Prometheus 6

I'm not the only one that sees no limits in the plan to convert our economy to market socialism.

Here’s the thing: historically, financial system rescues have involved seizing the troubled institutions and guaranteeing their debts; only after that did the government try to repackage and sell their assets. The feds took over S&Ls first, protecting their depositors, then transferred their bad assets to the RTC. The Swedes took over troubled banks, again protecting their depositors, before transferring their assets to their equivalent institutions.

The Treasury plan, by contrast, looks like an attempt to restore confidence in the financial system — that is, convince creditors of troubled institutions that everything’s OK — simply by buying assets off these institutions. This will only work if the prices Treasury pays are much higher than current market prices; that, in turn, can only be true either if this is mainly a liquidity problem — which seems doubtful — or if Treasury is going to be paying a huge premium, in effect throwing taxpayers’ money at the financial world.

There are folks going nuts over this already but it's an insanity I understand. Here's a little discussion of the problem Mr. Krugman points out in the above quote.

Consider: A bank wants to sell the TARPistas (also known as TAXPAYERS) a pile of stinky mortgage securities that it currently values at 60 cents on the dollar. Let’s assume that the most recent actual trade between market participants for similar assets was struck at 30 cents on the dollar.

So what’s a fair price that we TARPistas should pay for the assets?

If we bought at 60 cents, a price that the bank would argue is appropriate, we would most likely face a loss. The bank, however, would be much better off than if it had to dump at 30 cents.

Conversely, if the assets were sold at 30 cents, taxpayers could wind up making a profit on the purchase if the assets performed better than expected over time. But the bank would have to write down the value of the assets as a result of the sale, possibly threatening its financial standing yet again.

Do you think, perchance, that financial services lobbyists might be working their Hill contacts right this very minute to ensure that the TARP valuations are rigged in their favor?

You know the answer to that.

Got that? Now, let's make it worse by talking about what's LIKELY to happen instead of just what is possible. See, a lot of those collateralized mortgage obligations (CMOs) have never been on the market and were never intended to be. Having worked on Wall Street (one of my assignments was to go to the meetings my boss didn't think he'd understand and come back with translations) I can tell you those CMOs were boutique creations. A major financial firm would determine it needs a certain retern locked down for some specific period of time. Goldman Sachs or whoever would scoop up a pool of mortgages, carve out the principle and interest the major financial firm needed, and repackage the balance in various tranches (tranche is one of the words they made up for experts...think "sub-pool"), priced using the formulas for which Robert C. Merton and Myron S. Scholes received a Nobel Prize in economics in 1997.

They put the asset on their balance sheet and hold it for the specific period of time. The asset is not sold because it was never intended to be. This means it is valued according to that dread formula or worse...they'll take the face value plus all projected interest payments and backvalue it at the current Fed Funds rate. That would REALLY gas up the valuation of those things.

That's what I expect them to do. The worst thing possible.