Posted by
Philip D. Nathanson on Saturday, October 11, 2008 2:10:19 PM
Current monetary and fiscal policies have created an economic nightmare. The stock market has plunged almost 25 % over the past two weeks. And, as should be obvious, this is a response to the introduction and passage of the $700 million bailout package and additional $130 million pork add-on. While pitched as emergency liquidity legislation, it is in reality a nationalization of a substantial segment of the financial sector, even allowing the government to easily acquire ownership in financial institutions. When combined with $300 billion of additional bailouts for mortgage-holders, a similar amount to take over Fannie Mae and Freddie Mac, and assorted other programs, the total bailout exceeds $1.5 trillion. The stock market has sliced this amount from equity valuations as well as an even larger sum reflecting the inefficiencies and mis-allocation of resources in the overall economy that will be inevitable with government ownership or management of assets and banks. Importantly, the inflammatory rhetoric by Ben Bernanke and Henry Paulson warning of dire consequences if the bailout wasn't passed by Congress has precipitated a global panic and liquidation.
The genesis of the problem has been, and continues to be that a number of firms have assets, mortgage-backed securities, on their books that are difficult to value. As a result, lenders are reluctant to extend credit to them without collateral. Many investors are unwilling to own their stocks. Customers and suppliers hesitate to conduct business with them. Until these assets are valued at what the free market determines (a voluntary transaction between a private-sector buyer and a private-sector seller), our problems will not be efficiently or completely resolved. A government purchase will not generate a market-clearing price.
The selling of the stocks of one investment bank after another was caused by investors abandoning them, starting with the bank they perceived as the riskiest. Bear, Stearns was first, then Lehman. The Fed should have "welcomed" a bankruptcy of Bear, Stearns, as this would have led to the liquidation in a real market sale of their hard to value mortgage-backed bonds. This would have provided a benchmark for valuing similar assets at other firms and begun to clarify which businesses were in trouble and which were not. If these assets had been sold at fire-sale prices, then the buyers would have profited, word would have gotten out and the next sale of similar securities would have been at a higher price. Market-clearing levels would have been realized soon enough. By now, six months after Bear, Stearns collapsed, the cleansing process would have been well underway.
After Bear, Stearns was rescued, investors kept selling the stocks of the weaker banks until they could see, via a liquidation, what was in their asset portfolios. Ultimately, the Fed let Lehman go under and its bankruptcy provided information. For one thing, it showed Lehman had valued its sub-prime and alt - A mortgage-backed securities at 35 to 40 cents on the dollar, which appears to have been BELOW what investors had assumed. In fact, it appears that Lehman's fall was not a result of these securities, but from an overvalued commercial real estate portfolio. It was the bankruptcy that revealed this information to the markets. And a future sale of these assets will provide additional valuable information. It is no surprise that the runs on stock in Morgan Stanley and Goldman started after Lehman's bankruptcy filing, but they soon came under renewed pressure as policy-makers conveyed a sense of panic and "forced" their conversion to banks. AIG was rescued as well, whereas a bankruptcy reorganization and sale of selected troubled assets as necessary would have revealed much information helpful to valuing similar products at other firms.
Imagine if the government had purchased Lehman's bad assets (their mortgage-backed securities and their commercial loans). They would likely have have overpaid or underpaid, there would have been no market price established and no information about their true market value available to firms holding similar assets. In fact, revealing the government's purchase price would have given inaccurate information.
Only a free market sale will provide accurate pricing information. In a bankruptcy sale these assets will be purchased by a private buyer without the need for government funding. And almost certainly, these assets will be better managed by their new private owners than they would be under government stewardship. Banks and other companies that investors are now reluctant to fund could release information about their hard-to-value assets and lenders could make informed decisions about lending to them. However, in the current situation without any comparable market valuations, releasing the contents of an impaired portfolio is next to meaningless. And lenders will stay away. Would you lend to a customer who can't provide a reliable statement of asset value?
As mortgage-backed securities are valued by market sales, it will quickly become apparent which holders are in financial trouble. At that point, the government could possibly provide some short-term funding while troubled companies seek additional capital, are sold, or liquidate.
The Bernanke-Paulson program to buy $700 billion of impaired assets is not the solution and that is what the stock market is telling us. The only benefit to a troubled firm would be if it could unload all of its doubtful assets on the Treasury, spreading the loss to all taxpayers. But all firms can't do this, as there may be in excess of $2 trillion of possibly-impaired mortgages. If a recession knocks back housing prices in prime communities that have been minimally-affected to date, the problem will spread to prime mortgage securities. Even if the government were able to purchase all qualifying impaired assets, the longer-term inflationary implications are profound.
A reverse auction by the Treasury is NOT a free-market price test for mortgage-backed securities and other troubled assets. The U.S. Treasury is using an unlimited amount of someone else's money, the taxpayers', and has to buy quickly as Paulson leaves office in 3 months. With money "burning a hole in their pocket," the Treasury will overpay. And there is a contradictory mandate ... paying a high price to help banks and other impaired-asset holders versus paying a low price to benefit taxpayers.
There is yet another problem with a government purchase. There there will be intense political pressure for the government to forgive some principal and interest payments on the mortgages backing these securities, further impairing their value and assuring the government will not make money on its $700 billion purchase. Current Fed/Treasury/Congressional policy is clearly pointed in this direction. The government is strongly encouraging a devaluation of the collateral. A $300 billion mortgage reduction program now underway will reduce interest rates and principal on individuals' mortgages. The recent $700 billion bailout legislation authorizes the Treasury to buy securities and then move to forgive some mortgage principal and interest. The government talking-point is that reducing the mortgage will yield more money for the pool of securities than default sales. Perhaps. But government forgiveness tends to be taken advantage of. Many people will stop paying solely as a negotiating tactic to lower their mortgage payments. And lower interest and principal payments mean that the mortgage-backed securities will fall in value. The risk of future forgiveness programs will be discounted into an even lower valuation for the securities owned by banks and others. And will lead to higher rates on mortgages.
The bailouts of individual firms and the $700 billion Treasury package AVOID market pricing of assets and assure that essential information is kept from the markets, lenders and everyone else. Money is unavailable to many. This is occurring in an economy flush with cash, much of which will be used to purchase government securities. In other words, the Fed has flooded the system with liquidity, while at the same time preventing the needed market transactions to price hard - to -value mortgage-backed and other assets. Liquidity is not going to support productive economic activity, it is going into government bonds. Interest rates are low and credit is tight. Only the government can create such a conundrum. Top this off with inflammatory rhetoric by the Chairman of the Fed and Treasury Secretary, statements seemingly geared to implementing policies to greatly expand their control of the economy, and you have our current situation.