A Decentralized Bailout

Lucian Bebchuk has a powerful idea for improving the government’s purchase of troubled assets: “A Plan for Addressing the Financial Crisis.” (It’s fairly amazing that he’s produced an article of this quality in such a short time.)

The government wants to inject liquidity into the market by buying troubled assets. But how can we be sure that it isn’t overpaying for those assets and bestowing a massive gift on the sellers? In his paper, Bebchuk cites the Treasury’s official statements, which talk about having an auction test:

The price of assets purchased will be established through market mechanism where possible, such as reverse auctions.

This sounds good in normal times, but the very crisis in liquidity might mean that reverse auctions would not produce an adequate price to actually help these firms. If the price is set at what others are willing to bid, then the government is not helping to shore up sub-fundamental pricing.

Bebchuk proposes instead that the government divide its liquidity injection among competing money managers and let them compete with each other to determine the market price. Instead of a single buyer, this could create 20 potential buyers working as independent agents of the Treasury.

Bebchuk describes it this way:

Suppose that the economy has illiquid mortgage assets with a face value of $1,000 billion, and that the Treasury believes that the introduction of buyers armed with $100 billion could bring the necessary liquidity to this market.

The Treasury could divide the $100 billion into, say, 20 funds of $5 billion and place each fund under a manager verified to have no conflicting interests. Each manager could be promised a fee equal to, say, 5 percent of the profit its fund generates — that is, the excess of the fund’s final value down the road over the $5 billion of initial investment. The competition among these 20 funds would prevent the price paid for the mortgage assets from falling below fair value, and the fund managers’ profit incentives would prevent the price from exceeding fair value.


Tyler

The number of people who still think this is a handout baffles me. It's not a handout, it's an investment. On average, the government will MAKE money on this deal. They're becoming the investor of last resort. This isn't income redistribution, stop being such drama queens.

Pakoda

Hearing Hank, Ben and George's rhetoric over the past few days leads me to think that there MUST be some data they are seeing (other than whats on the popular media) which has them in bit of a panic.

So here's a BLEG: Anyone out there with some hard numbers on the magnitude of the crisis, which shows us that the number 700bn wasnt pulled out a hat?

PS: How much of the hullabuloo is because of the term "bailout"? Maybe if they had called it the "Home Owner's Credit Corpus"....

Fat Gold Chain

Stop with the "3k per person" talk. Unless your 3 year-old has a mortgage and pays taxes, they don't get a cut.

I think one of the major problems, and this has been touched on in several of the comments, is that there is no risk involved in these transactions. The seller will always have a buyer. Because the buyer, now the seller, will in turn always have another buyer. It doesn't seem like much of a free market. It seems like a shell game, and one that only ends in crisis.

There's simply no incentive for buying and selling quality and a lot of incentive for buying and selling garbage. Is there some way of introducing more risk into this game aside from out and out government penalties or years of FBI investigations?

Bill

I can't picture either presidential candidate backing a plan that gives money managers a percentage cut for gains they achieve with public investment funds. McCain's prior free-market principals might have made him support it, but it's not consistent with his recent posturing as an economic populist (blaming the crisis on greedy wall-street types). How can you let the villians profit from helping to fix their mess?

dwil

#34- to qualify as an investment there should be a reasonable expectation of profit. For that to happen, you have to be able to sell the product for more than it cost you, adjusted for holding costs. One of the many problems of buying illiquid mortgages is that there is no rational way to price them, so it's impossible to figure out what they're worth. This is like buying a bunch of green bananas and trying to sell to people who are allergic to them. Not only are the bananas heading to their peak value and then to their compost value, but the only buyers don't want them. Surely if there was money to be made in buying these aging bundles, the market would have done that instead of the feds doing it.

Kurt Greenway

Another proposal:

How about taking that 750 billion and returning it to the citizens (approx $3k apiece). A family of four would get $12k. Money they could save (helping the remaining financial institutions---the weaker links would fail) or they could spend (helping the economy in general.

Added incentive could be to double the amt if it is spent on a new home purchase and thus firming up that sector.

All the time, never enriching the Wall St "geniuses" whose got us here today.

Keith

#6,

$700bn divided by 200m is only $3500. Are you going to pay off your mortgage with that?

Gary

Aaron - post 25 -

If the Fed/Treasury is purchasing the loans at say, $.60, and the loans have a par value of $1.00, a writeoff occurs. The bank that sold the security would realize a loss of $.40 per $1 of par value. This occurs only at the bond level, not at the individual mortgage level, since in many cases, the bonds don't hold the whole mortgage, they hold the right to a portion of the revenue stream from a specific mortgage.

I cringe to think of the disaster it might be, but one would think that the treasury might be inclined to rework some of the loans in its portfolio if it finds that re-working the loans will generate a better return. It seems the banks haven't been inclined to do this. It stands to reason that taking even a 20% haircut on a loan, and re-financing someone into a 30 year fixed rate mortgage is more financially sound than letting them get foreclosed on, and losing 30% of the value in a foreclosure sale, plus court costs, maintenance expenses, and selling expenses.

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Matthew

@6: In response to your question, this isn't just about bailing out homeowners; the credit system is shutting down. Recently the city of Los Angeles tried to sell some bonds and got no bidders. My company is working with a city in Georgia to acquire funding for two major (mid 8 figure each) capital improvement projects and had to pull two bond issues off the market because there are no interested buyers. We've got construction teams ready to start and producing nothing because they can't get paid. Much of the corporate and municipal financial systems rely on being able to rollover short term debt obligations. Without an active and liquid credit market major corporations and cities are going to have major cash flow problems. If they default on debt and miss payments borrowing will get much more expensive and companies will face mass layoffs and shutdowns. Money is the blood of our economy and right now we are having a heart attack. The whole point of this is to get the heart restarted as fast as possible.

(I'm pretty sure I have all that right.)

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Kevin H

So, after reading the paper I am mostly sold. I'd say I have two concerns left:

First, he makes some assumptions without backing it up with any data. For example when talking about the idea of reverse auction for MBSs: "However, in situations in which assets are owned by a concentrated group or by repeat players that can implicitly coordinate strategies, such auctions may produce inflated prices." Well, duh, thanks for econ 101, but I'd like to know if the current situation actually falls into that category.

Second, I'm not so sure about the forced rights offerings. It seems like that could create it's own sort of panic, if you own a firm that is close to the cutoff of this legislation, you are going to have extra incentive to ditch the stock, that will surpress market prices, and lead into a nasty feedback loop which has possibly solvent companies suddenly completely insolvent.

So, the paper has convinced me that we should be paying fair market value for the MBSs, in a de-centralized fashion, and then deal with capital problems second.

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MikeM

Dear God, #17 and #19 are right!

We HAVE TO STOP incentivizing risk! And yet, here is yet another idea pushing it again.

Anybody who has worked in financial markets knows that a system where profits get you commission or bonuses and loses cost you nothing incentivizes risk. Yes, it incentivizes strong performance, which is good, but it doesn't punish failure nearly heavily enough.

Once you've worked for a few years making truckloads of cash, who cares if you lose your job at the end?

Maybe bonuses and commission should be tied up in the very investments that generate them, with controls placed on how quickly they can be liquidated.

Hunter

#11 - Kevin H

For a full and complete explanation of what is going on from a theoretical point of view, I recommend reading Akerlof’s “The Market for Lemons” and Grossman & Stiglitz’s “On the Impossibility of Informationally Efficient Markets” (I think I’ve remembered the titles correctly). Careful, there’s some math.

In a nutshell, Akerlof looked at the used-car market. The seller knows whether or not the car is a “lemon” or not. The buyer has no clue one way or the other. He really can’t know without buying it and driving it. If there is a certain level of trust between the buyer and seller (via a trip to the mechanic, a test drive, a prior knowledge of the seller or car, a warranty, etc), this “information asymmetry” is not enough to prevent a transaction. Take away the trust, or (as Akerlof puts it) create “perfect information asymmetry,” and sellers can’t find willing buyers.

Then, Stiglitz looked at what happens when everyone knows exactly what everything is worth. If you pay a certain fee, you get to be “informed” about the true value of a certain good. He didn’t use this comparison (the paper was published pre-internet), but imagine being able to join an “uber-CarFax.com” website with not only complete title history, but also maintenance records, gas mileage, fender benders, traffic tickets, car washes, average trip length, idle time – everything about every car on the market. Then you could easily identify the cars where your valuation of the car (based on the uber-Carfax data) plus your information costs (the access fee) would be less than the asking price of the sellers. You would be assured of a profit. Theoretically, you could also “flip” a car to another “informed trader” on the uber-CarFax site for a price somewhere between what you bought it for and what it’s actually worth. Obviously, the other “informed trader” would immediately agree to your valuation (because he has access to the same data) and likely the price (because he could theoretically “flip” it again).

The only way this works is if *not* all buyers and sellers are “informed traders.” Otherwise, for example, a seller would offer the car up for sale for exactly what it is worth – or not sell it at all. Any informed buyer who agrees to a price higher than the value is either irrational (in which case all bets are off) or has access to other information which increases the value unbeknownst to the seller (in which case there is no longer equal information for all). Barring those two situations, if the seller offers his car up for exactly the right price, then the only people interested in buying are those who need *that particular* used car – there is no opportunity to flip it to other informed traders. *Plus,* the buyer can’t possibly recover his uber-CarFax access fee – by becoming an “informed trader,” the only way he can profit from the transaction is by somehow turning the car itself into a money-making venture. Perhaps he could, like me, drive it to work until it falls apart or, as I like to call it, “hold it to maturity.”

Thus, when every buyer is as well informed as every seller, there is only one transaction left – from the person who has it, to the person who needs it. There is no “market” for used cars anymore. There are sporadic individual transactions which are based solely on the immediate and idiosyncratic needs of the two parties at that particular point in time. The end result of “perfect information symmetry” is the same as “perfect information asymmetry” – market failure.

And here is where we come to today’s problem. I think *everybody* who issued this paper knows *exactly* what it is worth. And that’s why no one is trading. They need someone – someone who doesn’t have access to uber-CarFax – to come along and buy up some of the used cars. They need “uninformed traders” to pay irrational prices to get a “market” going again. Guess who the sucker is? None other than the United States Department of the Treasury.

On another thread regarding Fannie burden of guilt for this mess, I offered up a test/term paper I wrote in 2005 (and got a half-dozen takers, thanks!). I’ve got another one from 2004 on this topic (30 pages, with footnotes!) if anyone is interested. Another warning: my professor dropped me a letter grade because he said my solution to the problem was inconsistent with free market capitalism. In my opinion, it pales in comparison to what we’re about to do. hunterath [at] hotmail [dot] com.

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Kevin H

@17 & 19

The only problem I can see with that logic is that if the manager has the possibility of taking a loss, they would have to verify that they actually have the money to take that loss. That gets us right back into the problem of low capital levels.

Now, there are certainly some firms that have good capital, so maybe that's not a huge concern, it really depends on the number of actors left after you exclude people who can actually pay for the losses.

Although if you don't include downside risk, I would personally be happy to manage a $1billion fund at the low carry of .1% !

Howard

First the Democrats blindly follow Obama ... now, they are willing to blindly follow Reid, Bush and Paulson ... in a decision which could dramatically affect every American for decades. Well, thank God, Senator John McCain, Senator Shelby, and hundreds of economists don't just want to take a few people's word for it. Already, Reid has tried to tack additional pork, like Acorn, to this bailout. I didn't think I could dislike inept Harry Reid, with his 15% approval rating, any more than I already did, but this isn't about Reid being left alone to decide America's future. It will be interesting to look back at this in retrospect, to see if we really did have to RUSH this 750 Billion dollar decision ... and, who really benefitted from pushing it through so quickly. Also, what's Alan Greenspan's opinon ???

Valpey

Split it into 50 groups named for each State with fund sizes proportional to the states' respective electoral college votes. Let the States decide who will manage their fund and let each state share its fund's profits with the Fed.

Michael

I think this is actually a terrible idea, and some of other posters got at the reason:

Managers are given money by the government so they have no skin in the game.

Lets say that there is a 75% chance a security could be worth $20, a 10% chance a security could be worth $30, and a 15% chance a security could be worth $10. The expected value of this security is $19.5. The actual market price of this security should be less than $19.5 then to adjust for the risk and the time value of money.

However, now there is no risk, only reward. The money managers can only gain the benefit. If I know there is a 10% chance that is price is $30, I will bid up the prices of these securities, knowing I can't lose anything. Either I gain the difference between what I paid and $30, or I get nothing. The end result is that everybody will bid up these prices to $30, less the time value of money. This is one of the results of moral hazard: over-valued assets.

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aaron

Are they going to do anything to try to make sure the paper has value? Something to reign in the risk that investors are so afraid of, like a rate cap on existing mortgages and possibly writing off a portion of pricipal?

Maybe think up a way get investment out of commodities and into securities so that run away prices don't cramp people's budgets and make defaulting look like a good option.

Gary

Michael post #17 raises an excellent point...

If the manager has no downside risk, then its to his advantage to buy the riskiest (and thus, presumably the highest yielding) assets he can, since he only participates in the upside.

That sort of thinking got us into this mess in the first place...

Hunter

Very nice, but it begs the question: Should the government be in the business of *creating* markets?

I think that almost everyone would agree that there is a place for government *regulating* markets to some extent, but bidding them to spring forth like Aprhodite from the head of Zeus (or whatever)?

The roots of this crisis stretch back to the misty origins of Fannie Mae - to create a secondary market for mortgages. This has collapsed. It was a grand experiment that failed spectacularly. Let's not repeat it.

Rian

Just an FYI for those interested in reading the paper for themselves, the fulltext of the article is available from Professor Bebchuk's site here:

http://www.law.harvard.edu/faculty/bebchuk/pdfs/Olin620_Addressing-Financial-Crisis.pdf

You don't have to buy it from the abstract link.