Dale Franks on the Bailout

I thought Dale Franks has a really good post on why the bailout is a crock.  Its quite long, but here is one excerpt:

Banks that made bad mortgage choices get a buttload of money for their
bad MBS paper. Banks that charted a more reasonable course"”and yes,
there are quite a few"”get no reward.

In a real free market, of
course, the banks that made bad decision would have to take the hit.
They'd auction them off at whatever price the market would bear, and
they'd have to suck up the losses on the difference between face value
and sale value, even if that meant driving them out of business.
Meanwhile, the more rational banks would be able to pick up the MBS
paper at a discount, and make some cash off of the distress sale from
the incompetent banks.

And, of course, the incompetent banks would probably be driven out of business.  Which, after all, is how it is supposed
to work. But, the government seems entirely uninterested in letting the
market work this out, which brings me to my next point....

I keep hearing over and over again"”and I've even said it"”that no one
knows what these mortgage backed securities are worth. But let's be
clear here: the reason we don't isn't because the price is mystifyingly
unknowable. It's because they haven't even tried to sell them off yet.
We already know it's possible to find out what the price is, simply by
offering them up for sale. Indeed, we did it in July when Merril Lynch sold off its entire MBS portfolio.

The reason we're not doing it now is because the holders of MBS paper expect a government bailout, and they expect to
receive through it a price significantly higher than they would in the
secondary market. If it were otherwise, they'd already be auctioning
them off.

After all, we're talking about securities based on the
value of mortgage repayments. We already know that the default rate on
most of the MBS paper will be around 5%, with a maximum of probably no
more than 10%. Everybody already knows this. Now, just to turn the
screw, a buyer might want a discount of over"”perhaps well over"”50%.
after all, it's a fire sale, and everybody wants a bargain, right.

But there is a market-clearing price for these securities, and everybody on the street knows it.
What they also know is that they have an excellent chance of receiving
a much better price from the Feds, and that waiting for the bailout
gives them a better chance to stay in business, even if the Treasury is
a large shareholder in the company. And, after all, if the Treasury is
a shareholder, how likely is it that the government will let them fail, losing all that equity?

The
bailout doesn't solve the problem. It keeps the bad banks in business,
lets them escape the worst consequences of their malfeasance, and
prevents the better run banks from taking up the reins that would be
otherwise dropped when the bad banks went out of business.

  • bobby b

    Talk of incompetent banks, all of whom made free-will choices, seems at odds with the prevailing theme I've been hearing all along - that banks got stuck buying bad mortgage paper because of the pressures put on them by the CRA.

    Is that untrue? Was this all a simple matter of choice? (Screwed-up choice, I mean, but still just a choice?

  • Methinks

    Bobby,

    It was some choice, some government mandates (like the CRA), some lulling into a false sense of security by the existence of Fan & Fred.

    Credit spreads tightened across the board on all loans. That part was choice.

  • http://www.tinyvital.com/ John Moore

    As I understand it, CRA had a larger effect than it might appear. Threats against institutions that didn't look good a la CRA reported coerced a lot of lending.

  • epobirs

    Bobby, the CRA is the root of the problem, this is true. But there were choices made that took a bad situation and made it immensely worse. The whole concept of Mortgage Backed Securities (MBS) has always struck me as trouble waiting to happen, ever since I read 'Liar's Poker.' Combine MBS and sub-prime mortgages, which are guaranteed to have a high failure rate, and you've got a disaster looming in regulatory action doesn't constrain how deeply invested companies become in this idiocy.

    The alarm has been raised repeatedly from the right and the left squelched it every time until we got to where we are now. If the general public could be made to understand how this is almost entirely the product of the left's policies there would be a mass evacuation of left-held seats and not a chance in hell of Obama being elected dogcatcher. But most people aren't interested if the 6:00 News doesn't tell them who the bad guys are in simple language that doesn't ask them to really think. Not that the average news broadcast will even give a hint that something called CRA might be part of this story.

  • Methinks

    The whole concept of Mortgage Backed Securities (MBS) has always struck me as trouble waiting to happen, ever since I read 'Liar's Poker.'

    Why?

  • epobirs

    Methinks, look at the essential problem behind this supposed crisis. The toxic items cannot be moved because they cannot be priced. Why do you suppose that is? Anybody with a mortgage should be able to tell you almost instantly the approximate value of their mortgage. That is, the payoff amount. It isn't until you bundle up a pile of mortgages, let them change hands several times, then treat them as the basis of financial instruments that aren't the mortgages themselves but still rely on the mortgages for their value, well, it doesn't take long before it all becomes play money with made-up numbers in the equation.

    If a believable market value cannot be assigned to these items, then they are worth NOTHING. Game over, thanks for playing. The failed financial companies should not be propped up. The only thing that matters is the depositors' funds. Let the foreclosed properties be seized and auctioned off for dirt cheap (many of these are so dilapidated they can only be valued by the land minus the cost of removing the structures so the buyer can start anew) with the proceeds going to the FDIC to protect the consumers.

    People need to get over the fallacious belief that this can all be fixed with the stroke of a congressional pen. There is some seriously broken stuff that is completely FUBAR. You can't get on with the cleanup until you accept that a bunch of stuff is lost and not coming back. Get rid of the market distorting nonsense like the CRA and get on with a life based on the world as it is rather than the world as it should be in socialists' dreams.

  • bbartlog

    We already know that the default rate on most of the MBS paper will be around 5%, with a maximum of probably no more than 10%

    I think epobirs has pointed out one problem with this idea: because of the bundling of mortgages into synthetic packages, we see a problem of asymmetric information. I could readily imagine that *some* of the mortgage-backed securities out there are toxic garbage, based on semi-fraudulent housing valuations or deliberate sorting of loan quality into different tranches - and those securities sure as hell won't have the 75 to 90% face value that they should. If sellers can't readily figure out which offerings are which, they won't buy (classic 'market for lemons' problem).
    Of course as you pointed out the expectation of a bailout also discourages sellers from pricing low enough to move their paper in spite of this problem. I believe that Merrill Lynch was forced to accept 0.22 on the dollar for its paper, which is a pretty brutal loss.

  • bbartlog

    We already know that the default rate on most of the MBS paper will be around 5%, with a maximum of probably no more than 10%

    I think epobirs has pointed out one problem with this idea: because of the bundling of mortgages into synthetic packages, we see a problem of asymmetric information. I could readily imagine that *some* of the mortgage-backed securities out there are toxic garbage, based on semi-fraudulent housing valuations or deliberate sorting of loan quality into different tranches - and those securities sure as hell won't have the 75 to 90% face value that they should. If sellers can't readily figure out which offerings are which, they won't buy (classic 'market for lemons' problem).
    Of course as you pointed out the expectation of a bailout also discourages sellers from pricing low enough to move their paper in spite of this problem. I believe that Merrill Lynch was forced to accept 0.22 on the dollar for its paper, which is a pretty brutal loss.

  • Methinks

    epo, ABSs have been around for a very long time and work very well. MBSs are simply ABSs which are backed by mortgages and have been around for at least 30 years or so. They work well and there's nothing wrong with MBSs per se.

    The problem is the loose lending standards and undeserved high credit ratings. The ABS is only as good as its underlying assets. Recently, the loans comprise the underlying assets of the MBSs worth a lot less because they lever people more than we could dream of levering LTCM in the 90's and because there was virtually no due diligence done on borrowers. That's the basic problem, not the ABSs - MBS or otherwise. Credit card ABSs, for example are working well. However, credit cards haven't loosened their lending standards as much and they still stick to arcane rules like actually doing credit checks on prospective borrowers [/sarcasm].

  • Methinks

    I believe that Merrill Lynch was forced to accept 0.22 on the dollar for its paper, which is a pretty brutal loss.

    But probably a fair price.

    We already know that the default rate on most of the MBS paper will be around 5%, with a maximum of probably no more than 10%

    No, we don't. You can't have it both ways - either the MBSs are too opaque to calculate default rates with such accuracy or they aren't too opaque to calculate expected default rates with reasonable accuracy and everyone should stop bitching about the opacity of MBSs. Which is it?

    If it's the former, it's unlikely that government numbskulls running the world's largest distressed debt hedge fund, bankrolled by taxpayers to whom they are not accountable, will be able to figure out that they are buying the riskiest, most overpriced crap. If it's the latter, then every distressed debt hedge fund will be bidding for those assets and we don't need Paulson's team of government morons to do it for us.

    We're screwed - and that's my optimistic prediction.