Price discovery

In a posting yesterday, I noted how the key to the Paulson/Bernanke financial plan was price discovery (and how that is important in monetization of intangible assets as well). Today there have been a number of comments on price discovery. Here are a few.

Floyd Norris in the New York Times notes:

And how would that price be determined? Mr. Bernanke thought “auctions and other mechanisms could be devised that would give the market good information on what the hold-to-maturity price was for a large class of mortgage-related assets.” That strikes me as dubious at best. Auctions of disparate securities with one eager buyer and sellers of varying desperation may show something, but it is unlikely to be the “hold-to-maturity value.”

To estimate such a price, you need to make assumptions on how many defaults are likely, and how severe the losses will be, for each group of mortgages that was securitized. The correct answer will depend in large part on how long house prices fall, and how severe the recession is. If you think you know all that, then you can make a good estimate of value.

The nature of securitizations is that the losses arrive in lumps. A given security might meet all its payments if the mortgage pool backing it suffered losses of 5 percent, and be wiped out if the losses reached 6 percent. Change your assumption a little, and the value may change a lot.

But coming up with any kind of fair value was not the real objective. Instead, the goal was to recapitalize the banking system by placing a floor under the prices of securities that never should have been issued.

The Financial Times also notes the problems with this approach:

Furthermore, it is debateable how much information will be created by the price-discovery process in the government auctions.

Since each security is so different, investors may regard marks based on these government prices as meaningless.

For the plan really to work the government will have to devise an effective new vocabulary for standardising mortgage- backed securities.

This may sound simple but it has eluded the private sector for more than a year now.

I understand, but disagree. I think the Wall Street Journal gets it right:

Economists and market experts agreed that a government purchase of distressed assets would help reveal the extent of losses at financial institutions, a necessary step before the financial sector can rebuild itself.

Many financial firms are holding assets on their books at unrealistic prices, in part to avoid taking necessary write-downs that accounting rules require when an asset becomes impaired. Because the market has frozen for these assets, companies have been able to avoid reflecting their real value on their books.

. . .

With Treasury buying these assets in the open market, every institution, whether or not they participate in the program, would have to reflect market prices on their books.

"The market for many of these mortgage-related assets is so illiquid that there's very little price information out there," says Matthew Slaughter, an associate dean at Dartmouth's Tuck School of Business. "Once the government begins buying assets it will help the firms themselves, their investors, and their counterparties better understand their current balance sheets."

As Arthur Levitt and Lynn Turner argue in their op-ed (How to Restore Trust In Wall Street - WSJ.com):

There is a direct line from the implosion of Enron to the fall of Lehman Brothers -- and that's an inability for investors to get sound financial information necessary for making sound investment decisions.

But, of course, simply restoring trust may not be enough. Paul Krugman argues that equity sharing provides the necessary compliment:

Why is that so important? The fundamental problem with our financial system is that the fallout from the housing bust has left financial institutions with too little capital. When he finally deigned to offer an explanation of his plan, Mr. Paulson argued that he could solve this problem through “price discovery” — that once taxpayer funds had created a market for mortgage-related toxic waste, everyone would realize that the toxic waste is actually worth much more than it currently sells for, solving the capital problem. Never say never, I guess — but you don’t want to bet $700 billion on wishful thinking.

The odds are, instead, that the U.S. government will end up having to do what governments always do in financial crises: use taxpayers’ money to pump capital into the financial system. Under the original Paulson plan, the Treasury would probably have done this by buying toxic waste for much more than it was worth — and gotten nothing in return. What taxpayers should get is what people who provide capital are entitled to: a share in ownership. And that’s what the equity sharing is about.

Bottom line: I continue to believe that price discovery is an important part of the process. But it is one that will leave a lot of blood on the floor before it is over (as everyone finally writes down these assets). Thus, the Paulson/Bernanke plan is just the start. The next President and the next Congress will have a lot more work to do.