A Stitch in Haste

Try to imagine, in an admittedly absurd Swiftian hypothetical, that a speculative bubble in philately has just burst and that the entire stamp collecting industry — including some firms that have been deemed “too big to fail” — is now turning to the federal government for a bailout.

The problem, the government soon discovers, is that the philatelists are carrying portfolios of stamps on their books at valuations that are now clearly inflated, as indicated by current market transactions. So, for example, a rare stamp that a philatelist bought for $10,000 will now only fetch $1,000 on the open market. If the philatelist writes down the value of the stamp, and others like it, then her firm will promptly go bankrupt.

The government has two options (recall that Option 3 — “do nothing” — has been dismissed ex ante as “bone-headed” by politicians and academics, including a winner of the Nobel Prize in Philately).

Option 1 is simply to give taxpayer money to the philatelists — perhaps as loans, perhaps as equity investments, perhaps as subsidies. The “toxic stamps” stay on the firms’ balance sheets, but they are at least in a healthier financial condition and better able to “ride out the storm.”

Option 2 is to buy the toxic stamps from the distressed philatelists and place them in a “bad album.” If and when stamp values recover, the government can systematically liquidate its holdings, thereby recouping some of the money that it paid to the distressed philatelists. Theoretically, the government could even turn a profit.

The problem with Option 2 is that the government must buy the toxic stamps from the philatelists at an above-market price. Otherwise the stamp collectors are in no better position than if they sold the toxic stamps on the open market.

So instead of simply giving a distressed philatelist $9,000 in bailout funding (Option 1), the government can instead buy the toxic stamp (worth $1,000 on the open market) for $10,000 (its now-absurd book value).

The first thing you should realize is that there is no conceptual difference between Option 1 and Option 2. The toxic stamps remain toxic, the distressed philatelists are still recipients of taxpayer funds, and the government is still exposed to downside risk if stamp values decline or even merely fail to appreciate.

The only difference between the two approaches is packaging. To the public, it might seem like Option 2 — the “bad album” — is a more substantive approach than Option 1 — which reeks more openly of “bailout.” Under Option 2, the government is buying a tangible asset, courageously stepping in to replace a free market that is “broken,” and not just “throwing money” at the “incompetent” (or “greedy”) philatelists who got themselves, and us, into this mess in the first place.

And besides, with the “bad album,” there’s always the chance that the toxic stamps are worth “more” than they’re, um, worth — that politicians and bureaucrats will be able to trade stamps more profitably than professional philatelists. Who knows — the taxpayer might actually come out ahead in the end. Or so the politicians tell us.

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Snap back to reality. Yes, this is all farcical in the context of philately. But it’s just as farcical in the context of subprime mortgages:

As the Obama administration prepares its strategy to rescue the nation’s banks by buying or guaranteeing troubled assets on their books, it confronts one central problem: How should they be valued?
…
While the government is considering several approaches to helping the banks, including more capital injections, buying or insuring toxic assets is likely to be a centerpiece. Determining the right price for these assets is crucial to success. Placing too low a value would force institutions selling and others holding similar investments to register crushing losses that could deplete their capital and make it harder for them to increase lending.

Of course, there already is a “right price for these assets” — the market price. The whole point of Option 2 — creating a “bad bank” — is determining how best to distort the “right price for these assets.”

Assigning arbitrary (i.e., false) prices to toxic assets is merely deciding the “right” mix of Option 1 and Option 2. But since Option 1 and Option 2 are, bottom line, the same thing, what exactly is all the noise about?

It’s certainly not about economics. So the only other possibility is that it’s about politics. Bone-headed politics.

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If the philately example is too contrived for you, how about a bona fide, real-world example:

The bond that is trading at 38 cents provides a vivid illustration of the dilemma in valuing these assets.

The bond is backed by 9,000 second mortgages used by borrowers who put down little or no money to buy homes. Nearly a quarter of the loans are delinquent, and losses on defaulted mortgages are averaging 40 percent. The security once had a top rating, triple-A.

Michael G. Thompson, a managing director at the S.& P. group, says his computer models can easily calculate what the bond is worth under different situations. “This is not rocket science, this is straight bond math,” he said. But determining what the future holds is much harder. “We are not masters of the universe who can predict the macroeconomic environment,” he added.

He can’t predict the macroeconomic future, but Timothy Geithner — who can’t even compute his own taxes correctly — can predict it flawlessly?

Who really believes that, besides George W. Bush (and now, apparently, Barack Obama)?

File that, I suppose, under “change we can believe in.”

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As an aside, the record should reflect that Paul Krugman is, for once, exactly right about the absurdity of the “bad bank” proposal. Broken clock, etc. And this in no way excuses his pathetic and unprofessional “bone-headed” tantrums regarding the stimu-pork proposal.

Previously:
–The Bailout, the President and the Fallacy of Intrinsic Value
–Linkfest: Some More Criticisms of “We’re Not Wrong, The Market Is!”

Filed under: Activist Legislators & Nanny Statists, Capitalism, Taxation & Fiscal Policy