by Calculated Risk on 9/24/2008 01:07:00 AM

From the WSJ: FBI Investigates Four Firms at Heart of the Mess

The Federal Bureau of Investigation's preliminary inquiries are focusing on whether fraud helped cause some of the troubles at Fannie Mae, Freddie Mac, Lehman Brothers Holdings Inc. and American International Group Inc., according to senior law-enforcement officials.
...
Pressure is building for the FBI and regulators to hold top executives accountable for the crisis that has crippled the nation's finance sector. ... Investigators say that despite calls from some quarters to prosecute wealthy bankers who helped fuel the mortgage bubble, it is unclear what crimes they will find at the root of the exotic financial vehicles that have sickened banks around the world.

by Calculated Risk on 9/23/2008 09:44:00 PM

Update to make this clear: I never focused on Section 8 (oversight) of the Paulson Proposal because I felt this was obviously going to be changed. To be fair, sometimes people put an offensive clause in a proposed agreement as a negotiating ploy. I think Paulson learned that negotiating ploys don't go over very well with Senators!

From Paulson's proposal:

Sec. 8. Review.

Decisions by the Secretary pursuant to the authority of this Act are non-reviewable and committed to agency discretion, and may not be reviewed by any court of law or any administrative agency.

Paulson today:



If Paulson really wants transparency, give us a website, updated daily, with the details of all transactions!

by Calculated Risk on 9/23/2008 09:08:00 PM

Predictions:

Bernanke and Paulson will enjoy tomorrow even less than today (testifying before the House Financial Services Committee at 2:30PM ET). The House is the key to passing any plan and I expect some fireworks.

Hopefully there will be some questions about pricing tomorrow, and maybe transparency (a website with all transactions!).

If you want to have an impact - call your Congressman - the vote will be closer in the House.

A plan will probably be passed within a week or so. The plan will probably include some type of contingent equity participation, and some oversight - and everyone will declare victory.

Goldman will buy some commercial banking assets by Friday. This is just a guess because of recent events: Goldman becoming a bank holding company, and Buffett investing in Goldman.

Emails: I've been swamped with emails this week and especially today. Many of the emails contained detailed questions or thoughtful alternative plans. I apologize that I'm unable to answer all the emails, and I sincerely appreciate the thoughts and questions. Best to all.

by Calculated Risk on 9/23/2008 06:11:00 PM

An interesting question is why do Bernanke and Paulson believe the Hold-to-Maturity price is higher than the current market price for MBS?

One possible explanation is market failure based on information asymmetry. Mark Thoma explores this question: "Hold to Maturity" versus "Fire Sale" Prices

Let me try to give a defense of paying above current market prices (in a devil's advocate sense). For markets to function according to competitive ideals, full information must be available to all market participants. When information is lacking, or when it is asymmetric, the outcome is inefficient relative to the full information outcome.

The nature of these assets - their opacity as it has come to be called - makes full information unavailable. I'm not sure how asymmetric information is, people holding the assets don't know themselves whether a particular asset might blow up and lose it's value or not, but there is some degree of asymmetric information in these markets (a standard lemons problem).

This is market failure due to lack of full information, and asymmetric information to the extent it does exist, is depressing prices.

In this case, I don't think the information is asymmetric because both buyer and seller are aware of the characteristics of the MBS. There is uncertainty regarding future house prices (and MBS performance is related to house prices), but that isn't a market failure.

Professor Thoma also links to Professor Kling: Hold-to-Maturity Pricing

Suppose that you owe $110,000 on your mortgage, due in one payment a year from now. The "hold to maturity price" is that $110,000, discounted back to the present. At an interest rate of 10 percent, the price is $100,000.....NOT!

The fair price depends on the probability that you will default. If there is a 50 percent chance that you will default, the fair price is more like $50,000.

The probability that you will default depends on the distribution of possible paths of future home prices. Along paths of falling home prices, defaults are much more likely than along paths of stable or rising prices.

It's hard to know how home prices will behave, but right now if I were pricing the risk (something I used to do for a living, unlike the key decision-makers in this bailout), I would include a lot of paths where prices go down. That would make the "hold-to-maturity" prices of the mortgage securities, properly calculated, pretty low in many cases.

First, this analysis assumes 100% loss severity in the event of default. If there is a 50% chance of default, half the time the mortgage will be worth $110K discounted back to the present. But if the borrower defaults, the value will not be zero since there is a recovery value on most mortgages. Kling apparently assumes a loss severity of 100% in the event of default (perhaps he was thinking of a 2nd mortgage), but a more normal severity would be around 50% or $55K discounted back to the present. So in this example, and using a 10% discount rate, the mortgage would be worth $100K * 0.5 + $50K * 0.5 or $75K at present.

But I think this might provide a clue to the pricing disparity: because of the uncertainty in future house prices (and MBS performance) potential buyers are probably using a higher discount rate than Bernanke / Paulson. Typically the higher the standard deviation of the potential outcomes (higher risk), the higher the discount rate. So even if investors view the future price the same as Bernanke/Paulson, they might view the NPV as much lower. In addition, the cost of capital is higher for private investors - also impacting their discount rate.

Perhaps Bernanke / Paulson believe that aggregating assets will lower the risk. Usually when you aggregate assets, the overall volatility decreases. This is almost always true for holding a group of stock (the beta on the S&P 500 is lower than the beta on most stocks in the S&P 500). But if the assets are all impacted by one parameter - in this case future house prices - aggregating assets does not lower the risk.

This would make a great question for Bernanke tomorrow. Why does he believe the Hold-to-Maturity price is higher than the current market price? Is this because of some market failure? Or because of different discount rates? Or some other reason?

by Calculated Risk on 9/23/2008 05:55:00 PM

Just headlines from MarketWatch:

Goldman to sell $5 bln preferred stock to Berkshire Hathaway

Berkshire also to get $5 bln in Goldman common warrants

A Buffett rumor that is true!

by Calculated Risk on 9/23/2008 04:37:00 PM

Wells Fargo Jumbo 30 year fixed mortgage rates are now at 9.0% (9.176% APR). (hat tip patrick.net)

Click on graph for larger image in new window.

This will really hurt the markets with house prices above the conforming loan limit. Here are the conforming loan limits by County from Fannie Mae (excel file).

by Calculated Risk on 9/23/2008 04:22:00 PM

From FinancialWeek.com: Goldman eyes IndyMac to build bank network

We plan to build our banking business organically and by buying retail deposits and bank assets in the wholesale market, not through opening branches,” a Goldman Sachs spokesman said.

“For example, the FDIC is selling IndyMac assets and those might be the sort of thing we’d be interested in looking at.”

by Calculated Risk on 9/23/2008 01:38:00 PM

From Reuters: Bernanke's comments on asset auction process

I believe that under the Treasury program, auctions and other mechanisms could be devised that will give the market good information on what the hold-to-maturity price is for a large class of mortgage-related assets. If the Treasury bids for and then buys assets at a price close to the hold-to-maturity price, there will be substantial benefits.

[B]anks will have a basis for valuing those assets and will not have to use fire sale prices. Their capital will not be unreasonably marked down.

Originally I expected the plan to have two components: 1) buy troubled assets from institutions, and 2) an RFC type recapitalization plan. However the plan did not include the recapitalization provision, so the clear intent is to pay premium prices (to current market prices) for troubled assets to recapitalize the institutions (with no equity participation for taxpayers).

Bernanke and Paulson are clearly arguing the current market prices are wrong - that they are "fire sale prices".

Krugman has more: Getting real — and letting the cat out of the bag

[T]he key question is what price Treasury pays for the assets. And here we have Bernanke effectively saying that it’s going to pay above-market prices — prices that allegedly reflect “hold-to-maturity” value, but still more than private investors are willing to pay.
...
[T]he plan only helps the financial situation if Treasury pays prices well above market — that is, if it is in effect injecting capital into financial firms, at taxpayers’ expense.

What possible justification can there be for doing this without acquiring an equity stake?

No equity stake, no deal.

One thing is clear - something we all guessed correctly - is that the intention of the plan is to pay premium prices for troubled assets to recapitalize the banks. It’s still not clear how the price mechanism will work, and unfortunately Paulson and Bernanke are unable to describe how this will work.

Except Paulson did say they would hire “really good asset managers” to determine the price. A little sarcasm: I suppose these are asset managers that have been shorting financials for the last couple of years (hat tip Seminole).

by Calculated Risk on 9/23/2008 01:08:00 PM

From the Independent: Hedge funds suffer mass redemptions

Hedge funds could have an unprecedented level of cash pulled out by investors this quarter, according to insiders, just as they faced millions of pounds of losses from last week's shock regulation of short selling.
...
The redemptions seem to have started in earnest, although currently the evidence is mainly anecdotal. One UK hedge fund manager confided that last week had the highest number of investors rushing to withdraw funds that he has known. The industry will know for sure whether it is a drip or a deluge when the data providers release their statistics for the third quarter, next month. One market analyst said: "I know even the good hedge funds have been suffering withdrawals recently. Investors are very nervous."

Roubini predicted that the next phase would be hedge fund withdrawals:

“The next stage will be a run on thousands of highly leveraged hedge funds. After a brief lock-up period, investors in such funds can redeem their investments on a quarterly basis; thus a bank-like run on hedge funds is highly possible. Hundreds of smaller, younger funds that have taken excessive risks with high leverage and are poorly managed may collapse. A massive shake-out of the bloated hedge fund industry is likely in the next two years.”

If this report is accurate, kudos (again) to Roubini!

by Calculated Risk on 9/23/2008 11:51:00 AM

A few quotes from Secretary Paulson's Testimony:

"I believe we need oversight. We need protection. We need transparency. I want it. We all want it."
...
"I am convinced that this bold approach will cost American families far less than the alternative - a continuing series of financial institution failures and frozen credit markets unable to fund everyday needs and economic expansion."
...
"I'm frustrated. The taxpayer is on the hook. The taxpayer is already on the hook. The taxpayer is already going to suffer the consequences if things don't work they way they should work. ...The best protection for the taxpayer is to have this work."