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.
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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.
ReplyDeleteRather than scrap it, why not try to fix it? Perhaps it would make sense to allow a temporary exception for mortgage backed securities so that they could be marked to model for some limited time. That would buy some time to work out some more robust ways to tweak mark-to-market pricing to avoid similar situations in the future.
"Buffett thinks the government will get a good rate of return. This suggests that Buffett, himself, thinks MBS's are underpriced."
ReplyDeleteBuffett said we'll get a good return if we buy at the current market price and NOT at Bernanke's suggested hold-to-maturity price (as you pointed out in an earlier post) so there's a fundamental difference between Treasury's Wall Street Giveaway and Buffett's suggestion.
and aren't the mark to market rules only for assets in the ready for sale pile? we need a CPA on here.
million said...
ReplyDelete"Buffett said we'll get a good return if we buy at the current market price and NOT at Bernanke's suggested hold-to-maturity price (as you pointed out in an earlier post) so there's a fundamental difference between Treasury's Wall Street Giveaway and Buffett's suggestion."
Yes, sorry, I was assuming the government will do the right thing. Probably not a safe assumption, though, huh?
million said...
"and aren't the mark to market rules only for assets in the ready for sale pile? we need a CPA on here."
I'm no accountant, so I could easily be wrong. It's only a hypothesis.
"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."
ReplyDeleteWhile it may be true that the majority of Americans will pay off their mortgages, that doesn't mean the value of "these assets" will likely be higher than their current price.
Why? Because "these assets", the ones the banks are going to want to unload on Uncle Sam, are the non-performing ones. The banks will keep the high quality, performing loans and securities for their own books and sell the duds to the bailout fund. Therefore, "these assets" won't be backed by the Americans that are highly likely to pay off their mortgages. Thus, Mr. Bush's statement is highly misleading.
I have to disagree with you, John. Most of these mortgages have been sliced and diced, and intermixed with each other, and split into tranches, and sold onto the market as CDO's, that you can't separate the performing mortgages from the non-performing ones. You can probably only differentiate the CDO's by their tranche and their year of issuance.
ReplyDeleteJames - I was going to say the same thing, but you beat me to the punch. The CDO's will stay bundled in the tranche and it will be tranches sold (stellar performing and crap performing mortgages included).
ReplyDeleteThe other question is what we pay for them. If we buy them at market value (similar to Merrill's 22 cents on the dollar) and do in fact hold them to maturity, we likely will make money on them.
However, if our purchase price is a "hold to maturity" price, (which seems likey, but not certain), it is debatable whether we will make a dime off them.
James, maybe this graphic will be of assistance to our discussion:
ReplyDeletehttp://www.portfolio.com/interactive-features/2007/12/cdo
I am well aware that individual mortgages have been securitized and sliced and diced into tranches. My point is this - Wall St. isn't going to sell the high quality, performing securities. They are going to want to dump the non-performing assets; the so-called equity tranches of MBSs and CDOs (the Baa level in the accompanying graphic). These equity tranches have great returns as long as most mortgages within the security perform. However, when even a moderate percentage of defaults within the pool, the equity tranches lose big time due to their subordination.
Sure the gov't may "only" pay 22 cents on the dollar, but the truth is that some of these bad assets (i.e., low rung tranche classes) may be so low on the totem pole that they aren't even worth 22 cents.
If done right (it's bureaucrats in charge so that's a big 'if'), the government will be in the driver seat. It should be the government deciding what to buy, rather than the banks deciding what to sell.
ReplyDeleteFor example, when I buy a stock, I don't have the seller dictate what stock I will buy. As the buyer, I make my own decision based on the quality and the price of the asset.
Perhaps we just need a savvy investor to represent the American people. I have a post on that subject scheduled for 7:15 PM ET today.
But we know for a fact that the fund is intended to buy "bad assets." This is the problem.
ReplyDeleteAnd btw, thanks for all of the awesome stuff you contribute to this blog. Top shelf!!
"Sure the gov't may "only" pay 22 cents on the dollar, but the truth is that some of these bad assets (i.e., low rung tranche classes) may be so low on the totem pole that they aren't even worth 22 cents."
ReplyDeleteOK, but, if thats the case, then the market value is not 22 cents - its 18 cents, or 12 cents or 2 cents - or whatever. There is always a ton of risk whenever trying to reprice anything that has so many unknowns. There is a chance you could be spectacularly wrong, in which case they are really worth 0.00001 cents on the dollar or you could be spectacularly right in that they are worth the otherwise jaw-droppingly low price of say 46 cents on the dollar on a hold to maturity value.
In any event, the reason we want to buy the bad debts is to restore confidence to the financial system. Banks do not trust each other at this point. Bank A says its worth 11 billion, but how much of that is real, and how much is refusal to mark down bad debt? Bank B fears overnight lending or other lending to Bank A because bank A could close up shop the next day, and now Bank B is out of covenant on some other collateral obligation of theirs with Bank C.
Either way, what this does, or is supposed to do is drain the pool. Take all the crap out of the system so we can know which banks really are worth 11 billion, and which ones are swimming naked (i.e. 5 billion of good stuff and 6 billiion of un-marked down crap). Once we know who is who, Bank A can lend with much better confidence that its overnight lending will be repaid (hence once again credit flows).
Mind you too, my first comment about price is only if the govt plans to pay the market value price (whatever that may be). There is some evidence the plan is intended to intentionally overpay to recapitalize the banks.
ReplyDeleteEither way, my second comment stands. The whole point of this is to get all the crap out of the system so it isnt a factor in further lending.