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 Regime, 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.
