A quarterly magazine of urban affairs, published by the Manhattan Institute, edited by Brian C. Anderson.
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Paulson Bails Out the Bailout
If at first it wont succeed . . .
12 November 2008
This morning, Treasury Secretary Henry Paulson confirmed what some observers had suspected for weeks: the government isnt planning to use any of the $700 billion financial-bailout money, awarded by Congress to the executive branch in October, to purchase troubled mortgage-related assets from financial institutions. We had continued to examine the relative benefits of purchasing illiquid mortgage-related assets, the secretary said. Our assessment . . . is that this is not the most effective way to use TARP fundsreferring to the month-old Troubled Asset Relief Program. Though Paulsons reason was a dispiriting onethat the credit-card and other consumer-financing markets have deteriorated so much that theyre now consuming more of his attentionthe announcement was a glimmer of good news nevertheless, since the original plan would have delayed recovery.
Much of the surviving regime within the old, failed financial industry is still in denial about its business model, and the government has been stringing it along. Consider what Tom Marano, the CEO of near-bankrupt mortgage company Rescap, said just two days ago at a conference of the Securities Industry and Financial Markets Association. Rescap holds a portfolio of mortgage loans and related securities. I get calls from people wanting to buy nonperforming [mortgage] loans all the time, Marano said, but the problem is that they want 20 to 25 percent returns on assets that include delinquent loans, after taking a discount for mortgages already far in default. That is, they want to buy the loans at prices low enough that, when they eventually sell them again, the returns will be hefty. Even on portfolios of mortgages whose borrowers are still making payments on time, Marano said, potential customers offer only 80 to 90 percent of the original face value of the securities, because they need a higher rate of return. No thanks, Marano tells them, and waits for the government to buy on better terms. As of Monday, he was hoping that TARP would buy mortgages in his portfolios that were 90 days delinquent.
But private investors have two excellent reasons for demanding that Marano sell his mortgage-related assets at what he thinks is too low a price. First, the risk that homebuyers wont continue to pay their mortgages in the future is simply higher than before. Its clear that the collateral behind many mortgageshugely inflated house valuesis worth less than it was two years ago. It also seems likely that future house-price declines will put more pressure on homeowners to default. Further, other federal programs could decrease the value of the remaining mortgages by encouraging more homeowners to become delinquent in hopes of winning cheaper loans. Just as important is that potential buyers of the securities now understand that these mortgage securities are structured very precariously. And the potential buyers also know that the securities arent the instantaneously tradable, cashlike investments that sellers once called them. Investors need compensation for all these risks.
Second, a few years ago, hedge funds and other potential buyers could borrow huge amounts of money, turning the small returns that these supposedly safe, consistent securities offered into huge returns. Today, that strategy wont work, since nobody will lend to them and the securities are far more volatile than they had once thought. So potential investors must seek out higher returns on the assets themselves. Another way of looking at it: the financial industry created mortgage-related and other opaque, intricate securities to meet demand for a particular productinvestments that paid a reasonably high return without seeming to carry much risk. But because of the industrys fatal miscalculations on many levels, the securities failed at the specific task for which they were created, and so their specific target market has vanished. The securities must find a new market now, one that wont pay the old, high prices that people like Marano are still demanding. Its as if RIM had designed a new BlackBerry that couldnt send e-mail and tried to sell it for $200. Somebody might want it, but not at that price.
Marano is not an aberration. Hes a representative of a dangerous way of thinking. Much of the financial industry still refuses to acknowledge that its business-model failure is permanent. Far too many people seem to consider that failure the result of temporary, extraordinary market conditions that areto use a phrase thats now become an unintentionally humorous clichéworse than anticipated. But the notion that complex financial engineering could make any long-term security always instantly salable and nearly risk-free was one of the roots of this crisis. Acknowledging its absurdity isnt a matter of punishment or demonization; its a matter of making sure that failed ideas stay dead, so that they dont come back stronger than before.
But the government has been doing just the opposite. Further, by promising to buy mortgage-related assets, it has given companies like Rescap an incentive to hang on to their bad debt for as long as possible, rather than sell it to those annoying investors offering prices that are too low. And that has delayed what is already likely to be a long, painful recovery.
To learn why, consider what got us out of our last major banking debacle, the savings and loan crisis of the late eighties and early nineties. William Seidman headed the FDIC in the eighties and later, as head of the federal Resolution Trust Corporation, handled the S&L aftermath. During that crisis, the U.S. government closed down failed S&L institutions and had to sell off their holdings. These holdings consisted of $600 billion in diverse assets, including office buildings, hotels, golf courses, and apartment complexes. There was no real market for such assets, Seidman said at Mondays conference. We decided we had to create a market. We said, were going to start selling these properties at whatever price we could get.
And what did the private owners of similar assets do when the feds started their initial sales? They howled. You can imagine the reception: Youre driving the market down, Seidman said mildly. Many of the critics were on Capitol Hill. Congress asked us to keep the assets for five years to get prices up. I said if Im sitting here just waiting to sell my assets . . . the price isnt going to go up. Selling at distressed prices initially was the only way you could get it done. We began to sell. Investors who bought assets at rock-bottom prices foundthrough their own diligence, asset management, and early resalesthat there was real value there, which encouraged investors to purchase more of the assets, increasing demand and raising the prices at future sales. Within a year, the market had begun to recover, with many formerly distressed properties approaching 70 percent of their original values.
What Seidman sensibly dismissed back thenholding on to assets to get prices upwas, until Paulsons announcement today, a key part of the governments working plan to fix the current crisis. But its only when holdouts and their creditors capitulate and start selling assets to private investors at distressed values that the market can begin to find its way to recovery, just as happened in the early nineties. This past summer, Merrill Lynchs sale of some mortgage-related assets for 22 cents on the dollar was a key step to this price discovery and eventual recovery. Then, two months later, the government stopped such deals cold when it put forward its own plan. Private purchasers could never compete against the government in making asset purchases (remember that during the S&L crisis, the government had never purchased assets, only inherited them). If the government had started to purchase mortgage-related assets, and soon found that it had overpaid, it would have tried to hang on to the assets for as long as possible, not wanting to face the political backlash of having to announce its losses. Private investors would have been wary of buying into a market that soon would be controlled by government sales, likely demanding even higher rates of return from private sellers like Marano and thereby keeping the market frozen.
Genuine market activity needs to resume, even if very slowly, so that other private-sector investors can see, for example, what prices competitors will pay for such assets, and what assets bought now at fire-sale prices will command, say, a year from now. Investor purchases at rock-bottom prices are critical for another reason: institutions that buy at such prices have a great incentive to work with mortgage borrowers and other investors in the same securities to slash their debt to more sustainable levels. Theyll earn a profit if they do so successfully. Companies like Rescap, though, would realize losses by doing so.
Private transactions, and the research behind them, are also the only way to get valuable information to the market. The governments purchases, by contrast, would have prevented information from getting out. Consider that Bloomberg News has had to sue the Federal Reserve to try to figure out what mortgage-related securities it has taken over from flailing financial institutions as collateral for loans.
Also note what the Fed and the Treasury did in hiding valuable information on Monday, when they revised their first two bailouts to AIG. Under AIGs latest bailout regime, in addition to $100 billion in other government aid, taxpayers will put up $50 billion to purchase mortgage-related and other asset-related securities owned by AIG and its trading counterpartiesthat is, institutions to whom AIG could owe money. The feds will deposit these assets into a special-purpose vehiclea sort of bad-securities purgatory where, apparently, theyre supposed to stay and stop annoying people with their pesky falling values. The governments purchase price herea little less than half of the securities initial value in the case of mortgage loansappears to be completely random. And since the government apparently plans to keep these securities sequestered in their new netherworld indefinitely, important information will remain hidden from the market. Further, the government, because it revised its bailout partly to save its own skin after having become AIGs biggest shareholder through its first bailout in September, has shredded whats left of the concept of the capital structure in the American corporate world. Shareholders, including the government, arent supposed to be in charge of bankruptcy-style restructurings. Theyre supposed to get whats left over after a judge figures out the best way out of a mess.
Officially killing one bad idea, though, represents progress. If, come January, President Obama wants to kill the rest of them, he should turn to former Fed chief Paul Volcker, who became famous nearly two decades ago for finally doing in the remnants of another failed financial-engineering experimentthe public-private idea that permanently higher inflation could finance permanently lower unemployment. Volcker might have some good advice on how to use the rest of the TARP money to deal with the economic effects of the hidden failures still lurking within the financial industry.
Nicole Gelinas, a City Journal contributing editor and the Searle Freedom Trust Fellow at the Manhattan Institute, is a Chartered Financial Analyst.