The Price of Salvation
by Simon Johnson, Peterson Institute for International Economics
and James Kwak, Yale Law School
Op-ed in the Financial Times
September 24, 2008
© Financial Times
The government plans to bail out the banking sector by buying up to $700bn (for now) of "impaired assets" … but at what price? Pay too little, and the banks will not have sufficient capital to remain solvent; pay too much, and the wealth of the American taxpayer will be unilaterally handed to the banks and their shareholders. Last week Hank Paulson, Treasury secretary, said the government would pay "fair market value", which, many pointed out, would do little to help the banks. On Tuesday, Fed chairman Ben Bernanke equated the current market with a "fire sale" and proposed paying "hold–to–maturity" prices. But what does this mean?
There are five different prices that the government theoretically might pay for a mortgage-backed security (MBS):
P1. The par value of the security (largely irrelevant at this point).
P2. The current book value on the holder's balance sheet: because of the accounting rules for banks, and because banks today have a strong incentive to overvalue these assets, these book values may be artificially high.
P3. Fair market value (FMV) in a market free of government intervention: Until September 17, this was set by actual transactions between buyers and sellers, such as Merrill Lynch's sale in July at 22 cents on the dollar. However, for most securities it was impossible to determine the FMV, because there were few comparable transactions.
P4. FMV with government intervention: Since the bailout was announced, the prices of MBS have drifted upward, on the assumption that the government has an incentive to pay artificially high prices (the point of the bailout being to pay prices high enough to ensure banks' solvency).
P5. Model value: The people who buy MBS on behalf of the government will use their own models of long–term cash flows to estimate their value.
The banks would like to get P2, since that would leave their capital levels where they are, but this amounts to paying whatever price the banks have decided their assets are worth, which is obviously foolish.
An ordinary fund manager would pay P3, but if that were the entire transaction, it would defeat the purpose of the bailout; banks could sell at P3 today, but cannot absorb the collateral damage to their balance sheets. As Bernanke acknowledged in Tuesday's Congressional testimony, the plan is to pay more than current market prices, which is another way of saying that Treasury will be overpaying to save the banks.
Bernanke's comments can be interpreted in two ways. He could be saying the government's liquidity and capacity to bear risk will create a new market equilibrium, and that Treasury will pay the new market price (P4). Alternatively, his "hold–to–maturity" price could be the output of a long–term cash flow model (P5). The two are not necessarily exclusive.
But either possibility raises problems. First, the valuation models that produce hold–to–maturity prices are highly sensitive to their assumptions, and can be used to justify virtually any price, removing any constraints on overpayment. Second, in either case it will be impossible to determine P3, the price absent government intervention, and hence the real amount of overpayment – making it impossible to know how much wealth has been transferred from taxpayers to banks. Third, what if neither P4 nor P5 is high enough to ensure bank solvency? In that case the bailout would fail to accomplish its most important task: to recapitalize the banks.
But there is another solution. Given the need to (a) take these "toxic" assets off the hands of the banks and (b) make sure that they get more money than they would get on the open market, the answer is to separate the two parts of the transaction. In the first step, Treasury would pay FMV for the securities; in the second step, after assessing the bank's resulting condition, Treasury would do a capital injection by buying newly issued preferred shares.
In order to determine FMV in the first step for a given tranche of securities, a portion of the debt could be auctioned to the private sector. Any debt bought by the private sector will have no further recourse to the government, i.e., it is "bailout free". Properly designed, this auction will indicate P3, the fair market value in a free market. The government would then acquire the securities not bought by the private sector, at the price established in the auction. With their MBS gone, it will be easier to assess banks' solvency and determine the appropriate terms for a government recapitalization.
By explicitly identifying the FMV of the assets and distinguishing the asset purchase from the capital injection, this mechanism provides transparency to the operations of the proposed fund and limits the risk of overpayment. More fundamentally, it provides the much–needed assurance that the overall plan is fair to the American taxpayer and not simply a handout to the banking sector.
Simon Johnson is a senior fellow at the Peterson Institute for International Economics and a professor at MIT.