Spero Consulting

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.