Sunday, September 28, 2008

What I Don't Understand About the Bailout Plan

Update: Peter Orszag, director of the Congressional Budget Office, just posted the CBO's very well-written summary and quick analysis of the proposal here.

Despite some additional bells and whistles, the basic plan is still to buy up mortage backed securities (MBS) at a price which is either their current market price or perhaps something closer to their "hold-to-maturity" value, which might be higher. Larry Summers and others have suggested that the taxpayers will not necessarily lose money on this deal because eventually their value may go up, above the value that we're paying.

If I understand correctly, the hold-to maturity value of these securities must be tied to the value of the properties on the underlying mortgages. If housing prices decline, the default probabilities increase (because more people end up with negative equity and no reason to keep paying their mortgages), and the value of foreclosed-on properties is lower. Both effects lower the value of mortgage-based securities.

The problem is, housing prices are still extraordinarily high--20% higher in real terms than in any pre-bubble point going back to 1987 (that's by the Case-Shiller index). So it's very likely that housing prices--and thus the value of the MBS's--will continue to fall and will not recover anywhere close to their current value in the forseeable future. This says to me that the most probable scenario is that the securities' market price and their hold-to-maturity value (if they are different) will plummet and not recover, meaning that the cost of the bailout will be very high. It still might be better than doing nothing, but it's not going to be at low cost.


DRDR said...
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DRDR said...

To play devil's advocate, I would argue (1) expections in housing price declines are already built into the value of the mortgages, so prices or expected prices would have to fall worse than current market expectations for there to be losses, (2) MBS are at fire sale prices now because of firm risk-aversion in the face of capital/survival constraints and extreme uncertainty, (3) the MBS would fetch a higher price in a future market environment with less uncertainty and more capital.

Don Pedro said...

Thanks for the comment. Yes, (2) is the point I have seen raised by advocates of the plan, and (1) should be true if prices reflect expectations--and those expectations are correct. (3) is less evident.

What bothers about claim (1) is that as the housing bubble grew, it became increasingly clear that the market's expectations were out of line with likely reality. So I'm skeptical that now all of a sudden the market is taking into account future expectations, especially when I see people talking as if a rebound in housing prices is just around the corner.

Steve Roth said...

This passage I find to be particularly egregious:

...the federal budget would not record the gross cash disbursements for purchases of troubled assets (or cash receipts for their eventual sale), but instead would reflect the estimated net cost to the government of such purchases (broadly speaking, the purchase cost minus the present value, adjusted for market risk, of any estimated future earnings from holding those assets and the proceeds from the eventual sale of them).

Sort of betrays the whole letter and spirit of the "google for government" initiative.

MattYoung said...

The other problem is the single buyer, multiple seller problem and doubts about that arrangement to set reasonably behaving prices.

In particular, if the MBS sellers actually plan on entering a recession and restructuring, then they would dump the risky tranches on Paulson and move on.

I would fear that sellers rearrange their portfolio before hitting this plan so they have little to fear from warrants.

Isn't this Buffet's plan? If the sellers plan a recession and Paulson plans no recession, then some party is going to be hurt badly.

ylDave said...

The bailout plan is a bad idea on so many levels. It is government intervention into the normal consolidation of a sector that has had a huge run up in recent years - in 2006 fully 1/3 of *all* US corporate profits were from the financial services sector.