corporate bailout

As we all know, several major finance corporations are performing a collective swan dive, and the government is talking about bailing them out with a package nearing $700 billion.

My questions are:

1. Should the government be involved at all? (I would figure that Objectivists would say no, but I'm asking just in case someone has a different answer.)

2. Why aren't they just filing for bankruptcy and selling off their assets, as well as their risky loans, bit by bit to a spread of smaller corporations that can afford to bear those risky loans? Isn't that what other organizations do when they are in over their heads?

2. Given that the government will be involved one way or the other, what's the best course of government action that we can reasonably hope for?

Jordan

Post 1

Wednesday, September 24, 2008 - 5:42pm

The better solution _would_ have been for the Fed not to have a discount window and to have reduced the interest rates as low as it has, but whats done is done... so that none of this would have happened.

Answering #1: But now, its hard to say whether the government should bail them out or not. For one, the Fed has given the impression that the bailouts would come, which lead investors to invest in the extremely risky (aka definitely going to default) loans. I'd say that the government shouldn't bail anyone out, that if you invested in that crap, then too bad so sad you loose. Because there is no way those failing banks are ever going to actually return your investments.

Answering #2: They can't "sell them", because they aren't simply "illiquid" or undesirable assets, they actually are nothing! Money completely lost because individuals took out loans that they will never repay. They don't want to declare bankruptcy because getting donations from the Fed is better!

Answering "[#3]": I think we'll experience some pretty heavy inflation over the next few years. Hopefully the Fed will increase the interest rates, which will appear to make things much worse over the short term. Tons more people _will_ default their mortgages, and banks will loose tons of money because the discount rate is higher than the interest coming in on the loans. But a higher federal interest rate means lower inflation, which means producers keep more of what they produce, and leeches can't leech as much, which makes things more efficient/productive.

Lastly, what do you all think about bankruptcy laws? Where is the justice in owing someone money, declaring bankruptcy, and then no longer owing money? Or am I missing something?

Post 2

Wednesday, September 24, 2008 - 7:20pm

Okay.

Answer 1. Probably not, but then the government helped create this mess to start with. In that respect, they should bear some responsibility for correcting it. I am not convinced they have a practical strategy though. For their own part in mishandling these accounts, the corporations being offered a hand should be very willing to make some harsh adjustments to their practices - cut personnel and expenses, eliminate the bad practices that helped put them in this position, and eliminate those managers who failed to guide them to responsible fiscal policies.

Answer 2. I would expect that every company included in the bail-out would do just those steps as they might otherwise do in a normal bankruptcy. The government appears to be 'buying off' their risky assets. The rest they should be doing for themselves to trim down and make their companies solvent and viable again (not all bankruptcies result in closing, some are for re-organization). And the government should get out of Dodge once those adjustments are made.

Answer 3. I agree with Dean, but would add a)get out of Dodge. and b)publicly and loudly acknowledge the errors made by the Federal government which contributed to this wild west show.

As to bankruptcy laws - good question!

jt

Post 3

Thursday, September 25, 2008 - 6:12am

1st question: The government should not have been involved. However, the facts are otherwise, and the more pressing question is, what is the government's best move in the circumstances? To conclude that the government should no nothing because it should not have been involved in the first place is akin to saying the U.S. military should immediately exit Iraq or already have done so.

2nd question: Bankruptcy is a slow, painful, and terminal process. Common stock owners are last in priority. The executives of the troubled companies are in fiduciary positions. The executives' on-the-job, foremost interests should be that of the stockholders and employees. That may best be served by trying to maintaining an ongoing firm.

3rd question: In the hearings Paulson and Bernanke talked about "fire-sale" prices versus "hold-to-maturity" prices. As I see it, their hopes for the RTC (or whatever the entity they propose might be called) are:
1. to substitute cash or Treasuries for distressed mortgage assets on the balance sheets of banks, thus strengthen them and ease credit;
2. improve the economy as a whole as a consequence of 1;
3. the RTC can hold to maturity the distressed assets acquired at near "fire sale" prices and eventually realize a decent positive return.

In the long run if the RTC does realize a positive return (in excess of interest paid on Treasury debt to finance the RTC), then there will be no cost or even a gain to taxpayers.

I hope they are correct about 3, but I'm very skeptical. The eventual impact of defaults and foreclosures is very unpredictable, and far in excess of what was anticipated when the distressed assets were created. Some may turn out to be worthless. Part is due, of course, to falling home prices. It seems to me the Paulson-Bernanke plan might be best characterized as the RTC buying an "out-of-the-money" option for $700 billion (or whatever is eventually paid to acquire the distressed assets). Big questions are how deep "out-of-the money" it is and how the underlying assets (real estate and mortgage payments) will perform. Like many options, in the end much of that $700 billion might be lost or there might be a gain.

Without a better understanding of the distressed assets, my preference at this time would be for this RTC to acquire by auction convertible preferred stock in the banks, with some caveats. There is less transfer of risk to taxpayers, some potential gain if bank stock prices rise, and the preferred stock could carry some covenants restricting executive comp. If the RTC converts, it must sell. The deal might be characterized as an "in-the-money" option. Incidentally, what I've described here is similar to the deal Warren Buffett struck with Goldman-Sachs. I wouldn't expect the RTC to be as astute as Mr. Buffett, but he is a fine role model.

(Edited by Merlin Jetton on 9/25, 7:12pm)

Post 4

Thursday, September 25, 2008 - 6:20am

At this point we can say that government caused it - and it did - and many people know that. Here are some good links on how this all happened:
http://www.chaosmanorreviews.com/oa/2008/20080923_col.php
http://online.wsj.com/article/SB122212948811465427.html?mod=djemEditorialPage
http://bits.blogs.nytimes.com/2008/09/18/how-wall-streets-quants-lied-

That said, we are in a position where no corporation has the financial power to "buy the assets" and fix the liquidity issue, so the government is the only one who can fix the problem they created. It won't be buying worthless stuff entirely either - many of the companies (AIG) the government will have an equity stake in and are fundamentally worth quite a bit. Similarly, despite devaluation, there are assets that can be sold they are not all zero. The key will be for them to solve the liquidity issue and disengage as quickly as possible. They will probably muck it up, but that doesn't mean it does not have to get done.

I think it would be beneficial to point out - as often as possible - why the problem happened, and to then push for ultimate disengagement.

My friend worked with some of these companies and was telling me he saw this coming awhile ago, and what was at play:

Fixed income is evaluated according to extremely sophisticated models, and they've spent literally billions paying people to do what my technology, for example, would help to do (they mostly use monte-carlo, etc.) But since deregulation of the MBS market, the securities have not been fixed -- they're much more like equities and much more fraught with risk.
The thing boils down to stupidity. Do you remember me saying that there was going to be a crisis back when I was at GMAC? Even at places as big as AIG they don't have any way to access granular loan data about their MBS's -- they can't look at the indivual loans that underlie their securities. So they can't tell what percent are underperforming, where the loans are, what the sizes are or anything else. You have to spend huge energy to figure out any of that.
So they used these things to value market changes of price when it's actually a question of the value of the paper.
That's the problem. Corruption on the part of some of the lenders who winked at lo-doc or other borrowers, then packaged shit and people on wall-street doing business as usual not thinking in terms of sweeping
change: That's just not the way bankers think.
It boils down to dumbness.

Post 5

Thursday, September 25, 2008 - 7:07am

Kurt,

Good articles. Thanks.

Nonetheless, I think the truth is that the rank and file American public do not know this. An many, if it were explained, still wouldn't either understand, or believe if they did understand. Call it the numbness brought on by the politically motivated lies of either party, or the dumbness of just wishing 'somebody else' would just fix things and not ask them to think.

I say this, and yet consider myself a relative optimist about people.

I am jt, and I approved this message.

jt

Post 6

Thursday, September 25, 2008 - 10:04am

Part of my skepticism about the Paulson-Bernanke plan is what Kurt's friend said. There is a lot of variety in these CMOs. So I have my doubts that the government will have the granular data to analyze what they might be buying. The analysis also requires making iffy assumptions about future default, foreclosure and recovery rates. The bidders will also probably be inclined to offer their least-wanted stuff and the government will overpay.

(Edited by Merlin Jetton on 9/25, 10:22am)

Post 7

Thursday, September 25, 2008 - 10:30am

Merlin,

When a property goes through foreclosure and is sold off, the proceeds go to the mortgage holder. How is this facilitated when the that mortgage was bundled up in a MBS? Someone somewhere has to have that granular data. What am I not understanding?

Post 8

Thursday, September 25, 2008 - 11:12am

Steve,

Let's call the legal, administrative entity between mortgagees and investors (the defacto lenders) the CMO-SPE. It collects mortgage payments and channels money to the various investors. The CMO-SPE would also be informed about prepayments, defaults, foreclosures, and sales proceeds after foreclosure.
http://en.wikipedia.org/wiki/Collateralized_mortgage_obligation
The CMO-SPE has the data it needs, but an investor may not have the data it needs to evaluate its own situation. Suppose the investor owns a CMO sequential tranche (not a pro-rata part of the entire pool). What will come down its channel in the future depends on the structure of the tranches and the status of the other CMO tranche owners. The investor also needs up-to-date data and it's frequently changing. There might also be data the investor is interested in, but the CMO-SPE is not enough interested in to produce, e.g. local default rates and current, local housing prices.

(Edited by Merlin Jetton on 9/25, 11:59am)

Post 9

Thursday, September 25, 2008 - 11:32am

Thanks, Merlin.

I just wanted to make sure that no one was going to claim that the information didn't exist. If this bailout continues and it consists of buying up the MBSs then I think each one purchased should be listed on a public website with it's identifying number, what organization it was purchased from, the price paid, and the current status ($ lost to foreclosures, $ over 90 days overdue in payments, current hold to maturity estimate, etc.) and let people offer bids for them as well as track them over time.

If Sarah Palin can put Alaska's jet on eBay, Bush and Paulson can do the same with the Mortgage Backed Securities they pick up.

The other thing that MUST be done is to get rid of that act congress passed requiring lenders to have a portion of their loan portfolio represent loans made to minorities or to the poor - there was a column today that pointed out how stupid it was to try to bail the water out of a sinking boat but not patch the hole.

(Edited by Steve Wolfer on 9/25, 11:34am)

Post 10

Thursday, September 25, 2008 - 12:12pm

If Sarah Palin can put Alaska's jet on eBay, Bush and Paulson can do the same with the Mortgage Backed Securities they pick up.

Very funny. However, there seems to be a lot more information needed to evaluate a CMO tranche that may not be easily obtained. On the other hand, a Bloomberg terminal can help. (Yes, the company was founded by the current mayor of NYC.)

Post 11

Friday, September 26, 2008 - 5:08am

Making "Toxic Waste"

Sequential pay CMOs have what I will call "residual tranches". They are carved out of the excess spread. The payments to a residual tranche are typically widely spread over time. How much the payments are depend very much on the level of prepayments and defaults/foreclosures. Higher than expected (when the CMO was created) rates of both negatively impact a residual tranche. They are the CMO's "shock absorbers." They are, like Kurt's friend says, much like equities and fraught with risk. (If prepayment rates are much lower than expected, then a residual tranche can give an excellent return.) Given the level of defaults/foreclosures that have occurred and are still forthcoming, a residual tranche morphs into "toxic waste." Hardly anyone would want to buy them from their current owners.

The IO part of an IO/PO structure has the same sort of risk character.

(Edited by Merlin Jetton on 9/26, 5:25am)

Post 12

Sunday, September 28, 2008 - 7:45am

Banks' Willingness to Lend

Here is an article about the tight credit market than the government bailout is intended to alleviate. One topic the article doesn't mention, and I wonder about, is that the tightness is at least partly due to the drying up of the securitization market. It is how primary lenders like commercial banks can bundle up loans they make and securitize them. The securitization market makers then often carve up and repackage the bundles into CMOs, CDOs, and the like and resell them. The main securitization market makers have been ... guess who ... investment bankers. Bear Stearns and Lehman Brothers went bankrupt. Morgan Stanley is shaky. Goldman Sachs isn't in great shape. The commercial banks would presumably be more willing to lend if they could bundle up their loans and sell them. If they can't do that, then they have to be more willing to keep the loans on their books until they get repaid or the securitization market revives. If they have to keep the loans on their books, then they are going to be far more cautious about who they lend to.

Post 13

Sunday, September 28, 2008 - 10:42am

Merlin,

You make a very good point when you say, "If they have to keep the loans on their books, then they are going to be far more cautious about who they lend to."

And here is another point: If they were going to keep them to maturity, they would be sure that the rate of return covered the risk of rising interest rates. Many, many loans went out at very low rates. The resale price and the rate of return don't look very good when interest rates go up. If the government borrows to do the bailout, I'd expect it suck up a lot of capital and drive interest rates up and that will make the mortgages still less attractive.

Instead of a FDIC type of insurance, what the industry needs are different forms of insurance they can buy when they buy a mortgage or a bundle of mortgages - there could be foreclosure add-on insurance (many of the mortgages will already have insurance obtained by the originator), there can be interest-hedge type of insurance, etc.

I haven't seen a simple list anywhere that shows the numbers: How many mortgages made versus how many foreclosed, by year - showing if there was insurance, if there was a loss to the holder after the foreclosure sale, if the mortgage was bundled, etc?

Post 14

Sunday, September 28, 2008 - 4:01pm

Instead of a FDIC type of insurance, what the industry needs are different forms of insurance they can buy when they buy a mortgage or a bundle of mortgages - there could be foreclosure add-on insurance (many of the mortgages will already have insurance obtained by the originator), there can be interest-hedge type of insurance, etc.

They have that; they're called credit default swaps, and AIG was in that business in a big way.
http://www.npr.org/templates/story/story.php?storyId=94748529&ft=1&f=1001

I haven't seen a simple list anywhere that shows the numbers: How many mortgages made versus how many foreclosed, by year - showing if there was insurance, if there was a loss to the holder after the foreclosure sale, if the mortgage was bundled, etc?

I'd love to see some simple statistics on this mess, too.

Post 15

Sunday, September 28, 2008 - 5:54pm

Thanks, Laure.

There ought to be some kind of online tutorial for all this stuff. AIG obviously didn't think things through, like the article said. It also appears they didn't lay off their bets at all - no working hedge against a downturn. With most insurance, you have annual premiums divided into monthly payments - seems like that should have been the case with the CDSs as well - as the risks go up, up go the premiums.

Post 16

Monday, September 29, 2008 - 7:31am

September 29, 1929 Black Tuesday 79 years ago.

The Wall Street Crash of 1929, also known as the Crash of �29 or the Great Crash, was the most devastating stock market crash in the history of the United States, taking into consideration the full and longevity of its fallout. Three phrases�Black Thursday, Black Monday, and Black Tuesday�are used to describe this collapse of stock values. All three are appropriate, for the crash was not a one-day affair. The initial crash occurred on Black Thursday (October 24, 1929), but it was the catastrophic downturn of Black Monday and Tuesday (October 28 and 29, 1929) that precipitated widespread panic and the onset of unprecedented and long-lasting consequences for the United States. The collapse continued for a month.

Sam

Post 17

Tuesday, September 30, 2008 - 11:38am

Thanks for the replies, everybody. This is one complicated mess!

Jordan

Post 18

Wednesday, October 1, 2008 - 4:59am

Yesterday the SEC eased the "mark to market" accounting rules for assets, like mortgage-backed securities, for which the market has dried up or nearly so (source).

The Wall Street Journal also reported this. I won't give the link because the whole article is for on-line subscribers only. This article added that the Federal Accounting Standards Board -- not a government agency -- approved the change.

An indicator probably often used as evidence that credit is very tight is the TED spread. The Wikipedia article on it was updated very recently and it is way above the historical norm.

(Edited by Merlin Jetton on 10/01, 3:46pm)

Post 19

Wednesday, October 1, 2008 - 3:39pm