Sunday, September 21, 2008

Recapitalization?

I was all set to write another post about “The Great Bailout,” but apparently Paul Krugman has already said about half (the more important half) of what I wanted to say, so I’ll outsource, with my own comments interspersed to supply the other half. Prof. Krugman is leaning against the plan, and I’m generally in favor of it, but our primary concern is essentially the same. I yield the floor:
What is this bailout supposed to do? Will it actually serve the purpose? What should we be doing instead? Let’s talk.
First, a capsule analysis of the crisis.

1. It all starts with the bursting of the housing bubble. [I'll quibble on whether it was actually a housing bubble or just a credit bubble, but it doesn't really matter.] This has led to sharply increased rates of default and foreclosure, which has led to large losses on mortgage-backed securities.

2. The losses in MBS, in turn, have left the financial system undercapitalized — doubly so, because levels of leverage that were previously considered acceptable are no longer OK.

3. The financial system, in its efforts to deleverage, is contracting credit, placing everyone who depends on credit under strain.

4. There’s also, to some extent, a vicious circle of deleveraging: as financial firms try to contract their balance sheets, they drive down the prices of assets, further reducing capital and forcing more deleveraging.
I think Prof. Krugman has missed a couple of things here. Deleveraging and undercapitalization are important, but they're not the whole story. A couple of other important problems, possibly more important, are illiquidity and uncertainty.

Many asset prices are declining, but that’s only part of the story; in many cases the asset prices simply don’t exist, because buyers and sellers cannot agree on a price. To put it in market terminology, there are very few bids, and there are few offers to sell, and there is a wide price spread between what bids and offers there are. Since nobody really knows what these assets are worth, buyers are not willing to take the risk that they may be paying too much, and sellers are not willing to take the risk that they may be asking too little. As a result, these assets are frozen on the books of banks, and the banks have difficulty raising cash when they need it.

Moreover, because nobody really knows what these assets are worth, nobody knows what the asset-holders are worth. Even if you have all the detail of a bank’s balance sheet, you still can’t tell whether the bank has enough capital or not, because you have only a wild guess as to whether the assets on the balance sheet are being fairly valued. This uncertainty makes it impossible to tell a good bank from a bad bank. Since almost any bank may turn out to be bad, banks are afraid to lend to one another.

Continuing with Prof. Krugman:
So where in this process does the Temporary Asset Relief Plan offer any, well, relief? The answer is that it possibly offers some respite in stage 4: the Treasury steps in to buy assets that the financial system is trying to sell, thereby hopefully mitigating the downward spiral of asset prices.

But the more I think about this, the more skeptical I get about the extent to which it’s a solution. Problems:

(a) Although the problem starts with mortgage-backed securities, the range of assets whose prices are being driven down by deleveraging is much broader than MBS. So this only cuts off, at most, part of the vicious circle.

(b) Anyway, the vicious circle aspect is only part of the larger problem, and arguably not the most important part. Even without panic asset selling, the financial system would be seriously undercapitalized, causing a credit crunch — and this plan does nothing to address that.
OK, but, if you notice, the plan, provided that it turns out to be large enough, pretty much solves the other two problems that I mentioned. (Well, in a sense it doesn't solve the uncertainty problem; it just makes it the government's problem instead of the private sector's problem. But that's OK with me, because I'm confident that the government is a good bank, given that it has the option of printing new money if it runs out.)

With the illiquid assets off the banks’ books and replaced with liquid, easily valued assets like Treasury bills, illiquidity and uncertainty are no longer a problem for the banks.

OK, now comes the main point I wanted to make, before I was scooped by the Professor:
Or I should say, the plan does nothing to address the lack of capital unless the Treasury overpays for assets. And if that’s the real plan, Congress has every right to balk. [Italics his; bold mine.]

So what should be done? Well, let’s think about how, until Paulson hit the panic button, the private sector was supposed to work this out: financial firms were supposed to recapitalize, bringing in outside investors to bulk up their capital base. That is, the private sector was supposed to cut off the problem at stage 2.

It now appears that isn’t happening, and public intervention is needed. But in that case, shouldn’t the public intervention also be at stage 2 — that is, shouldn’t it take the form of public injections of capital, in return for a stake in the upside?
Hit the nail on the head: if the purpose of the plan is to recapitalize banks, then it is the wrong plan. The right plan, as we have already seen in the case of AIG, is for the Treasury (or the Fed) to take equity positions in the undercapitalized companies.

I support Secretary Paulson’s plan if the purpose is to provide liquidity, resolve uncertainty, and end the vicious circle of deleveraging. But, I repeat, if the purpose is to recapitalize the banks, then it is the wrong plan. In effect, the government would just be giving away money – a blatant example of welfare for the rich. If a company needs capital and comes to me for help (well, assuming I had about 100 times as much money as I actually do), I’m happy to consider buying into a stock offering if I think the price is fair. I’m not going to just give them money as an act of charity. And neither should the government.

Possibly, banks that need capital will be pig-headed and continue the financial meltdown by refusing to accept capital on reasonable terms. If that happens, then it may be time to consider the very drastic step of forcing them to accept capital on the government’s terms. Nationalization. Socialism. If it comes to that. That certainly would not be my preferred outcome, but at least it should be a credible threat.

14 Comments:

Anonymous Anonymous said...

«in many cases the asset prices simply don’t exist, because buyers and sellers cannot agree on a price.»

Well, here you are just channeling the dissembling of the "liquidity" guys.

If sellers and buyers cannot agree on a price, then the market price is ZERO.

An asset without buyers has ZERO market price.

Sun Sep 21, 05:31:00 PM EDT  
Anonymous Anonymous said...

«end the vicious circle of deleveraging»

It is not a vicious circle -- it is a virtuous adjustment.

If some bank have on their books a lot of $500k mortgages on $150k homers, that's not called deleveraging, it is called booking losses and being bankrupt.

Deleveraging would be for the bank to sell the loan for $500k; then it would have less assets and more capital, and thus lower leverage.

But if the bank tries to sell the loan and it sells for $150k, then that's not deleveraging, it is booking a $350k loss, which destroys $350k of capital.

And for 3m homes that have been overbuilt, there are a lot of 100% losses.

All this talk of "nobody really knows what these assets are worth" and "deleveraging" and "can’t tell whether the bank has enough capital or not" is just prevarication.

the basic story is that there are way more than about $1 trillion of unbooked losses in the financial system, they exceed by far the capital of the affected institution, and they are all bankrupt, and everybody can tell that.

The whole plan is to gift existing banks and their existing management teams with FREE MONEY so they can continue to operate as usual.

The alternative is either to buy them out for $1 each or to let them all fail and provide capital for a new set of banks to continue funding the real economy, which would probably be a lot cheaper.

But in both cases their existing management teams would object.

Sun Sep 21, 05:41:00 PM EDT  
Blogger knzn said...

I could just as well say that an asset without sellers has an infinite price. If the asset isn't trading, there isn't any market price. It's not zero if someone is holding the asset and refusing to dispose of it.

In any case a market price is not quite the same thing as a "fair" price. When an asset is temporarily subject to an unusually high risk premium, and at the same time it's perceived as being unusually risky, the market price may be extremely low. In part, the Treasury's job is to estimate what the risk premium will be in the long run and use that to value the assets. Moreover, the very fact of having the assets held by the Treasury rather than the private sector makes them less risky. Because the Treasury has unlimited liquidity, it will never be forced to sell the assets when the price is too low. (The Treasury does essentially have unlimited liquidity, since it can issue the most liquid of all assets except for money.)

Sun Sep 21, 05:41:00 PM EDT  
Blogger knzn said...

All this talk of "nobody really knows what these assets are worth" and "deleveraging" and "can’t tell whether the bank has enough capital or not" is just prevarication.

You are wrong.

Sun Sep 21, 09:37:00 PM EDT  
Anonymous Anonymous said...

«"nobody really knows what these assets are worth" and "can’t tell whether the bank has enough capital or not" is just prevarication.

You are wrong.»

Oh no. Your argument seems to be that without ratings each and every security should be anlayzed on its merits by each buyer.

But things are much simpler than that, because there are securities whose value is known without spending much time on it:

* The shares of financial companies are worth zero, because the losses on bad debts are on aggregate much larger than their capital.

* All the lower tranches of CDOs are worth zero, because they take the hit first.

* All the CDSes are worth zero because there is not enough capital at the issuers to pay out if needed.

The main securities about which there is some uncertainty are the super senior CDOs, and ordinary bonds, which may be worth a fraction of nominal, but who knows.

But the main thing is that everybody is rightly certain that everybody else is insolvent, but they just don't know the full extent of the insolvency.

That's why the plan is to make everybody solvent again by ensuring that all the worst securities are sold to the government at or near nominal, and the government is prepared to take at least $700 billion of losses on it.

Explanation of the latter point: the bill authorizes Paulson to conduct any amount of operations as long as the losses outstanding at any one point are under $700 billion (or rather under the new debt ceiling).

Mon Sep 22, 07:50:00 AM EDT  
Anonymous Anonymous said...

blissex asserts that illiquidity makes no sense because if no one wishes to buy at a price that anyone wishes to sell, that means the price is zero. I suspect a better way to appreciate the problem with these assets is Akerlof's market for lemmons, and the role of asymmetric information. Suppose sellers have a pretty good idea of the value of the assets based on the future income streams they will generate, but buyers can't distinguish good assets from bad. That seems fairly likely here in many instances. With MBSs, sellers may have experience with the payment histories of mortgagees, and other such information. Buyers, on the other hand, haven't yet adjusted to a market in which case-by-case research and analysis must supplant unreliable ratings. Akerlof tells us such markets can collapse -- and it doesn't mean that used cars (or MBSs and other such assets) have no value.

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