Marcus Cake

Just a quick note on my last post “Beyond terminal US insolvency - bailouts, debt defaults, collapse, receivership committee formed “. The United States government could make a profit on its “bailout”. Bailout is an emotive term that is popular in an environment of fear and uncertainty. The primary fear being that the funds will simply replace losses in financial institutions and be government expenditure. The US government would be buying residential mortgages with an exposure to residential property prices that have a recoverable value in the future. The US government could make a profit. It depends on three things.

Bailout or Investment?
The difference between a bailout and investment in these circumstances will be the price paid, the dynamics between buyer and seller and whether financial institutions need new equity or just liquidity (cash) to continue operating.

Price paid for distressed assets
We have all, ofcourse, hear anecdotal stories four bedroom homes being sold for US$10,000 or even a few dollars. I understand that a portfolio of residential mortgages were sold by Bear Sterns for 20 cents in the dollar recently. My study of economics showed me that property is just like any other asset class. Over longer term cycles, the property assets class can offer zero investment returns for a decade or two and fall 50% from peak prices after a bubble. Is the average US property price likely to fall more than 80%? Japan in the 90s provides a useful insight. New investors can just price in these factors including property maintenance, vacancy rates, rental returns, property abandonment rates into their models. Residential mortgages are a safe and predictable asset class (as a portfolio). A market price can be determined and investors could make significant returns.

Dynamics between buyer and seller
This is interesting. What are the dynamics between the buyer (US government) and seller (distressed or failed financial institution). Are the sellers genuinely interested in acting quickly to save their institutions or could they be belligerent and just roll the dice for a higher price. The sellers could argue for a “bailout” - we need you pay us more than market, otherwise our institution will fail and the economy will lose employment and productive capacity. The buyer (US government) may be the only one with a sincere interest in saving the financial system. Recent delays in passing the bailout package have sent a clear message that bailout funds may not be an “easy” source of money for institutions. The financial institutions have been extremely successful in selling these assets around the world to other sophisticated financial institutions. Will these financial institutions outsmart the government executives? Can the bureaucracy execute good deals fast enough?

New equity or just liquidity
Given the “assets” are assets. There is an opportunity for some good investment returns by the US government (and others). If a financial institution can sell its assets at a significant discount (ie; 20 cents on the dollar), does this save the institution, maintain employment and productive capacity for the economy? Can the institution continue operations? A market price for distressed assets may not allow the institution to survive by providing liquidity (or cash) to continue trading. A bailout pays more than market for an institutions assets to provide new capital to the institution. In our climate of fear, the assumption is that the fund provided by the US government are a “bailout”. The funds could also be an investment.

We should also consider the opportunity cost of poor governance within financial institutions. What else could have been achieved with the capital poorly invested in real estate. More capital has been invested at higher prices. We need a system that encourages counter cyclical investment, rather than more investment at higher prices.

EDIT 7th October 2008: Just a short note to clarify this article. I don’t believe the US taxpayer will make a profit on this bailout. The US government will pay beyond market rates for distressed assets because it negotiates poorly or in response to a perceived/manufactured necessity to “save” financial institutions. If they must spend the money, the US government should pay market rates for the distressed assets and aim to invest the balance as new equity into the financial institution. A bailout bill has been passed, but will foreign investors fund it. The ultimate financier for everything in the US is the foreign investor. Will they buy US bonds to fund the bailout? I wouldn’t, but foreign investors have funded the US in the past. If the money stops, what will the US do?