Assume that I'm talking about the Democratic revisions to Paulson's plan here. I'm not defending $700B with no oversight, rather Paulson's general concept with reasonable limits and oversight.
Here is what the plan isn't:
- It's not a plan to hand or even loan money to failing companies.
- It's not a plan to specifically buy out bad mortgages
It is a plan to buy up mortgage backed assets - bonds that are mortgages all bundled up - comprised of both good and bad mortgages at a fair valuation which can be sold later for something close to their purchase price. The goal is not to drop cash into companies that need it, but to provide a buyer for these assets, not so that companies can unload them, but so that companies can value them properly.
The problem really isn’t the defaults. In total, we’re talking about maybe $300B in defaults, and a certain percentage of that can be recovered once the property is seized and sold. The market can absorb that, if that's all that it is facing. The problem seems to be the fair market valuation accounting system that we put in place to stop the kinds of scams that Enron and others have pulled on investors for declaring certain assets as being worth more money than they really were.
We have a set of accounting principles which require companies to value their assets based on fair market values. These have been in place since about the time of the S&L crisis and have been amended from time to time since then. They read something like this:
The definition of fair value retains the exchange price notion in earlier definitions of fair value. This Statement clarifies that the exchange price is the price in an orderly transaction between market participants to sell the asset or transfer the liability in the market in which the reporting entity would transact for the asset or liability, that is, the principal or most advantageous market for the asset or liability. The transaction to sell the asset or transfer the liability is a hypothetical transaction at the measurement date, considered from the perspective of a market participant that holds the asset or owes the liability. Therefore, the definition focuses on the price that would be received to sell the asset or paid to transfer the liability (an exit price), not the price that would be paid to acquire the asset or received to assume the liability (an entry price).
This Statement emphasizes that fair value is a market-based measurement, not an entity-specific measurement. Therefore, a fair value measurement should be determined based on the assumptions that market participants would use in pricing the asset or liability.
What is says is that if you are holding an asset, you need to price it according to what you could get for it if you were to sell it on the open market right now. So, if you have a share of stock that you paid $20 for and you need to declare the value of that stock today, you would check the stock market price right now, and if it was $10 you would declare it at $10. You don't have the choice to declare it at $20 or at $40 that you think you can sell it in a year. It's worth $10.
Now, let's say you are a bank and you have originated a whole bunch of mortgages for people that you decide to bundle up into one package. There are 100 30-year mortgages in there that all that will eventually pay a total of $100M, assuming everyone pays up. You paid out $30M for people to buy those 100 homes, so over the next decade you'll get back about 3x what you paid out today. So what is this package worth? You would say that it's worth at least $30M, because you've already invested that much in it, but it's not worth $100M either because you need to wait so long to recover all that value. Well, these things get traded on the open market and so when you packaged up the mortgages into a bond you'd get a rating agency to look at it and declare it to have a certain risk (the AAA, BBB, CCC ratings that you usually see) and when things are working normally, we'd find that the real value is in fact a bit above $30M. Part of the variation in the price will come down to how many of those mortgages are expected to default. Let's say 6%, and so rather than collect $100M, you'll really collect only $94M, but you anticipated that and still wrote the mortgages, so surely you expected that the $30M was a good investment and so will everyone else. So, on your balance sheet you'd value it at that market value.
Later you need to revalue the asset, so you go back to the market. A few things have happened in those 3 months. First, foreclosure rates are up to 8% and so people wouldn't be as willing to buy your bond since it's rating has gone down a little, so it's worth less. Further, because the assets of the buyers on the market have been weakened as well for the same reason, they have less money to use to buy up other bonds, and so they demand a higher premium when they buy, which pushes the price down even lower (more sellers than buyers). So now you revalue your asset (write down the value) and you've lost a few million dollars on it, even though you still expect to get $92M out of the mortgages. That makes your balance sheet look worse, and investors punish you by selling your stock. Your credit rating goes down as well, so now you need to put up more money when you borrow and you need to keep more money on hand to help get your rating back up.
Later you need to revalue the asset again, so you go back to the market again. Things are worse. Because the value of these securities have been falling, nobody has much money to spend. In fact, there's so little money to spend that the price of bonds like yours have collapsed. Your bond is now worth far less than $30M because there simply is nobody around with money to buy it. You still expect to get $90M back from the homeowners, but you have to value the package at what the market would pay, which is now much less than what you invested to begin with - say $20M. Now you are showing a loss due to accounting rules, even though you still expect to turn a good profit on it. You now need to make big write-downs on your balance sheets and your assets have now fallen far enough that you need to raise cash to not be overleveraged according to regulatory rules. So now you might even be forced to sell that bond for $20M just to get into compliance with the law. Of course, doing so pushes the value of those bonds even lower hurting the other people in the market. Eventually, the entire thing can collapse.
Now, here's the thing. Internally, these mortgages are still worth a good bit of money. After all, people are still paying their monthly bills, and you are still collecting cash on them. You may have no intention of ever selling those mortgages to anyone else, but you still need to value them as if you were and that puts you at the mercy of the market. If the market say that they are worth less than the next months payments, then that's what you need to declare them to be.
Now, this is why Warren Buffet is semi-bullish, because he sees all of these guys with bonds valued WAY below a reasonable price. He knows that if you could walk in with cash and not be subject to these accounting rules you could buy up a lot of reliable mortgages for a good price.
This is what Paulson is proposing to do: Take this giant pile of money and start buying bonds not at market prices but at a reasonable price relative to what the bond should pay out. The government doesn't care about those fair market rules, so they are the only agent that can actually pull this off. So by being a buyer of the bonds, and buying at an inflated price for the market, but still a discounted price for what they should yield (which you can calculate by looking at the value of the mortgages in the package and their foreclosure rates), Paulson not only gets everyone's bonds reset to a reasonable value, salvaging their balance sheets, but he also helps some of the firms needing cash raise it by providing a market to sell into. How much would he need to buy? He doesn't know. Nobody does. He just starts buying until the market can do it by itself again, which is why he's asking for such a large pot of money.
Some of the issues people have been raising:
- How do you know what to pay?
Krugman has been asking this, and given a hint to the answer. Either they can be valued by their intrinsic worth - just what we think they ought to pay out, or Paulson could set up a reverse auction with independent pools of money. Maybe break the $700B into 7 $100B funds managed by different people and have them bid against each other. That should give a close approximation to what they are worth provided they have enough money to work with. This is what Krugman is referring to when he posted about “price discovery”. The markets have screwed up the pricing of these things and we need to reboot the market to a point that it can get back to what it should be. Economists are good skeptics though, so he's also asking a lot of valid questions about why were details omitted, and so on, but it seems as though Krugman is on board with Dodd's version, so I think he's gotten a lot of that worked out.
- How do we get our money back?
Once the market is unclogged and buyers return, we just sell them back to the market. If they can buy at a good enough discount, it's very possible that some will be sold for a profit, some at a loss, but I'm guessing that they're expecting no more than a 5% loss overall, worst case and are really planning on a profit. They should be able to get that close. Now, it'll take some time before they can do that, but if Treasury is holding the bonds, then the mortgage payments are made to us while we wait. Fortunately, we have Fannie/Freddie available now to help manage the whole thing.
- Would he just buy up bad mortgages?
Actually, the bad mortgages are probably already written off. So the plan should be to buy good mortgages. Yeah, there'll be some bad ones in there, but that's not the focus. The real losses aren't the defaults but the good mortgages that are expected to pay out but are horribly undervalued because nobody has money to buy anything.
- Would he just buy from failing banks?
No, that defeats the purpose. He needs to buy from everyone. And that's why this isn't a bailout. Banks that made bad bets will still probably fail - the only way to fix that is to just hand them cash, which isn't what the plan is. It's the banks that made good bets and are getting crushed on the accounting stuff that will get saved. But it's also why banks are buying others. I imagine the thinking inside of JPMorgan and BofA is that if this doesn't get solved, it's just a matter of time before they fail as well - so there's no downside risk to buying up WaMu or Merrill. If it does get solved, then they got a great deal on assets that they see as having a true value much higher than what they had to declare the assets as worth. In other words, WaMu was just that much weaker than BofA that the valuation death spiral caught up to it first, but BofA is likely in the same death spiral - it just has more time to fight to stay alive. WaMu may not really have been all that exposed to bad mortgages, but it was exposed to bad valuation enough that it couldn't hold on any longer. Wall Street started digging into them pretty badly, and once that starts you're pretty much done for. Same happened for the other investment banks. Commercial banks in general aren't as bad off because they have far more assets in things that don't have this problem - cash from you and me, for instance - so the valuation squeeze is only affecting part of the business.
- Does it solve the problem?
Sort of. It doesn't solve any of the underlying problems that created this situation. It does solve the critical problem that prevents anything else from getting done though. Imagine your house just caught on fire and you have a big propane tank in the back. If the propane tank blows up, it really doesn't matter if you get the fire out soon or not. This plan is akin to moving the propane tank out of harms way. The house will still be on fire, but you have to solve that problem first. They'll probably need to rework the valuation rules and add regulation to lower the leverage limit so that if something like this happens again, it'll happen more slowly.
- Are there other solutions?
Probably. Rewriting the rules for how to value assets would work, but there may not be time to do something like this, and if you rush it, you might just create new loopholes. Some people have called for suspending the rules, which would be quick, but others predict that you'd have an ocean of fraud come from that. We put the rules in place for a good reason after all, and the rules work fine 99% of the time. This is the 1%. But Paulson is proposing something that gives him flexibility and I'm guessing he expect to turn a profit off of it. Having been head of Goldman, it's also a solution that I'm guessing he feels more comfortable with than trying to get Congress to write a bunch of new regulation in a hurry. It may not be the best solution, and it sure as hell wasn't a good presentation to a solution, but it has it's advantages and I think Democrats will get more real mileage out of this (by getting pay limitations, homeowner protection, etc.) than they would be able to get out of a regulation package.
- Why so urgent?
The urgency comes in that the calendar quarter ends in 6 days, firms will need to report earnings and we'll see yet another round of write-downs, and this will just cycle along. Further, the tightening in the credit markets have gotten quite bad the last few days. Bad enough that the last time we saw it this tight was the 1987 crash.
If you don't think the credit market is tight, the fed rate is currently 2%. That's what the fed charges to loan money out to big banks. Wells Fargo lists their 30 year normative rate at 6 1/8%. Those are loans that can be bought and sold through a wider market, including Freddie/Fannie. Their 30 year jumbo rate - mortgages that are harder to move in the market - is 9 1/8%. So if you go from a $415K mortgage to a $420K mortgage, your rate jumps from 6 1/8 to 9 1/8. For someone trying to buy a home in an expensive area - SoCal, Bay area, parts of the northeast, etc. you're facing a 9% mortgage - and the fed rate is already really low. That's going to put a huge damper on home buying in those regions, and it's simply because nobody has money they are willing to loan. They don't want to get sucked into that cycle outlined above.
So, the bailout isn't a handout. It's not really because people made bad decisions - it's more of a collective problem that even responsible companies are contributing to. Nobody is likely to get rich off of this, not in any meaningful sense. It's not a substitute for regulation and oversight that will still be needed later, and it will come and affect regular people if it doesn't get addressed. Democrats are adding a bunch of nice provisions to this to help homeowners directly, which is good, but I haven't seen an alternate plan that is likely to work. Certainly not the House Republican plan.
People are getting way too bent out of shape due to how this was presented. Assume the Democrats get the oversight that should be there because the Republicans are insisting on that as well. This shouldn't cost us any meaningful amount in tax increases, but it would provide a good point off of which to pivot to a revised tax and regulation policy. If successful, it won't just help these large companies, but consumers as well that are already seeing the effects as I noted (and which will expand with time). We should be backing Dodd on this one, not opposing it.