Here is the key passage from President Bush's speech last night:Greg Mankiw is right to be suspicious. It is very presumptuous of government officials to assume they know the proper value of mortgage-backed securities better than the free market does—especially since Bernanke and Paulson have been consistently wrong about the housing market.as markets have lost confidence in mortgage-backed securities, their prices have dropped sharply. Yet the value of many of these assets will likely be higher than their current price, because the vast majority of Americans will ultimately pay off their mortgages. The government is the one institution with the patience and resources to buy these assets at their current low prices and hold them until markets return to normal. And when that happens, money will flow back to the Treasury as these assets are sold. And we expect that much, if not all, of the tax dollars we invest will be paid back.In other words, the premise appears to be that the market is irrationally pessimistic. That might be so. Nonetheless, one has to be at least a bit skeptical about the idea that government policymakers gambling with other people's money are better at judging the value of complex financial instruments than are private investors gambling with their own.
However, Warren Buffett's comments yesterday seem to support a hypothesis that I've had in my head for a while now. Buffett thinks the government will get a good rate of return. This suggests that Buffett, himself, thinks MBS's are underpriced.
My hypothesis is this: Even if the mortgage-backed securities would be a good investment in the long run, highly-leveraged financial institutions can't risk buying them if the price continues dropping dramatically in the short run. With mark-to-market accounting, the declining prices could cause any highly-leveraged buyer to find itself insolvent in the short run, even if it is holding assets that will pay off in the long run.
The problem with MBS's is that the only natural buyers of them are highly-leveraged financial institutions. Ideally, unleveraged sovereign wealth funds could swoop in and purchase MBS's on the cheap, but while the world's sovereign wealth funds are flush with cash, they are not sophisticated investors with the courage and instinct to buy undervalued assets during a panic. Thus, the only solution for this problem is for the U.S. government to essentially establish its own sovereign wealth fund, and buy up the undervalued assets. (Investors like Buffett are puny compared to the size of the market.)
In the meantime, there is no natural buyer of these assets that can afford to buy them. Since the price of MBS's is determined at the margin, every time a financial institution tries to deleverage by selling MBS's, it forces all other financial institutions to take losses. This in turn forces them to deleverage by selling off MBS's, thus creating a vicious cycle. The market is not being irrational; the market is being forced to deleverage. The goal of America's sovereign wealth fund (the Troubled Asset Relief Program) is to stop the vicious cycle.
A far cheaper solution than this bailout would be for the U.S. to abolish mark-to-market accounting, but that would likely create more problems than it solves.