Big Bailout is
Unlikely to Work

JAMES SAFT
Reuters / International Herald Tribune 25sep2008

LONDON — The U.S. "hold-to-maturity" bailout plan is really just the new "mark-to-myth," and even its heroic proportions are not likely to paper over solvency problems in the banking system.

Ben Bernanke, the chairman of the U.S. Federal Reserve, told lawmakers that the plan to spend $700 billion to buy up bad assets would allow banks to avoid unloading loans at fire-sale prices.

"Auctions and other mechanisms could be devised that will give the market good information on what the hold-to-maturity price is for a large class of mortgage-related assets," he said, trying to persuade a skeptical Congress that the plan he and Treasury Secretary Henry Paulson Jr. have been pushing will give value for taxpayers' money.

Banks are forced to mark their assets to market, a process that has become increasingly painful and is likely to lead to bank failures as a shortage of investors and the swiftly declining performance of the underlying collateral have driven prices lower. Since many securities are so complex that they seldom trade, banks sometimes must mark the assets according to modeled prices, a process sometimes referred to as "marking to myth" by doubters.

What "is a 'held-to-maturity' price, and how in the world can an auction or 'other mechanism' be devised that gives the market a good idea of 'hold-to-maturity' prices - since there is no such thing?" the economist Thomas Lawler, a former Fannie Mae manager now with Lawler Economic & Housing Consulting, wrote in a note to clients. "Of course, everyone knew what he meant: 'held-to-maturity' means 'above market."'

The hope, presumably, is that the subsidy given by buying debt for more than it will fetch on the open market will be enough to prop up banks and attract new investors.

If it is a subsidy, why not call it one?

And though $700 billion is a lot, it is not enough to wipe the slate clean and leave banks with workable balance sheets; the plan will only work if that $700 billion, which amounts to far less in terms of capital relief, is leveraged by new money from outsiders now sitting on the sidelines.

But I find it hard to believe that the sovereign wealth funds of the world, already burned by banking investments, will be attracted by a price arrived at through what promises to be an opaque process.

One possibility being discussed is a reverse auction, where banks will compete to sell bonds to the government. Given that private label securities are often unique, that may be difficult to carry out in a competitive and transparent way.

And since part of the purpose of the exercise is to establish a mark for banks to use on their portfolios, there is scope for collusion.

If banks do compete and bid down the prices of debt instruments, the authorities may be faced with another round of failures, as ailing banks are forced to use new marks and find their capital deficient in the new light.

Alternatively, the government, which has bottomless pockets and no liquidity risk, may simply arrive at a price based on what it, or its advisers - and one wonders who they could be and if they saw this disaster coming - think is a fair bet on what repayment flows will be.

There is also the issue of protecting the taxpayers, who may justifiably argue that they should share in the benefit of any subsidy offered to the industry in return for footing the bill. But taking equity stakes in banks in exchange for below-market funding or asset sales probably would choke off any hope of new equity infusions from actual investors seeking profits.

It's easy to understand why the United States is considering an apparently indiscriminate reward for those who took too much risk. The stakes are very high, and a disorderly deleveraging would be worse than an orderly one, even if the orderly one isn't perfect.

The debate about whether or not the United States will need a huge intervention of public capital into its banking system and wider economy is over. The crisis requires a huge outlay of public funds, both to clean up after the many banks that will fail and to soften the blow to homeowners and consumers.

Banking is a confidence game, even if done soberly and responsibly. But this plan, because it fails to meet the issue of insolvent and failing institutions head on, is not likely to work.

source: 29sep2008