What's Going to Be a Key to the $700 Billion Bailout? Pricing...Of Course
A major issue in today’s financial crisis is banks' efforts to rid their books of mortgage backed securities. We are being told that banks are trying to sell these securities on the open market, but there’s no market.
“C’mon,” I needled a longtime economist friend of mine. “There’s a price for everything. Surely an investment group will offer something (i.e., pennies) for these unpopular securities.” As it turns out, this is true. In July, Merrill Lynch sold a $30.6 billion portfolio of mortgage backed securities for 22 cents on the dollar to a Dallas based distressed assets buyer, Lone Star Funds. Ouch, that write down has got to hurt. So there is a market for these securities, banks just don’t like the prices they are offering.
Granted, the current market is probably not accurately valuing these securities because they are spooked. These securities have a bad rap and this negative sentiment has hammered their prices downward.
A key component of the government bailout involves buying these tainted securities from banks. The key question, of course, is at what price? One pricing mechanism that Treasury is seriously considering is using Dutch auctions. This would involve Treasury saying, for example, we are buying $500 million of a specific type of security – send us your bids. Banks would then submit bids to sell their securities. These bids would be along the lines of “I’ll sell this volume of my security for X cents on the dollar.” Treasury would then rank the bids from lowest to highest price. Next, Treasury starts buying at the bottom (lowest price) and works upwards until all of the money is used. If your bid misses this cutoff, you're out of luck. The auction part of this process is the notion that banks are in competition. The lower their price, the better the chance they’ll get in on the Treasury bailout gravy train. This competition pushes security prices lower. But wait a second, the bailout objective is to maintain liquidity and keep banks solvent, not for the government to purchase securities at the lowest price.
The bid floor, of course, is what the current market is, say 22 cents or so on the dollar. This money is available any time. So if I am a bank and I want Treasury bailout cash, I’d make my bid 22 cents plus some amount that I think will still give me a good chance of winning the auction – let’s add 5 cents, so 27 cents. In other words, the bids that banks place have little to do with the true value of their assets. Instead it’s about setting a price that “games” the system: “How low do I go to ensure that I’ll win the auction.”
So point 1: a Dutch auction based bailout won’t yield prices that reflect a security’s true value. And point 2: the resulting prices may not be high enough to keep banks solvent.
I think we need to go back to the drawing board regarding what mechanism to use to value mortgage backed securities.
If you are curious to learn more about this financial crisis in language everyone can understand, my good friend Steve pointed me to this great hour long discussion on NPR.
