By Neil Irwin and Binyamin Appelbaum
Washington Post Staff Writers
Tuesday, September 23, 2008
As the government weighs how to bail out the financial sector, the plan's engineers face a dilemma.
The higher the prices the government pays for troubled mortgage securities held by banks, the more the rescue will bolster those banks and sustain the lending that is vital to the broader economy. But higher prices would also mean a worse deal for taxpayers.
In other words, the more effective the plan, the more expensive it will ultimately be.
Under both the Bush administration's proposal and many of the variations finding favor among Democrats, the government would buy up to $700 billion in shaky assets now on the books of financial companies. As the government does so, it will be forced to grapple with the same question that has vexed the brightest minds on Wall Street for more than a year: What are the darn things worth?
The very reason for the financial crisis of the past 14 months is that no one knows for sure. Wall Street created securities so complex that their value can swing wildly depending on what happens to the overall housing market. For example, a particular type of mortgage-backed security might offer a giant payout if home prices drop 10 percent but be worthless if they drop another 15 percent.
The outlook for the broader economy and housing market is so uncertain that investors have been unwilling to buy these exotic securities at any price. With these impossible-to-value investments clogging their books, banks haven't been able to make loans to people and businesses, a major reason for the nation's economic distress.
If the government buys the assets at relatively high prices, this would fortify the banks and help lending return to normal. Even banks that do not sell their securities to the government could be forced under accounting rules to assign the government sale price to assets on their books, giving them some clarity about their financial outlook.
"Psychologically, it's very, very important," said Thomas A. Renyi, former chairman of Bank of New York Mellon, referring to the price the government pays. "It provides the underpinning beneath what is a very, very uncertain market. It provides a stable environment for the proper valuation of assets in the marketplace."
If the government pays relatively low prices, it would protect taxpayers more, even giving them the potential of profiting on the deal when the Treasury ultimately sells them in the future.
But if the government sets prices below those that banks have placed on their own holdings, these financial firms could be forced to take the difference as a loss. Indeed, the prices could be set by the banks most desperate to sell, artificially depressing the value of similar assets on the books of healthy banks. As a result, some of those banks may become less healthy, requiring them to raise more money to cover their expected losses.
"What it could show is the depressing news that even greater infusions of capital are needed across the banking system than previously thought," CreditSights analysts wrote in a note to clients yesterday.
The plan also could hurt banks that have set relatively high values for their holdings. Until now, there has been no way to prove those banks have inaccurately priced their assets. But the government plan could force a massive repricing. In a research note to clients yesterday, a Merrill Lynch analyst warned that regional banks were particularly vulnerable because many of them have been slower than large banks to write down the values of mortgage loans on their books.
Under the current proposal, private companies will be hired as asset managers to help figure out which assets to buy, how to buy them and ultimately when to sell them off.
The Treasury Department has provided only broad outlines of how it intends to set prices, saying in a fact sheet that it will use "market mechanisms where possible, such as reverse auctions." In a reverse auction, the government could agree to purchase a specific amount of assets and buy those that are offered at the lowest price.
But that may be harder than it sounds, economists said.
The problem is that there are thousands of kinds of mortgage-related securities. If the Treasury just opens the door for banks to sell those securities to the government, firms will offer up the very worst ones, possibly leading to huge losses for taxpayers. But if the government specifies exactly which securities it will accept, the Treasury secretary will have unusually broad authority to decide which banks get bailed out and which don't.
Imagine that the market for used cars had fallen apart and the government decided to restore order by buying up thousands of vehicles. If the winning price in a reverse auction was $3,000, owners of lower-priced Ford Pintos would trade their cars in to the government, while owners of higher-priced BMWs would hold on to theirs. When the government went to sell the Pintos, it could not recoup its investment and would lose money.
In an alternate scenario, the government could have separate auctions for Pintos and BMWs. But in choosing how many of each to buy, the government would be deciding which kinds of car owners to bail out and which to let suffer.
"Which assets do you buy and how much of each?" asked Douglas Elmendorf, a senior fellow at the Brookings Institution. "That determines who you end up helping. If it's at the discretion of investment managers, I assume we'll hire good smart ones, but that discretion when applied to $700 billion seems like a lot of discretion, and has a lot of potential for unfair outcomes and abuse."
Elmendorf suggests that a way around that problem would be for the government to make investments in financial companies, proportional to the firms' market value. That way, the companies would have extra cash and then could sell the troubled assets on private markets for a loss while continuing to make loans and operate normally.
That approach could have its own drawbacks, though, including making the government a major shareholder of large financial companies, which to some critics smacks of socialism.
The very structure of the auctions will go a long way to determining the outcome. The people who design how the auction works can set the rules such that almost any outcome is likely.
"Just because it's called a reverse auction doesn't mean it results in lower prices automatically," said Bob Emiliani, a Central Connecticut State University professor who studies reverse auctions. He said that in some cases, reverse auctions are set up so the buyer accepts the highest price submitted by any of the sellers and then pays that price across the board -- even to sellers who were willing to accept lower prices.