The Fed Chariman has no Clothes
In arguing for the $700 billion bailout plan, Federal Reserve chairman Ben Bernanke says that the government should pay "hold to maturity" prices for assets, which are currently notably higher than the market prices private investors are willing to pay.
Bernanke's stated belief is that the government can pay more for these assets, but because the market is underpricing them now, it can effectively subsidize financial firms (by paying more than market prices) without risking taxpayer money (because if held long enough, the assets will be worth more than he's paying).
Markets can be irrational, both in bidding up assets and in bidding them down, so it is possible that Bernanke could be right with his guess. But by talking of "hold to maturity prices", Bernanke is speaking of something that does not exist. The cash flows from these assets are highly dependent on default rates and recovery rates in default situations, and those are highly dependent on both real estate prices and the strength of the overall economy: if your house is worth less, or if you lose your job, you're much more likely to default. And the more people who are defaulting, the more house prices fall as foreclosed properties hit the market, which further reduces the value recovered when defaults occur.
Bernanke is pretending that precision exists, and that there are assets that, if only held to maturity, will pay at par. The reason current market prices, where they exist, are low is precisely because of the risk: people don't know how these things will perform in future scenarios. You can use models to run simulations, and to chart out what you believe to be optimistic or pessimistic scenarios, but it's still guesswork.
This is why the price for entry to any bailout must be some serious equity in the firms that participate. I agree with Bernanke that to recapitalize the banks, the Treasury would need to pay more than current fire sale prices, but to lower the risk to the taxpayer, and to keep in place some sort of moral hazard for troubled financial firms, the government needs to get more than troubled assets for its recapitalization. Sure, more solvent banks might balk at dilution, in which case they can absorb losses on their own. Requiring an equity stake as a condition for a deal will ensure that the bailout funds only go to those institutions that are in the most need, and also that, should those institutions survive, the taxpayer gets some participation in their recovery.
Bernanke's stated belief is that the government can pay more for these assets, but because the market is underpricing them now, it can effectively subsidize financial firms (by paying more than market prices) without risking taxpayer money (because if held long enough, the assets will be worth more than he's paying).
Markets can be irrational, both in bidding up assets and in bidding them down, so it is possible that Bernanke could be right with his guess. But by talking of "hold to maturity prices", Bernanke is speaking of something that does not exist. The cash flows from these assets are highly dependent on default rates and recovery rates in default situations, and those are highly dependent on both real estate prices and the strength of the overall economy: if your house is worth less, or if you lose your job, you're much more likely to default. And the more people who are defaulting, the more house prices fall as foreclosed properties hit the market, which further reduces the value recovered when defaults occur.
Bernanke is pretending that precision exists, and that there are assets that, if only held to maturity, will pay at par. The reason current market prices, where they exist, are low is precisely because of the risk: people don't know how these things will perform in future scenarios. You can use models to run simulations, and to chart out what you believe to be optimistic or pessimistic scenarios, but it's still guesswork.
This is why the price for entry to any bailout must be some serious equity in the firms that participate. I agree with Bernanke that to recapitalize the banks, the Treasury would need to pay more than current fire sale prices, but to lower the risk to the taxpayer, and to keep in place some sort of moral hazard for troubled financial firms, the government needs to get more than troubled assets for its recapitalization. Sure, more solvent banks might balk at dilution, in which case they can absorb losses on their own. Requiring an equity stake as a condition for a deal will ensure that the bailout funds only go to those institutions that are in the most need, and also that, should those institutions survive, the taxpayer gets some participation in their recovery.
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