Since we don't know exactly what is on each bank's balance sheet, we can only assume that many, many big banks are in this situation.

Paulson is asking for $800 billion dollars to create a giant hedge fund, owned by the government, that will buy these illiquid mortgage-backed securities. The idea is that by getting them off the books of the banks, investors and the general public can have confidence that the banks won't go out of business and that the financial system won't collapse. But everything hinges on the price that this hedge fund will pay for those securities, because that's where your $800 billion are going.

We know that the government isn't going to pay market price ($20), because (a) the banks could sell the securities for $20 today without any government intervention, and (b) if they only got $20 they would go bankrupt, because then their assets would be less than their liabilities. In fact, the whole plan only works if the government pays enough to keep these banks solvent. But if the government pays whatever the banks think the securities are worth, then $60 of your money is being exchanged for "$60" worth of mortage-backed securities - which, according to the free market (remember that?) are only worth $20. So we all lose $40, and the bank gains $40; it's a handout, pure and simple.

There is only one scenario under which everything works out. There are some people who believe that, if held to maturity (basically, if you hold onto the security and see how many people actually pay their mortgages), it will turn out to be worth $60; the fact that no (sane) person would pay $60 for it today is just a result of irrational panic. If that is in fact the case, then the banks will get bailed out, and we the taxpayers will not lose money. Of course, this is predicated on the belief that markets are not efficient; if they are (which free market advocates would have us belief), then $20 really is what they are worth.

So of that $800 billion, we will get some fraction back, but most is disappearing into the pockets of the banks. Now, we are told that this is necessary to avert a complete meltdown of the financial system and the economy. But are there ways we could have accomplished this objective without taking $800 billion of our money and handing it to a hedge fund created by a former head of Goldman Sachs and undoubtedly staffed by investment bankers, whose purpose is to overpay banks for their bad investments?

Well, think about this. Even after the government buys those mortgage-backed securities at artificially high prices, the banks that have just gotten bailed out will still be able to foreclose on the homeowners at the beginning of the chain, because that $800 billion is just going to the banks, not to anyone else. And this will create another wave of social costs that the taxpayers will have to pick up. What if, instead, we used the $800 billion to help homeowners pay off their loans instead of defaulting? In addition to helping the homeowners, that would also help the banks, because that $800 billion of cash would increase the number of mortgages that get paid off, thereby increasing the value of all those mortgage-backed securities that all those banks are holding. The difference? In one case all the benefit goes to the banks, in the other it is shared between ordinary homeowners and the banks.

At the end of the day, Paulson's plan could be the largest and most egregious example of self-dealing in the history of the American financial system, under cover of a legitimate emergency - which should come as no surprise from an Administration whose modus operandi has been using the levers of power to enrich the already rich.

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