Spero Consulting

Dur­ing the past week, we have crit­i­cized the President’s and Congress’s pro­posed finan­cial bailout on prin­ci­ple and for what we will call strate­gic and tac­ti­cal rea­sons. The title of this post per­tains to some of the tac­tics, which we’ll men­tion later in the post. How­ever, we’ll take a moment to reit­er­ate our pri­mary opposition.

First, we dis­agree in prin­ci­ple with the pro­posed bailout/​subsidization of finan­cial firms that either (1) reck­lessly lent money for mort­gages to unqual­i­fied bor­rows or (2) reck­lessly pur­chased mort­gages, mortgage-​backed secu­ri­ties, or CDOs with­out suf­fi­cient analy­sis. By “reck­lessly” we mean that lax man­age­ment per­mit­ted exces­sive risk-​taking, and by “exces­sive risk-​taking” we mean both (1) the elim­i­na­tion of lend­ing stan­dards and (2) the deter­mined igno­rance the envi­ron­ment by employ­ees and man­agers about all of the bad things that could hap­pen, par­tic­u­larly the sys­tem­atic com­po­nents of real-​estate val­ues in com­mu­ni­ties and regions, which they tend to be highly related. (There’s a domino effect when prices are going up or down.)

We could make a tech­ni­cal argu­ment, which would use a model sim­i­lar to Moody’s cor­re­lated, bino­mial expan­sion tech­nique, but doubt that most read­ers care about the details. So, we refer inter­ested read­ers to a post from April, Trad­ing, Incen­tives and Orga­ni­za­tional Struc­ture and Risk Man­age­ment, which explains how we see home prices being set. See the sec­tion enti­tled Thinly-​traded “mar­kets,” but we think the entire post is worthwhile.

Sec­ondly, we don’t like the strate­gic deci­sion to over­es­ti­mate of the neg­a­tive impli­ca­tions of not pass­ing the bailout. We view the wolf-​crying, sky-​is-​falling bureau­crats at the Fed and the Trea­sury with deep sus­pi­cion. We think that many of our fel­low mem­bers of the hoi pol­loi har­bor sim­i­lar sus­pi­cions. We think those sus­pi­cions (and the implicit lack of respect for the audience/crowd) is one rea­son why most opin­ion polls have shown that majori­ties of respon­dents are against the bailout.

Thirdly, from what we’ve read this evening, we also dis­agree with the devil in the details. An arti­cle on The Wall Street Jour­nal’s web site tonight, Cri­sis Hits Europe’s Banks As U.S. Seals Bailout Deal, has empha­sized the reverse auc­tion aspect of the pro­posed pur­chase plan. If that is the case, then for a par­tic­u­lar mortgage-​related secu­ri­ti­za­tion issue – MBS or CDO – the Trea­sury will buy at the low­est ask­ing price. Pre­sum­ably, this mech­a­nism is being empha­sized to min­i­mize com­plaints (from peo­ple like us) about sub­si­diz­ing irre­spon­si­ble behavior.

Unfor­tu­nately, as we men­tioned Fri­day in Moral Haz­ard and Another Prob­lem with Illiq­uid Assets…in a Mark-​to-​Market Account­ing Régime, the prob­lem with illiq­uid assets is that there are few – if any – prices to observe. 

So, the Treasury’s pur­chase price will set the mar­ket price (and the mark) for all the other hold­ers of the issue. And, that price is the low­est ask­ing price; so, all else equal, every firm that doesn’t sell now has an unre­al­ized loss, and hav­ing banks rec­og­nize addi­tional unre­al­ized losses is not the way to regain finan­cial sta­bil­ity in the industry.

We’re not an expert on auc­tions, but maybe some type of second-​price, reverse auc­tion is would work out best. We need to think more about it, and – as always – are will­ing to enter­tain com­ments and other perspectives.