Spero Consulting

in a Mark-​to-​Market Account­ing Régime.

Here’s a cou­ple of related issues that we can dis­cuss in the con­text of today’s The Wall Street Jour­nal arti­cle, Bailout Pro­posal Gets Hung Up Over Cen­tral Issue: Will It Work?

We’re deeply con­cerned about the moral haz­ard impli­ca­tions of any gov­ern­ment bailout, and we doubt that we are the only observer to har­bor such dark thoughts. How­ever, we also think that those impli­ca­tions could be real­ized imme­di­ately rather than, say, dur­ing the “next” down­turn in some far dis­tant time. Thus our pes­simism grows as does our annoy­ance with the fed­eral offi­cials who have pro­posed mas­sive snd expen­sive actions with­out suf­fi­cient lev­els of thought.

In that respect, can the reader say, “com­mer­cial real-​estate loans and CMBS?” And, does the reader know that illiq­uid CMBS – that’s redun­dant by the way-​is very dif­fi­cult to value, too? Not much dif­fer­ent than CDOs of MBS. We com­mented on some of those val­u­a­tion issues three months ago in this post: On Nedges and Sledges and Paving the Road to Hell.

We men­tion CMBS because we saw in the ref­er­enced arti­cle that many banks, not just the ail­ing ones, are try­ing to round-​up every­thing they don’t want, i.e., crappy loans and secu­ri­ties, to make it avail­able for sale to the government.

Can you, dear reader, blame the banks? We can’t. We’d cer­tainly like the feds to buy our Sub­ur­ban at its his­tor­i­cal cost, too. Mr. Paul­son are you listening? Can you help me, here?

As the arti­cle men­tions, it turns out that the banks would rather sell these items at their cur­rently marked val­ues than be forced to pos­si­bly devalue them at the end of the next report­ing period, which hap­pens to be next Tuesday.

It is prob­a­bly too late, so we doubt that it will hap­pen on Mon­day, but we could see a banker try­ing to con­vince a gov­ern­ment bureau­crat that the bank’s mark from June is still the best guess of where an item sells (if it were to sell to any­one in the mar­ket that doesn’t exist.)

We could also see the bankers’ expec­ta­tions of the sales (to the gov­ern­ment) to color their val­u­a­tions next week. As we wrote yes­ter­day in The Uncer­tain Value of Mort­gage Secu­ri­ties that expec­ta­tion will likely lead to greater adverse selec­tion prob­lems because of the pos­si­ble increase in the uncer­tainty regard­ing the value of each bank’s assets. In our view, this will exac­er­bate, not mit­i­gate, the cur­rent pan­icky behav­ior among banks as they deal with each other (until such exchanges with the gov­ern­ment actu­ally occur). How­ever, we could see it lead­ing to prob­lems after the bailout, too.

With that in mind, we ask the dear reader to guess the mul­ti­ple of $700 bil­lion that banks have iden­ti­fied as assets they’d like to sell? We’re guess­ing a mul­ti­ple of at least three – a few tril­lion dol­lars worth – with a sub­stan­tial amount of CMBS and inven­to­ried, pipelined, com­mer­cial mort­gages thrown into that mix. (Those are loans that con­duits made and planned to bun­dle into secu­ri­ties but are cur­rently stuck with because no one wants the CMBS that would be struc­tured from them.) Does the reader believe that only homes were over­built in for­mer boom towns?

So, for argument’s sake, and to be excru­ci­at­ingly pre­cise, let’s say that we are cor­rect that the bank’s col­lec­tively think that they’ll be able to sell $2.1 tril­lion worth of thin­gies to the gov­ern­ment at prices that the banks like. How will take affect next week’s third quar­ter val­u­a­tions, and what will hap­pen when they’re stuck with $1.4 tril­lion of stuff that they wish the gov­ern­ment had bought?

And that leads us to our sec­ond issue about the nature of dis­jointed and illiq­uid mar­kets and how a lit­tle infor­ma­tion can hurt a lot. You see, in social sit­u­a­tions, more infor­ma­tion is not nec­es­sar­ily better.

The fact that no one wants to buy the stuff doesn’t mean that there aren’t a lot of firms hold­ing sim­i­lar secu­ri­ties. So, let’s say that 20 firms are hold­ing a part of a par­tic­u­lar illiq­uid CDO issue or CMBS issue or what­ever it is that no one else wants.

If the thing is illiq­uid then – nowa­days – that means it’s not traded at all; so, there is no observ­able price; so, it is likely that the cur­rent marks vary across the 20 firms because they are all using slightly dif­fer­ent mod­els or all have slightly dif­fer­ent – albeit, likely inflated – expec­ta­tions of what a sale to the gov­ern­ment will bring.

All things equal, it would seem to us that the most des­per­ate firm would accept the low­est price offered by the Trea­sury. Again, all else equal, that’s usu­ally how its works; oth­er­wise, we have to add an adverse selec­tion argu­ment, too.

If that is true, then depend­ing upon how much of the issue the Trea­sury pur­chases, that low­est price is now an observ­able “mar­ket” price for the other 19 firms, and that’s not good with mark-​to-​market account­ing where a lit­tle bit of infor­ma­tion, based pos­si­bly upon one firm’s des­per­a­tion sale to the gov­ern­ment set the new (likely lower) mark for the other 19 firms. It might be infor­ma­tion and it might be the truth, but it cer­tainly wouldn’t help soci­ety. More infor­ma­tion isn’t always better.

That means addi­tional write-​downs may be forth­com­ing from, say, the other 19 firms. If that issue is part of our hypoth­e­sized $1.4 tril­lion above, then those write-​downs in the future after the gov­ern­ment pur­chase will be larger than they would have oth­er­wise been with­out the bailout. Of course, that’s based upon our argu­ment that the book val­ues of the issues would be higher than they oth­er­wise would have been (due to each bank’s antic­i­pa­tion of sell­ing to the gov­ern­ment at an inflated price). Such a sce­naroi would lengthen the dura­tion of the cri­sis and neg­a­tively influ­ence the behav­ior of the firms when they lend to each other in the near term. There will be more pan­ics that occur far­ther into the future.

Is this all idle spec­u­la­tion? Of course, we were a the­o­rist in col­lege. Are we wrong? It is quite pos­si­ble – the chair­man men­tions that it often hap­pens – but we doubt it in this case. Let us know what you think.

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