The Times reports that Wall Street appears to be “dazzled” by the Geithner/Treasury bailout plan. Today’s 500 point rise in the markets may be the ultimate proof of the cognitive bias built into market pricing. The Geithner plan announced today contains only an ounce of new information from the plan announced a few weeks ago.
And that first Geithner announcement was only a rehash of the failed original Paulson plan.
Why won’t this approach work?
First, the original face value of toxic assets is in the trillions not hundreds of billions. So the amount on offer is not nearly enough.
Second, the toxic assets that Geithner proposes to buy with our money are not merely beaten up good securities, they are dead securities that will never be worth a penny. No private buyer, once they are fully engaged in the due diligence process, will want to buy them no matter how much leverage is provided by the Federal Government to super charge the returns. (Or is the cheap debt offered the private funds a bribe to soft pedal ordinary diligence? If so, they better secure waivers now for securities fraud.)
The second point is more complex.
First, a very large share of the toxic assets that are most troubled are those created in the last couple of years of the credit bubble. Many of these are so-called “synthetic” CDOs based on credit default swaps, or CDSs, written by groups like AIG. Synthetics are pure speculative instruments created to sate the hunger of hedge funds trying to free ride on the credit bubble. AIG fed the beast and raked in huge premium payments as one of the central providers of the CDSs. And lately they have been, as I pointed out in an earlier post, paying off on those instruments 100 cents on the dollar with our money, scraping their bonus money off the top.
The important thing to understand about these synthetic CDOs is that there are no underlying mortgages owned by these investors. No private investor should want to purchase these in the absence of any real collateral so they will continue to weigh down the balance sheets of banks unless those banks are nationalized and the assets destroyed. And sure enough the Geithner Plan is limited to CDOs that are backed by actual mortgages, meaning the banks are struck with the synthetics!
Second, even those “Cash CDOs” which are based on a so-called reference pool of actual mortgage loans are created in such a way that it is very difficult for investors in them to figure out if they have any right to the underlying collateral, namely the actual homes and land that they originally helped finance.
When the Paulson plan first emerged, I was generally supportive (see my talk on the early stages of the meltdown here) because it appeared to hark back to the Reconstruction Finance Corporation of the New Deal. The RFC, however, was able to enter the mortgage market directly and purchase property outright. In theory, the US Government should be able to do a similar intervention here if the financial markets had not done such a bang up job of making the simple mortgage business so complicated.
If the Government could buy up the mortgage loans directly they could in theory renegotiate the terms of mortgages directly with home owners allowing them to stay in their homes until the value rose or the mortgage was paid off. The Government would be acting much as specialists or market makers act in the stock exchanges providing a floor under prices to maintain, or restore liquidity.
I think the reason the Paulson team backed away from the original proposal to intervenve because of these complexities. Obama on the other hand is under severe pressure to be seen to do something. His nervous laughter on 60 Minutes – which provoked the suggestion that he might be “punch drunk” – indicated the depth of the problem. And yet Obama is in deadly fear of nationalization since that would open him up to charges of socialism and other crimes.
Today’s announcement bought the Administration and in particular its overwhelmed if not corrupted Treasury Secretary a little more time. But the markets can be fickle and once the realities of today’s complex world of “fictitious capital” begins to be understood they will likely turn in another direction.