in a Mark-to-Market Accounting Regime.
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.
