# Second thoughts about the bail-out

From the beginning, I have been violently opposed to this thing.Â  And there is nothing that Hank Paulson, Ben Bernanke, Barney Frank (spit), or George Bush (SPIT) could have said to change my mind.

There is one man who has made me doubt myself, though.

Part 1

Part 2

Part 3

This interview is required material if you want to have an opinion on this topic.

Well, I would say this.Â  If I didn’t think the government was going to act, I would not be doing anything this week.Â  I might be trying to undo things this week.Â  I am, to some extent, betting on the fact that the government will do the rational thing here and act promptly.

Last week we were at the brink of something that would have made anything that’s happened in financial history look pale.Â  We were very, very close to a system that was totally dysfunctional and would have not only gummed up the financial markets, but gummed up the economy in a way that would take us years and years to repair.

What you have, Joe, you have all the major institutions in the world trying to deleverage.Â  And we want them to deleverage, but they’re trying to deleverage at the same time.Â  Well, if huge institutions are trying to deleverage, you need someone in the world that’s willing to leverage up.Â  And there’s no one that can leverage up except the United States government.Â  And what they’re talking about is leveraging up to the tune of 700 billion, to in effect, offset the deleveraging that’s going on through all the financial institutions.Â  And I might add, if they do it right, and I think they will do it reasonably right, they won’t do it perfectly right,Â  I think they’ll make a lot of money.Â  Because if they don’t — they shouldn’t buy these debt instruments at what the institutions paid.Â  They shouldn’t buy them at what they’re carrying, what the carrying value is, necessarily.Â  They should buy them at the kind of prices that are available in the market.Â  People who are buying these instruments in the market are expecting to make 15 to 20 percent on those instruments.Â  If the government makes anything over its cost of borrowing, this deal will come out with a profit.Â  And I would bet it will come out with a profit, actually.

In fact, one thing you might do, is if someone wants to sell a hundred billion of these instruments to the Treasury, let them sell two or three billion in the market and then have the Treasury match that, for what they pay.Â  You don’t want the Treasury to be a patsy.Â Â  But I’ll tell you, with Hank Paulson on top of it, you couldn’t have any better guy to do that.Â  The important thing is that if this program extends into the next administration is to have somebody in the next administration that has similar market savvy.

You can be pretty fanciful in marking positions in Wall Street, particularly when things aren’t trading.Â  The one thing you want to make sure, when the Treasury is buying things, is the marks they have don’t make any difference.Â  Like I said, it wouldn’t be a bad idea, if you’re buying ten billion of a security and you’re the Treasury,Â Â to have them sell five-hundred million, or something like that into the market, so you find out what the real market price is and then buy the other 9-1/2 billion at that price.Â  I really think, I really think the Treasury will make — I think they’ll pay back the 700 billion and make a considerable amount of money, if they approach it in that manner.

Buffett is essentially describing a U.S. sovereign wealth fund run by our ex-Goldman CEO at the Treasury.Â  The fund would buy good fixed-income assets at extremely depressed market prices, and ultimately make a killing. Why can’t the banks already sell these assets at market prices today?Â  Well, the “market price” for an asset can be very different if you are trying to unload $1000 worth than if you are trying to unload$1 billion worth.Â  So Buffett says, let’s establish the market price with small sales, then have the fund buy unlimited quantities at that price.

If this is what they are really talking about…Â  Then I admit that I was wrong, and we should all be supporting it.Â  However, I still have two reservations:

1. The most toxic instruments are each different from the next.Â  So I am not convinced anybody can tell when the “market price” for one is useful to establish the “market price” for another.
2. I am not convinced that this is what they intend to do at all, especially after Bernanke’s testimony yesterday.Â  The goal does not seem to be to restore liquidity, but to recapitalize the banking system…Â  And that can only be achieved by overpaying for these assets.Â  And I would still object to that, very strongly, equity stake or no.

Anyway, I have gone from “violent opposition” to mere “skepticism” about the plan.Â  We will know the details soon enough.

• foss

since no one else ever seems to post here (why I don’t know, your blog is excellent and thankfully free of the politcial side commentary that gets tiresome on CR)

here is a little story from cnbc I think you might like (and quite accurately predicted)

http://www.cnbc.com/id/26891418

shorting cannot be stopped, nor should it be. and for the record I am long the market.

• foss

just read this post in detai

et tu Nemo?

• Thank you for the kind words, foss. I deliberately set up the comments to make them a little hard to use (requiring registration etc.) because I was not really sure I wanted to deal with them. And I wanted to avoid spam. But maybe I should just bite the bullet and set up my own account with HaloScan…

Thank you for the link; I have added a little “update” to the earlier post on options.

et tu Nemo?

• jesse

“And that can only be achieved by overpaying for these assets.”

That is why the reverse auction idea was being used. If the market price is below what will prevent banks from being insolvent, they will not take the bid. The reverse auction will hopefully ensure AT LEAST one bank is recapitalizing. Or am I missing something?

• Hi, jesse. Yes, that is the theory behind the reverse auctions. But they have their own problems as Arnold Kling notes.

There are three relevant numbers for these assets: What the “market price” is, what the assets are “really worth”, and what they are carried for on the banks’ books. (These are almost certainly in order from lowest to highest.) As long as the Treasury avoids paying more than the assets are “really worth”, this exercise matches Buffett’s description. The problem is that nobody knows what they are really worth. What we know is that there are smart people buying them at what they think is a discount.

The reverse auctions introduce another number: “What the banks are willing to sell them for.” Which does not necessarily bear any particular relationship to the other numbers.

In short, I like Buffett’s idea better. But what really irks me is all of this noise about McCain and foreclosures and executive pay and mortgage modifications and equity stakes. By FAR the most important question is how the Treasury will determine pricing. And so far, I have seen not a single word addressing this in the current proposals.

• jesse

“The problem is that nobody knows what they are really worth.”

Hi Nemo, from the “tone” of the CNBC Buffett transcript I hear the Buffett DOES roughly know the proper value of the assets and thinks they are great value but he claims he can’t do much about buying them all. It sounded like since he couldn’t buy ALL of them the financial system may turn up many of the otherwise good assets bad in the fallout. The implicit guarantee of the government providing solvency will make the assets’ discount rate that much lower — a sort of “discount window” for assets.

If the deal is such a good investment, why is Buffett hedging his words with talk that it’s a crappy deal but with worse alternatives? I think he’s tiptoeing around something but overall I think the guy is a straight shooter who just happens to be stinking rich.

• jack

Here’s what I haven’t seen discussed yet . . .

Isn’t a security’s value just the Net Present Value (NPV) of the stream of future cash flows?

Couldn’t a buyer just look at the cash flows and make some prediction about the future cash flows based on history? Since the housing bust is already well underway, the trend is probably established.

• foss

please nemo, stay against this foolish expenditure. Buffett is very shrewd, but not all knowing, and he has been captured by the system.

good money after bad. this is not what any of us signed up for.

and please note, i am a homeowner, i don’t short the markets, i really don’t have a skin in this game. except our freedom. men and women have not died for our country to go down this insane path. i don’t short the markets, but i will defend anyone’s rights to do so to the death.

as for the comments and haloscan – stixk with what you have – it gets to be a bit much on CR though of course i know we do spend way too much time on that site.

keep up the great work (and thanks for the hat tip, but given that you actually predicted this well in advance of the article – shouldn’t cnbc be giving you the hat tip?)

• jack —

Isnâ€™t a securityâ€™s value just the Net Present Value (NPV) of the stream of future cash flows?

Yes, and for the past several years, that is precisely how these instruments have been valued.

The problem is that the future cash flows for a mortgage depends on whether and when it defaults (including “early payment default”), and on the value of the collateral (house). This alone is a complicated question, and the answers going forward are very uncertain… They certainly look nothing like they did during the housing boom.

Plus the MBSes (based on pools of mortgages) and CDOs (based on pools of MBSes) and CDO-squareds (based on pools of CDOs) are even more complex. You can plug in historical numbers and project future cash flows down to the sixth decimal point — in fact, this is precisely what was done — but the answers you get will be meaningless if the future does not look like the past. At this point, literally nobody knows what these “securitized” instruments are truly worth, because nobody has a good handle on the future cash flows. Very small changes in default rates can cause very large changes in the cash flows for these unbelievably complex instruments.

And the TARP would have authority to buy any of them.