Opinion: Reflections on a Bailout

As Congressional leaders debate the merits of a historic bailout proposal being pushed by the Bush administration, and Democrats look to tack their own social agenda to the back end of the proposal – free homes for everybody! – perhaps it’s time for all of us to admit something: this is a complex mess. As someone well versed in both real estate finance and capital markets, and who is lucky enough to know some of the smart people that play in the distressed asset space, the truth is that we’re facing a mess that has many moving parts, and many known and unknown variables. Mortgages are a central cog, sure, but far from the only one. With that in mind, I’ll admit something publicly few others will: how to solve this mess is anyone’s guess. Anyone suggesting they know precisely how to do it is either listening to their ego or missing a critical angle – or both. All of that said, I do know one thing: for all of the myriad of factors that got us here, only one now matters, whether or not there is a government bailout. That factor? Pricing. And what we’re hearing from our leaders in this area has me very, very worried. Both Fed chief Ben Bernanke and Treasury chief Henry Paulson have sought to sell their plan to Congress by suggesting a dichotomy between current “fire sale” prices and the long-term “fundamental value” of an asset; the argument is that a lack of market transparency and investor fear have driven the prices of whole loans and ABS/MBS/CDO issues to levels that no longer reflect their fundamental value. The government, they say, will buy these assets at prices greater the current market is assigning them; the idea is that in so doing, balance sheets are freed, institutions are recapitalized, and pricing discovery takes place (which, in turn, is supposed to help the prices of ABS/MBS/CDO issues recover). And thus the lending machine starts anew. Let me make something clear, outside of the academic debate now being used to sell this bailout: if any of this junk had value, it would be trading right now. And more importantly, the lack of trading activity has little to do with a need for “price discovery,” a term being bandied about inside the Beltway with reckless abandon this week. There is an ugly truth that Paulson is choosing to keep to himself: most already know what the prices for these sort of assets are. The problem is that there isn’t a financial institution whose balance sheet can handle selling at those prices — at least, not without putting an entire business into the side of a canyon. This is the real reason assets are clogging up balance sheets at inflated values, or put into Level 3. Or the reason that whole loans are marked at a value that in no way reflects the price that loan would receive if it was sold. Paulson & Co. are telling Congress that the government may break even or profit from this venture, but paying an above-market price for assets valued by the market at junk levels is the pretty much the definition of how to lose money in asset management. And gobs of it, too, far more than the $700 billion figure associated with this plan. Further, tacking on provisions to force massive loan modifications is, in a perverse way, a great way to ensure huge losses for the taxpayer. I’ll save the technical analysis for another paper, but the bottom line is that wide-scale loan modifications to mortgages underlying a securitized pool generally has an adverse effect on capital structure and cashflows. And while aggressive loan modifications can be profitable on whole loan acquisitions, that profit comes from buying loans at justifiable prices, not some phantom estimate of “fundamental value.” It appears that the goal of this plan is to recapitalize banks to stimulate lending again; and therein lies the second problem: what is “fundamental value,” anyway? Is it the value that can recapitalize a bank and ostensibly start lending again, which is higher than current marked value? Or is it marked value, which is still above the prices assigned to an asset by the market? Or something else? Beyond all the questions around pricing, there is a more fundamental question that has yet to be asked: has the risk profile around lending shifted irrespective of capitalization? In other words, there is little guarantee that bailing out an ailing financial institution and clearing its bad assets off of its books at inflated values will stimulate the sort of lending activity policymakers are expecting. Think of a drunk driver crashing his car; then think of the government providing a new car to that driver, hoping he’ll hit the sauce again, and not crash the car. Hardly seems to be the best use of what may end up being trillions of taxpayer dollars. Editor’s note: Paul Jackson is the publisher at HousingWire, and a mortgage market veteran.