Will the Geithner Plan Produce True Market Prices?

March 25, 2009

The transcript of the media conference call with Sheila Bair on the subject of the bank bailout is online, and is well worth reading; many thanks to Justin Fox for the pointer. This exchange between Bair and BusinessWeek’s Jane Sasseen jumped out at me:

MS. SASSEEN: So, in other words, are you saying that the prices that will result in this will be much more realistic prices than would result right now, you know, to the extent that there aren’t any buyers?

CHAIRMAN BAIR: Exactly. Exactly right. They will still be, they will be market prices. We’re just trying to tease out the liquidity premium. What’s weighing on market prices right now is that people can’t get financing to buy assets, they can’t get financing to buy assets not many people want to buy, you don’t want to buy. And then you have to hold on to them forever because there’s nobody to sell them to. So, that’s — by providing that liquidity that’s lacking now, we’re hoping to get the prices up to what would really be a true market level.

This is certainly, then, the government’s position: the public-private partnerships won’t be able to pay a premium on the grounds that the FDIC is taking all their tail risk; on the contrary, the toxic assets are simply trading on an illiquidity discount right now, thanks to the lack of available financing. Since the FDIC is stepping in to provide the financing, the prices which come out of this scheme will be reliable market prices.

This I think misses a crucial point: the whole reason why the banks are in such trouble right now is that they provided an enormous amount of low-cost tail-risk financing to the buy-side, in the form of super-senior debt, leveraged loans, and the like. Most of us, looking back on the excesses of the 2005-6 era, reckon that the market price of loans which can be leveraged very cheaply is not a "true market level" at all, but rather something fake and bubblicious.

The fact is that no one with purely commercial motives would ever extend financing against these toxic assets on anything like the terms which the FDIC is making available. So I’m not at all convinced by Bair’s protestations that this scheme is going to be a great means of price discovery.

The government clearly thinks that it needs to inject capital into the banks, in order to prevent a systemic meltdown. That’s fine, but I’d be much happier if it did so transparently, rather than trying to pretend that all of its operations were taking place at true market prices.

Reprinted from Portfolio.com

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