Tuesday, September 23, 2008

What price for the bail-out? Hold to maturity or market prices

Chairman Bernanke made some interesting comments on the proposed Treasury bail-out or TARP. He suggested that it would be better for the Treasury to buy the assets not at current market levels or fire sale prices but at prices close to what would be considered the value if held to maturity. He stated that this would provide "substantial benefits" and that "we cannot impose punitive measures on the institutions that choose to sell assets".

In fact, this would be a potential windfall of the owners of the securities. What happened to air value pricing? what happened to market efficiency? Granted the price of these securiies are depressed because of a lack of liqudity but they are also depressed because it is uncertain what are their values.

The whole purpose of mark to market accounting is to provide investors with transparency of what is actually on the balance sheet of firms. Would it be easier to change the accouning rules associated with the pricing of these securities? If you price at hold to maturity, a term that does not have a clear meaning, there certainly will be no windfall for the government. There will be no concession to the government for financing or providing liquidity. Now there is a moral hazard problem because those that picked bad securities will receive a benefit. There is a benefit to using this pricing. It maximizes the amount of money that will go to help the bank portfolios. It may be easier to price, or at least it may seem to be easier.

A key problem with mortgage securities is that you may not know when the cash flows will come. There are large changes in the weighted average life of the securities that are affected by delinquencies, defaults, foreclosures and structure. All of these issues make the value of these securities difficult in the best of times but especially difficult in uncertain times. The best alternative would be to try and buy securities at the price that currently prevails in the market. Of course, the presence of the government as a buyer distorts the value of securities but that cannot be helped.

In some sense, the current program of holding assets as collateral at a haircut in exchange for lending is a better solution. The borrower still owns the security and would be responsible for selling or finding the best price when he determines that there is a an appropriate buyer.

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