Could a “Bailout” Prolong the Financial Crisis?

Or, Creating Additional Uncertainty at Quarter’s End.

We’ve written in Public Bailout? Why Rush or Do It at All? that we’re against the proposed $700 billion bailout of mortgage securities.  Although our dissatisfaction is mainly for moral and philosophical reasons, we also doubt its necessity as there is a huge difference between certain doom and the arguments that Mr. Paulson and Mr. Bernanke have made, which tend to use words like “risk” or “chance” of a downturn.

Furthermore, as we explain below, we’re beginning to think that any such commitment from the government to buy the worthless and semi-worthless securities may exacerbate the problem and lengthen its duration until resolution, and we don’t mean duration as a measure of price sensitivity, we mean it in the old-fashioned way.

By the way, before continuing we’d also like to note that we really dislike the improper use of the adjective “toxic” as in “toxic securities” that we’ve seen any number of places in the last few weeks.  As many aging baby-boomers with smooth foreheads can attest to, many toxins have uses and value, which make them quite different than many of these securities, particularly the ones that reference defaulted mortgages on vacant homes in deserted, semi-finished subdivisions in Florida or the Southwest.¹

Returning to our central thesis, we note that the proposed bailout may play one of three roles: (1) a massive attempt to subsidize somewhat negligent financial institutions and to recapitalize those institutions at far above their current, “true” values; (2) a massive smokescreen or focal point to provide no real economic advantage other than to signify that the federal government in now involved so all is well, and everyone can relax and go about his or her business as usual–move along, move along, nothing to see here; or (3) as an actual, straight-forward attempt to pay fair value for the things, that no one seems to know how to value, and hold them until either they or the underlying collateral becomes valuable again.²

If the plan is (1) a massive subsidization to recapitalize the financial industry by injecting hundreds of billions of dollars of equity, then we argue that the federal government should own those firms that it is investing our money in, and current shareholders should be wiped out as a way to stem future moral hazard problems in both finance and other”vital” industries.³ Note also that such a subsidy is grossly unfair to existing institutions that did not disproportionately concentrate their assets in particular regional housing markets or among particularly risky classes of borrowers or with particularly poorly understood instruments but would be more likely to do so next time.

If the true reason is either (2) or (3), then, because this crisis is unfolding in mid-to-late September, it might end quicker without such intervention.  We say this because the government’s plan will add further uncertainty about the possible (auction) value of the securities, which is something that banks must consider within the next few weeks as they must perform the dreaded “mark-to-market.”  We’d see it as exacerbating the adverse selection issues (Akerlof’s Lemons Problem) causing less extensions of credit among the banks.

Unlike the investment banks, all large US commercial banks have fiscal years that match the calendar year.  Therefore, September 30 is the end of the third quarter, and the date on quarterly earnings must be calculated.

So, next Tuesday is the date at which these various securities must be marked–with the unrealized gains or losses affecting either net income or owners’ equity depending upon the banks’ intentions for each asset.  (Other the other hand, whole mortgages, which are not for sale need not be marked, but a loan-loss provision must be calculated and recognized for them on the same time.)

While our argument is about additional uncertainty that a bailout would create–by changing the possible range of future realized values–we’d be very interested in having these institutions independently mark their securities next week. (We italicize independently because, in fact, they would likely attempt to get quotes from one another regarding the value of these “tradable” securities, and we put quotes around “tradable” because while that’s technically the case in theory, it doesn’t seem that many of them are being exchanged, and that’s pretty much the root of the problem.)

So, if the government’s purchase of these thingies is approved, we would expect to see a continuation of the panicky behavior until the securities are actually transferred to the government because it is unlikely that anyone one will know who has the worse ones so all remain suspect. (Also note that the most panicky firms might be ones who are projecting their portfolios onto others, and so might be the ones that other firms would like to avoid.)

So, unless the “purchase” is a subsidy, don’t expect calm until the government owns these thingies. If the plan is approved and is signed into law, once the government (eventually) realizes that calm has not ensued, expect it to move quickly to buy the worthless and semi-worthless securities.

In that regard we ask: has the federal government, when rushing to make massive purchases, ever been for good us, the average taxpayers.