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Bernanke Signals U.S. Should Pay More for Bad Debt

By Craig Torres and Kathleen Hays

Sept. 23 (Bloomberg) -- Federal Reserve Chairman Ben S. Bernanke signaled that the government should buy devalued assets at above-market values to make its proposed $700 billion rescue package most effective in combating the financial crisis.

``Accounting rules require banks to value many assets at something close to a very low fire-sale price rather than the hold-to-maturity price,'' Bernanke said in testimony to the Senate Banking Committee today. ``If the Treasury bids for and then buys assets at a price close to the hold-to-maturity price, there will be substantial benefits.''

Bernanke's remarks, an unusual departure from his prepared testimony, come as lawmakers and the Bush administration negotiate a rescue plan aimed at easing the worst financial crisis since the Great Depression. The Fed chief said paying prices higher than the bad assets would fetch in the open market would help ``unfreeze'' credit markets and aid the economy.

Analysts said Bernanke is essentially advocating that government use a pricing model that assumes that the debt will be paid in full over a long period of time. That is different from the mark-to-market model used by investment banks that prices assets at what they are worth on a given day.

The risk is that the model does not provide transparent pricing of the assets taxpayers are taking on, said Ann Rutledge, partner at R&R Consulting in New York, a firm that specializes in structured finance. Many of the securities ``are not going to pay at maturity,'' Rutledge said.

Housing Recession

Nearly one in 10 mortgage loans are in default or delinquency and house prices have fallen for eight consecutive quarters, according to the S&P Case-Shiller Index. Paulson and Bernanke are betting that the asset purchases will free up lending and break a self-perpetuating cycle of tight credit leading to lower home prices and more defaults.

``Under the Treasury program, auctions and other mechanisms could be designed that will give the market good information on what the hold-to-maturity price is for a large class of mortgage-related assets,'' Bernanke said. There are ``substantial benefits'' to buying assets at a cost close to the ``hold-to-maturity'' price, he said.

Treasury Secretary Henry Paulson, who with Bernanke urged lawmakers to act on the plan quickly to address investor concerns at the deepening crisis, said the ``major focus'' of debt purchases would be mortgage-linked assets.

Seeking Flexibility

Paulson rejected an idea floated by Democratic Senator Sherrod Brown of Ohio for banks to retain some portion of the asset they sell to the Treasury.

``I don't think that that would be a successful way to deal with something systemically,''
Paulson said at the hearing.

Bernanke opposed efforts by banks to lobby regulators to remove mark-to-market pricing in their portfolios. A suspension of such accounting would hurt investor confidence, he said.

Anne Canfield, executive vice president at the Consumer Mortgage Coalition, an industry group representing mortgage lenders and loan-servicing companies, sent a letter to Treasury officials yesterday evening saying the bailout plan ``will only be successful if it leads to substantially higher prices'' for mortgage assets, according to a copy obtained by Bloomberg News.

``In past bailouts (Brady bonds, etc.), discounted Treasuries (zero-coupon bonds) have been used to create the perception that principal would be fully repaid,'' Canfield said in a letter to Acting Treasury Undersecretary Anthony Ryan and David Nason, an assistant Treasury secretary. ``Under mark-to- market rules it is more difficult to create such perception.''

Letter to Treasury

Treasury spokeswoman Brookly McLaughlin wasn't available for comment.
Merrill Lynch & Co. in July sold more than half of its mortgage-linked collateralized debt obligations for about a fifth of their original price, setting a price for those securities at that time.

Bernanke's remarks today indicate he favors paying above the market rate. ``We cannot impose punitive measures on the institutions that choose to sell assets,'' the Fed chief said today. ``That would eliminate or strongly reduce participation and cause the program to fail.''

``They are basically saying, `Let's take a best-case scenario, let's assume we don't have losses,''' said Julian Mann, vice president at First Pacific Advisors LLC in Los Angeles. ``Home prices continue to deteriorate. There are real losses here.''

Political Shield

The pricing method Bernanke is advocating would also provide a political shield, analysts said. Congress wouldn't be able to see if prices fell during a quarter, nor would they be able to push the Treasury to sell if they saw the value of the securities rise. That would also protect the market from the sense of an overhang if in fact the government did acquire a $700 billion pool of mortgage-related assets.

``The plan allows you to hold the assets off the market,'' says Bradley Hintz, former chief financial officer at Lehman Brothers Holdings Inc. and now an analyst at Sanford C. Bernstein & Co. Inc. It treats the Treasury as ``an investor with a perpetual life span, an infinite amount of money, and no commercial interests.''

Does "hold to maturity" suggest "no default?" I don't think it does; and therefore the idea doesn't imply "best case scenario" as one commentator is quoted in the article as saying.

Since Bob has connections with people who know Ann Rutledge, maybe he can get some clarification on this. ;)

It sounds like Mr. Bernanke is suggesting that the assets be purchased at "fair value" (assuming it can be approximated). But something in human nature seems to demand a putative, market distorting price. Questions of punishment aside, it seems the market is not done any service at all -- either here or abroad -- by a fire-sale transaction.

And speaking of "abroad," it's apprarently another "villify America" fest at the UN.


Faculty (Undercover)
Thanks--this is priceless. Nice to see Ann being quoted here, too, since Sylvain is the one who gets most of the press.

Wasn't aware that they were paying even above-book for these things. I can see why the Senate is balking. That sounds like a terrible idea to me.

Some random political-ish thoughts to add to this:

(1) Won't there be a bad smell when foreclosures happen in pools backing securities owned by the bailout vehicle? Imagine the headlines: "Federal Government Repossesses 20,000 Homes." Then they'll quote the amount recovered on those transactions. "Feds Bail Out CEO's, Kick Out Sick Children." Good times for reporters everywhere. Bad times for the elected officials who have their names associated with it.

(2) The market "correction" basically reversed McPain's gains after the Republican convention. A bailout now, if it fixes the markets (even in the short term), takes away Jobama's main campaign advantage. A market rally is exactly what the Democrats don't want right now, even if it opens them up to charges of obstructionism. There'll still be room for Jobama to claim that they're in favor of the plan, and it's just the political establishment blah blah blah hooey hooey.

(3) This is very risky business, and there is really no cover available. Even the guys who cooked it up aren't conveying certainty that it will work. So you're stuck between being seen as doing nothing while Rome burns, or throwing almost twice the current Federal Budget deficit on the fire and hoping that puts it out. They may be politicians, but they're serious people. Something like this, if the market tanks anyway, could be a big problem for them personally in the short-term, and a big problem for the country going forward.


Faculty (Undercover)
Does "hold to maturity" suggest "no default?" I don't think it does; and therefore the idea doesn't imply "best case scenario" as one commentator is quoted in the article as saying.

Since Bob has connections with people who know Ann Rutledge, maybe he can get some clarification on this. ;)

It sounds like Mr. Bernanke is suggesting that the assets be purchased at "fair value" (assuming it can be approximated). But something in human nature seems to demand a putative, market distorting price. Questions of punishment aside, it seems the market is not done any service at all -- either here or abroad -- by a fire-sale transaction.

And speaking of "abroad," it's apprarently another "villify America" fest at the UN.
I haven't spoken to Ann about her (no doubt cruelly abbreviated) comment in this article.

However, I have a feeling that the "other mechanisms" referred to here may somehow bear a resemblance to the "other mechanisms" that led to this whole business in the first place. I especially love this auction idea. That's a laugh. Citigroup bids on something of BofA's, then BofA bids on something of Citi's...very cozy. The only thing missing is having S&P on hand to pour the champagne.

My feeling is still that you pay the fire-sale rate, but lend in such a way that it gives the holder enough breathing space to either (1) mark the securities down in an orderly--and gradual--fashion if they are in fact crap or quasi-crap, or else (2) realize some share of the gains that come from their portfolio outperforming the market valuation over time.
I'm not a guy who takes pleasure at CEO's being fired or children left homeless, but I do read history and I was an adult to see the Japanese bubble in real estate and equities last for over a decade in the 90's. Both of those asset classes in Japan ended the decade at about 25% of their original value at the bubble peak in the late 80's.

We in the USA were quick to point out to the Japanese that our economy did not suffer the same fate as theirs as we were quick to take our pain, absorb the loses, and resell the bankrupt assets to new owners with productive intentions. In other words, we did not tie up our capital and human recourses on underperforming assets as they did in trying to protect private companies and jobs with immense government programs and spending. In terms of measurable economic statistics we had the better time of it in the last 15 years by far.

As US citizens, whether we are actively involved by supporting the process, or on the sidelines listening in disbelief, we now have the government intervening to save private financial companies "for the good and welfare of all" in complete reversal of our strategy of the 90's. I wonder if the "people" understand by intervening in such a forceful manner we are likely prolonging the time period of the adjustment as well as diverting financial resources to activities that might no be the most productive choices available.

I know the world will go to hell quickly if this is not done, but I just can't help thinking that one class of citizens (and their children) are paying for the sins committed by another class of citizens! I personally prefer the AIG "save" where the government can get majority equity for their investment that can be sold later then picking up "assets" at above market prices to help the companies stay afloat. If I were a auto worker, I'd be marching to Washington to ask for my slice of pizza!
I just want to add that, in my opinion, Bernanke's remarks seem so politically naive because he's not grinding a political axe. He's a student of economics and particularly of crises (having authored, they say, the authoritative study on the Great Depression).

This is why I didn't dismiss or immediately discount his remarks -- especially as "quoted" by Bloomberg -- while I might have if they were coming from, say, a congressman.

I presume his good judgment of the role of a central bank in a crisis, and his remarkable understanding of market mechanisms, is worth paying close attention to.


I suspect that a diligent effort to establish a fair value for the assets in question on the part of the Fed would not only immediately alleviate paralyzing uncertainty in the market for those assets (and thereby allow the markets to come alive again) but will also prevent further artificially low marks and the potential for further market dislocation that would entail.

Putative actions apply directly to actions that are taken to keep individual firms afloat, but the salvaging of an entire market is another matter entirely. One of degree, perhaps, but a different proposition nonetheless. In the case of the latter, it seems the obligation is to establish fair value, not to distort it.
I've been watching the testimony of Mr. Bernanke. The man has the patience of a saint. These...individuals... in congress don't seem to grasp markets. Some are really off the wall, and are using their time allotments for political rants.

Meanwhile, the fire in Rome is being barely held in check... and as usual, even that is "Bush's fault."
Thanks to Bob's fresh politish perspective again.

I think Big Ben is better off going back to Princeton and write his books instead of being caught in the cross-fire of a political tussle; he didn't help out much anyway in yesterday's testmony where Hank took all the heat and questions while trying to desperately save his buddies on the street, in GS maybe to be more specifically.

Congress man may not grasp the idea of the market, but who did? those who led people down this road?

It may be true that average people can not see or grasp the altitude of this crisis like Hank and George, but at least those congress man still (and maybe hopefully) had a grasp of what "common sense" means, for whatever reason, and maybe the simplest common sense can lead us to navigate out of all these.
The executive branch is asking the legislative branch to act. It's the separation of powers at work. It ain't always pretty, but, like any other market, it works when everyone shows up and does his part faithfully.
It would appear that balance sheets (of protection sellers) that contain written-down CDS on MBS will be looking very much better indeed under the proposal (or anything close to it).