Wednesday, September 24, 2008

Krugman on the Arrogance of Henry Paulson

Economist Paul Krugman sat down with Keith Olbermann
this past Sunday to discuss the bailout plan (click on video above to watch). Read Krugman's related New York Times op-ed piece, Cash for Trash.

(For a different view of Paulson and this rescue package, read the Wall Street Greek's latest comment).

Another interview worth watching is Charlie Rose's discussion about the economy and the 700 billion dollar bailout of Wall Street with Rep. Barney Frank (D-MA) Chair, House Financial Services Committee.

According to Rep. Frank, the sticking point right now is the golden parachutes that these Wall Street execs still cling to:

Barney Frank (D-Mass.), chairman of the House banking committee, made his way into the House media gallery to face 75 reporters yesterday afternoon. The hard-hearted chairman hitched up his trousers, took his seat, and showed no remorse toward the CEOs who stood to lose so much.

"The Endangered Species Act apparently does not apply to financial institutions," he joked, cruelly.

He vowed, callously, that there will be "no golden parachutes while we are the owners" of Wall Street firms' bad debts.

"It's inconceivable that people would say the taxpayer should put some money at risk because of bad decisions made by people who would then continue to be rewarded without any restriction and, in fact, would be rewarded for their mistakes," the merciless chairman argued.

He then cynically turned Paulson's defense of the Wall Street executives upside down. "Let me defend CEOs against Hank Paulson's attack on them," Frank said with feigned sincerity. "Here is this absolutely essential program that's needed to keep the economy going, but there are CEOs who won't participate in it if a few of their many millions are going to get nicked? That's really what he's saying, that some CEOs put their ability to get unrestricted excessive compensation, including rewards for failure, over and above trying to cooperate and help the economy. If that's true, we're in worse shape than we think."

It was a brazen attempt to exploit the suffering of the CEOs, but it was irresistible to Frank's fellow Democrats.

"If you're taking a federal dollar to bail yourself out, you ought to get a federal salary," Sen. Jim Webb (Va.) said on the Senate floor.

"It is wrong to have executives who have created all kinds of problems and cost the taxpayer millions, if not billions, then walk away with golden parachutes," Sen. Chuck Schumer (N.Y.) told MSNBC.

Confronted with such demagoguery, the Republicans by day's end were beginning to falter in their compassion for the struggling CEOs. After Republican presidential nominee John McCain came out against golden parachutes for bailed-out executives, Rep. Louie Gohmert (Tex.), talking with fellow opponents of the rescue plan, told The Post's Paul Kane that golden parachutes are "repugnant."

After a meeting with the Senate banking committee chairman, Chris Dodd (D-Conn.), Sen. Bob Corker (R-Tenn.) was ready to sacrifice the needy CEOs on the altar of expediency. "There are things sometimes one has to accept to reach a solution," he told The Post's Lori Montgomery.

Even Martinez, who only hours earlier was on television defending the CEO pay provisions, was now of the opinion that "there needs to be some language involving executive compensation."

It was enough to make a big guy feel small.

Greed, arrogance and stupidity, the perfect "golden cocktail" which paved the road to this financial disaster.

On a separate issue, a buddy of mine sent me this USA Today article on pricing mortgage-backed securities:

The Treasury, then, is left in the difficult position of naming a price for assets that no one else will buy. And that's where things get tricky. Some possible approaches:

•Fire sale. Not everyone thinks that the market for mortgage-backed securities, even subprime ones, is dead. "There is a market for these assets, but the sellers don't want to accept the price," says Alessandro Pagani, senior securitized asset strategist at Loomis Sayles. Merrill Lynch effectively sold a massive chunk of mortgage securities at the distressed price of 22 cents on the dollar. Those securities were collateralized debt obligations, which are more complex and riskier than most mortgage-backed securities, Pagani says, and most of what the Treasury will be buying should fetch higher prices, even at a fire sale.

The drawback: Banks and other institutions would have to book the sale as a loss — meaning they would probably have to raise more money as a cushion against future losses. And that's very difficult to do in the current market environment.

•Reverse auction. Unlike a regular auction, where many players put in bids for one item, a reverse auction would have only one bidder: the Treasury. Several financial companies would offer their assets to the Treasury and give an offering price. The Treasury would take the lowest bid, in theory setting the price at the lowest level that companies feel they could afford to take.

The drawback: Reverse auctions can be complicated to set up, particularly because you need to have a reasonable number of companies offering very similar securities. Given the vast array of securities that Wall Street produced in the past five years, that could be tough.

•Future payouts. Accountants are trained to measure assets' value by examining what equal or comparable securities are trading for. It's not unlike how you can figure out how much your Pez dispenser is worth by looking for completed auctions on eBay. Robert Maltbie of Singular Research estimates that a price of 30 cents on the dollar for the debt is prudent, based on recent transactions.

Lacking a market, one solution might be to measure the value using the so-called discounted cash flow approach, says Colum Chan, chief investment officer at CC Investments. Here, analysts can estimate how much cash the investments will generate each year as mortgage borrowers continue to make their payments, then adjust those cash flows based on the interest rate a buyer would demand to be paid for taking the risk.

This method, used by some stock and bond investors, would allow the government to estimate the value of the securities and perhaps pay a reasonable price, which the market is unable to pay due to excessive fear of the unknowns, he says. "If the government sells when things start calming down, taxpayers might end up winning in this one," he says.

The drawbacks: Not having an active market to indicate what the securities are worth isn't the only challenge. There's also the problem of not knowing just how high the delinquency and foreclosure rates will ultimately be on the securities, Maltbie says. The delinquency rate on mortgage loans finished the second quarter at 6.4%, and the foreclosure rate was 2.75%, according to the latest data available from the Mortgage Bankers Association. It's unclear how ugly things could get, Maltbie says. During the Depression, Maltbie says, the delinquency rate ended at 27% and the foreclosure rate at 10%.

Even if the current crisis gets as bad as the Depression, Maltbie estimates, the loans the government is taking over would ultimately be worth closer to 80 cents on the dollar. And since the government can be patient and hold the securities rather than dump them at the same time and drive down the price, there's a greater chance taxpayers will get that value back.

But the cost in the short term is unavoidable, as the government is forced to borrow more to cover the losses. Maltbie estimates that the price tag will end up being $300 a year on average per taxpayer for the next 10 years if taxpayers are left holding the bag and there is no workout or resale of the mortgages. And that's the decision that Congress — and the Treasury — is wrestling with now.

Here are his specific comments on pricing liquidity risk:

There is a way of pricing liquidity risk which is not market based. By definition, the value of the liquidity risk for an asset in a given portfolio is equal to the expected loss on operation (and any others) upon the inability to sell a given asset.

For example, if CDP is not able to liquidate enough assets in a quarter of 2018 in order to pay for retirement benefits, it must borrow the money for a short-term... to my knowledge this is how liquidity risk is priced from the market makers. This risk is very specific to individual portfolios and institutions but it has an upper limit... the commercial paper rate!!!

Another comment... if they want to price it, they just have to do it like the market does... Fix yourself an IRR (internal rate of return) by risk group... and solve for the purchase price that gives you this IRR!!! Basic!!!

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