Patterico's Pontifications

10/1/2008

A Couple of Simple Suggestions On How To Build Support For the Bailout Package

Posted by WLS:

One of the great weaknesses of the bailout package as proposed was its lack of specificity about where the money was going. It was too easy to simply demagogue the package as a bailout of Wall Street “Fat Cats.”

Treasury should provide a list of institutions that will be considered for relief under the proposed legislation, and an estimate of how much in bad debt each institution will be trying to sell to the Treasury.

The reality is that not all this money is going to Wall Street “Fat Cats.” As an example — and this is simply a hypothetical made to make a point — I think public sector employees in California might view this issue differently if they knew that CalPERS (California Public Employee Retirement System) owned $20 billion in bad mortgage bonds. That would be a huge drag on CalPERS’ ability to generate earnings in the future.

Right now those bonds have a value of $0.00 because there are no ready buyers in the market. But, if a given bond is backed by $5 million in real estate as collateral, then the bond — even with no buyers — has an inherent value of $5 million. If the Treasury buys that bond from CalPERS for $2.5 million, CalPERS has to take a 50% hit on its balance sheet, but at least it gets the $2.5 million to invest elsewhere on behalf of its retiree members in an effort to generate earnings/income for its beneficiaries. Right now that bond is nothing more than wallpaper.

So, if Treasury had a tangible list of institutions that are likely to be the recipients of bailout money in exchange for collateralized debt instruments they cannot sell in the current market conditions, a large segment of people who are viscerally opposed to this approach may begin to understand that they have a financial interest in seeing these institutions be able to un-tangle themselves from this mess.

Second suggestion — have the legislation require that in an agreement that each selling institution must sign in order to participate, that the money they receive be held in a separate blocked account which can be used for no other purpose than to reinvest in their core business functions. It cannot be used for ancillary business needs such as compensation, dividends, etc. This would be subject to both regulatory and congressional oversight. If the businesses want the billions to take the bad debt off their books, then they are going to have to commit to using the money they receive in a constructive fashion. They can make the specific decision about where they put it to use, but certain types of uses would be prohibited.

— WLS

22 Responses to “A Couple of Simple Suggestions On How To Build Support For the Bailout Package”

  1. Perhaps. But there is an awful lot of money out there that would like the Feds to get out of the way so that they can get in. The “losses” that worry many went somewhere, they did not disappear. This bailout nonsense is like someone wanting to bailout NASA because they shot a billion dollar spacecraft into space. The “billion” dollars did not go into space, just tons of metal and plastic. The money is still here on the ground citculating in the economy (or in the bank). And so it is with these “loses” of current worry. As it stands now, the prices of houses and stocks are too high for smart money to wander in and buy, so the taxpayer is going overpay for this entirely unnecessary bailout.

    C. Norris (84e23b)

  2. If this is truly a credit crunch affecting Main Street business then: for every financial institution regulated by the Federal Reserve that meets the current capital adequacy standards for its investment risk – lower its reserve requirements by half.
    This does not save bad banks, it does not reward risky behavior. Banks that have adequate capital will be able to double the lending that their existing reserves will support. If the reserve requirement reduction is set for 5+ years. or until the bank fails to meet the capital adequacy standards based on risk, the bank will avail themselves of the opportunity to make more money but will continue to do so prudently.

    Voila! no more credit crunch.

    If the goal of the bailout is also to restore the banks on the verge of failure then this will not be sufficient.

    Bernie (ff56e8)

  3. How about not letting those institutions who threatened or way of life have unlimited access to the money of the people

    Let em fail – today

    EricPWJohnson (c00a5d)

  4. Illiquid ≠ valueless.

    But the amount of due diligence to sell some of these toxic bundles is decidedly non-trivial.

    Picture if it was just an ordinary (hypothetical) $200,000 house bought last week with no new known defects of any sort. If you had to sell your house immediately, what would the price be? Even in a crazy market, getting 80-90% back shouldn’t be a problem… over time.

    But that isn’t the mark-to-market question. The question is today’s price. For your own house, you might be able to get a reverse mortgage, a line of credit, or some other method other than a straight sale to gather cash. Mostly because the due diligence is 1) looking up the title, and 2) eyeballing the physical house.

    But the way the mortgage derivatives are intertwined, there’s a whole lot of physical houses that need re-examination. Which takes more time than a simple house sale. So – more illiquid. Sufficiently illiquid (especially when there’s no trust in the seller of the toxic paper) that you can be pretty sure you can’t sell it at any price… today.

    Al (b624ac)

  5. Three quick arguments:

    1 – Outfits such as Calpers should NOT be able to participate in this bailout/rescue. The goal is to allow entities whose assets are comprised of ‘fuzzy’ assets to replace those assets with cash, thus allowing the participating entity to regain the trust of its trading and lending partners. Calpers does not face such a problem, and the goal should thus NOT be to allow investors such as Calpers to rid themselves of bad investments, even at less than 100 cents on the dollar.

    2 – The bonds on Calpers books are more than ‘wallpaper’. Whatever the exact form of the asset, it is an interest/dividend paying instrument that is yielding Calpers a stream of cash that Calpers uses to pay its obligations to retirees. Because of foreclosures and late payments, the income stream may not be at 100% of what Calpers expected, but there is a cash flow.

    3 – Per my first point, the purpose of the bailout funds is NOT to provide money for the entities to reinvest in their ‘core business’, it is to replace ‘fuzzy’ assets with liquid cash, thus allowing the entity to prove to its trading and lending partners it has the cash to back up its borrowings. An analogy is the sole proprietorship looking to borrow money from a banker who, because he can’t get a grip on the value of the business, just refuses to make a loan. Replace the hard-to-value asset with liquid cash and there’s no shortage of people willing to loan money. Put another way, these mortgage assets are already pledged against borrowings, they’re not available to be invested in the core business and thus, neither are the assets that replace these mortgage assets available to be invested in the core business.

    steve sturm (369bc6)

  6. “Right now those bonds have a value of $0.00 because there are no ready buyers in the market.”

    Wrong. I will pay $100 for it. Surely someone would outbid me into the millions. The value might be ridiculously underpriced, but it is not $0.

    Josh (7900e3)

  7. Alternatively, Calpers could sit tight on those investments, knowing that they have an “inherent” worth, and wait until this all sorts itself out, rather than sell out to somebody (the feds, whomever) at pennies on the dollar.

    And those mortgage-backed securities don’t have an “inherent” value anyway. They are probably not worth ZERO, because land will never be free again, not since the great land grants of the 19th century. But the actual value of those securities, and the mortgages underlying them, is somewhere between zero and the face value of the principle & interest owed on the mortgages. In many cases, the mortgage owed is more than the value of the property even before the housing bubble burst. Certainly now, after it, the amount owed on a great many mortgages will be higher than the current value of the real estate… especially after you add in legal fees and other potential costs of foreclosure.

    I’m opposed to the bailout or rescue plan or whatever it’s called. If these mortgages really do have substantial value, let the market chill out and sort that out. Don’t cave in to pressure for the easy fix. Right now, what I hear the people who have capital to lend saying is: “we’d rather lose money than take any chances at all right now by lending money to anybody.” That strikes me as fundamentally irrational, and I think if the government would tell them to shove it, they’d get back out there and find some way to make some money again.

    PatHMV (653160)

  8. I agree with WLS, as well as c. norris. My apprehension with this bailout is that nothing will be fixed. For example, the managers who made the decision to diversify CalPERS into real estate bonds should be fired, as well as barred from any decision positon in the finance market permanently.

    Anyone attempting to convince you that there were ‘no problems’ with these decisions is covering their ass and lying at the same time.

    It is indicative of a broken system when this amount of poor decision making by ‘professionals’ is rewarded with a save from the government. If there’s to be a bailout, then the ones responsible, both private sector and government sector, need to be dismissed and prevented from gaining these positions again.

    Apogee (366e8b)

  9. I don’t care about calpers. Let ’em drown.

    Shouldn’t we have a bailout bill that compensates everyone whose portfolio hasn’t done well over the last few years? I know someone who lost 50k in the stock market last year and that hurt his buying power which consequently hurts the economy. Shouldn’t we bail him out and give him $50,000?

    j curtis (3c4f3b)

  10. WLS’s first suggestion is OK. The 2nd suggestion is vague, unworkable, and likely to cost more to enforce than the raw bailout itself. Neither suggestion makes me a bailout supporter.

    Contact your senators today. No More Bailouts!

    gp (72be5d)

  11. Following up on the $0.00 valuation, I believe that assets held for investment (as opposed for trading purposes) are not required to be marked to market and are carried at cost (which is certainly not $0.00). And hopefully, Calpers bought these assets intending to receive the cash flow and not for the purpose of flipping them for a quick profit.

    steve sturm (369bc6)

  12. Apogee: The decision to diversify Calpers (as well as pretty much every other pension fund in the country) into real estate (as well as other investments beyond simple equities) was made decades ago. It’s been a long time since pension funds were fully invested in the stock market. How are you going to fire some guy who retired 25 years ago?

    steve sturm (369bc6)

  13. I would shed not a tear over any Calpers loss. I am utterly fed up over the entitlement that the overwhelmingly vast majority of their members claim. They insist on lifetime employment with platinum-clad benefits. These people, through their union clout, have held hostage the taxpayers of California for eons. Screw them all to heck.

    This is the very same Calpers who dictates social policy to the boards of the various companies in whom the invest, or consider investing. These demands eat into the profits of these firms, and yet Calpers is supposed to maximize ROI. Now that the social engineering of FM & FM has come back to bite them (I’m assuming they’ve invested), they can just choke on their own hubris and malfeasance.

    Ed (385e88)

  14. #1 Exactly. If a big tree falls in the forest other trees grow to take its place. Or is it more like, if the lion dies there are many other animals waiting to grow fat on its body?

    Has anyone anywhere come up with an actual probability that no bailout will lead to a depression or really bad recession?
    What are the odds?
    What computer models did they use?
    Are their models somehow better at predicting the future than, say, climate change models?

    EdWood (c2268a)

  15. Ummm, no. I do not think it will make people more likely to support the bill, but it would be benificial to show transparancy. I would like to know how many billions are going to go to Goldman Sachs, the most likely benefactor, due to Paulson’s complete and total conflict of interest here.

    A Stoner (efe02f)


  16. Right now those bonds have a value of $0.00 because there are no ready buyers in the market. But, if a given bond is backed by $5 million in real estate as collateral, then the bond — even with no buyers — has an inherent value of $5 million. If the Treasury buys that bond from CalPERS for $2.5 million, CalPERS has to take a 50% hit on its balance sheet, but at least it gets the $2.5 million to invest elsewhere on behalf of its retiree members in an effort to generate earnings/income for its beneficiaries. Right now that bond is nothing more than wallpaper.

    This is an overly-simplistic and in some ways inaccurate example that doesn’t really fit any reality I recognize and glosses over many issues that are highly relevant.

    First of all, “no ready buyers” doesn’t mean they mark a bond to 0 per se. That’s just not how it works. Typically bonds are marked using some combination of models, quotes & bids for similar bonds, perhaps by benchmarking them to an index (ABX), etc. So the mere fact that such-and-such bond has “no ready buyers” doesn’t mean it gets immediately marked to 0, like, at all.

    Second, it’s unlikely CalPERS (or anyone else) owns any bonds marked fully at 0 unless that bond is clearly going to take a full writedown. If a bond is marked at 0 it’s actually not a problem in the context of what Paulson is supposedly trying to fix, because something marked at 0 takes up no balance sheet!

    Third, just because a bond is backed by “$5 million in real estate” doesn’t mean it has any such “inherent value”. This depends on the nature of the bond: where is it in the sequential-pay structure? How much credit support does it have? A bond backed by $5 million in real estate could easily have very little value, i.e. if there are 5 bonds ahead of it in the pay structure that are each due to receive $1 million. Also, there’s no such thing as “$5 million in real estate” per se, because like anything else, the value of real estate can change. What is worth $5 million today could be worth $3 million when the bond is due to be paid. Furthermore, when the mortgage defaults and the collateral needs to be seized & sold to pay off bondholders, it is rare to recover the full value of the bond. Typical quoted recovery rates are something like 60%. So let’s say what was originally $5 million in collateral is foreclosed and sold and $3 million is recovered. If losses are allocated in such a way that a bond is subordinate to other bonds due to receive at least $3 million, guess what? That bond gets squat.

    So to try to clean up & salvage your example a bit, we have to imagine that CalPERS owns a $5 million bond that was originally AAA but is, say, a last-cash-flow senior, 07-1 vintage and is currently marked at, say, 60, because the bid has dried up & if losses reach the seniors, this bond will be hit (losses aren’t allocated pro rata in this deal). So they have taken $2 million loss already.

    Then we come to the part where Treasury buys it, supposedly to help CalPERS according to your story (? I thought it was to help banks?) and we hit a snag because it’s still not clear what prices Treasury intends to pay. If Treasury really does conduct a reverse-mortgage, then most likely they’ll buy this bond or a similar one from someone for less than 60, because after all, a reverse-auction is supposed to find the best (=lowest) price out there. So if anything, the Treasury plan and auction causes Cal-PERS to take a further writedown on their bond. Unless they themselves are the sellers, in which case they probably had to bid under the market, i.e. under the current mark, in order to win the auction. So again, they take a loss vs. their current mark of $2.5mm.

    But perhaps they’re happy with that because it’s cash in hand instead of a $2.5mm bond maturing in, say, 5.5 years. But wait, supposedly (according to Mr. Paulson and various commentators who echo him) all these bonds have ‘hold-to-maturity’ values that are higher than their current marks. If we believe this then CalPERS could just hold onto the bond (it is, after all, a retirement fund!) and make far more than the Treasury auction price.

    So how does that help CalPERS again? Treasury ripping their face off helps CalPERS? And so this is why we should support the bailout proposal? So Treasury can steal money from the pocket of our retirement funds?

    But maybe I’m wrong. In fact I can think of at least two ways that my counterexplanation above could be wrong:

    1. Maybe Paulson has been lying to us and will not really find prices via reverse auction like he says. Maybe he’ll intentionally overpay, one way or another. Who knows? The “plan” is so vague that it’s not clear to me how prices will be chosen, and he *does* babble about somehow paying the hold-to-maturity price from time to time, which it’s unclear how he’d achieve via auction. (Do auctions find the best price or don’t they?)

    2. Maybe Paulson is wrong that the ‘hold-to-maturity’ price for most of these bonds is somehow far higher than the current ‘fire-sale’ mark in the first place. In fact, looking at various bonds, I don’t really see much evidence that bonds are somehow being marked ‘too low’ (as most commentators tend to assume). When a bond’s collateral is crap then a low mark is accurate, not ‘fire-sale’. Many of these bonds are simply crap.

    In either case, then yes one can imagine CalPERS being happy unloading their bond to Treasury for intentionally-too-much cash. On the other hand, if that’s the case, then all the people going around saying this plan will make money for Treasury, are full of it.

    You can’t simultaneously underpay for bonds (via auction, so as to reap the hold-to-maturity value) and overpay for bonds (we’ll give banks the hold-to-maturity price! This will help balance sheet!). Yet from what I’ve heard this is the story Paulson has been selling, and many commentators have fallen right in line and echoed the same paradox.

    And then they tell me I’m an idiot for not supporting the bailout, and that I “just don’t get it”. Ah, irony.

    Sonic Charmer (8c1456)

  17. Sorry, in a couple places I wrote $2.5mm where I meant $3mm..

    Sonic Charmer (8c1456)

  18. Sonic Charmer, if you are correct then why did SEC and FASB feel the need to tell banks this week that they did not have to mark to market as valueless those assets?

    SPQR (26be8b)

  19. Because that’s not really what happened SPQR.

    Sonic Charmer (8c1456)

  20. Ya know, maybe, JUST MAYBE!, iffin enough average joes and janes see their portfolios shrink by thousands of dollars within a single day, they might figure out that it is NOT the pres that is in charge!

    IT”S CONGRESS!!!!

    FLUSH THE TOILET!

    There is ample obvious evidence that congress did not do the job we hired them to do! FIRE THEM TODAY!

    I dare any of you to go tell your boss tomorrow to go suck an egg!

    Congress did not get the message two years ago when so many got turned over, and they still do not get it!

    Vote no for ANY incumbent over two terms! Oh and especially if they voted to hand over a trillion dollars with little oversight! The Dems could not pat themselves on the back enough over their, “victory” and spouted all the changes they were going to make in 100 days. To date 700 days later they have accomplished NOTHING EITHER!

    Sans that, load up on ammunition of the accurate kind. Cuz change might become more forceful than this society is used to.

    TC (f398ed)

  21. These sections are actually in the $700 billion bill passed by the Senate.

    * Temporary Increase In Coal Excise Tax: Funding of Black Lung
    Disability Trust Fund
    * Tax Credit for Carbon Dioxide Sequestration
    * New Qualified Plug-in Electric Drive Motor Vehicles
    * Exclusion From Heavy Truck Tax for Idling Reduction Units and
    Advanced Insulation
    * Transportation Fringe Benefit to Bicycle Commuters
    * Extension of the Economic Development Credit for American Samoa
    * Extension of Mine Rescue Team Training Credit
    * Seven Year Cost Recovery Period For Motorsports Racing Track Facility
    * Tax Incentives for Investment in the District of Columbia
    * Permanent Authority for Undercover Operations

    It also repeals a 39-cent excise tax on wooden arrows designed for children.
    http://www.bloomberg.com/apps/news?pid=20601103&sid=aKd0vyGN8L2k

    McCain voted for this.

    Wesson (f6c982)

  22. Comment by Wesson — 10/2/2008 @ 9:12 am

    As did many others, who have convinced themselves that the unknown of doing nothing is more damaging than what they did.
    That being said, this 452 page abomination needs to be sent to the Capitol Hill shredder by the House.
    It is obvious that the Senate has no backbone, and hasn’t for a very long time.

    AOracle (0e000d)


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