Bailout,” “rescue,” call it what you will: Congress this month created a huge new buyer of toxic assets, and that should drive prices higher, right?
Maybe not. Or maybe not just yet. Prices of nonagency mortgage-backed securities ticked up when rumors of the $700 billion government fund first surfaced, and went even higher when the Treasury announced details of its original proposal. “Trades that were short Treasuries versus the other high-grade markets worked well,” says Daniel Dektar, chief investment officer at Durham, North Carolina–based Smith Breeden Associates. “It signaled that we were headed for a more inflationary future and less likely into a depression.”
Nobody knows what price the government will pay for securities under the Troubled Asset Relief Program, however. Treasury Secretary Henry Paulson Jr. and Federal Reserve Board chairman Ben Bernanke talked about something less than face value but above today’s market price — a wide range for triple-A-rated subprime mortgage-backed securities that in October, when the bailout was announced, were trading at 50 to 60 cents on the dollar, never mind the lower-rated tiers trading below 10 cents on the dollar.
“TARP will bring some stability in the marketplace, but it’s going to take time,” says Stephen Vogt, chief investment officer at Chicago-based Mesirow Advanced Strategies. “It’s not an overnight fix.”
Some order may be imposed now after the government’s move to spend up to $250 billion of the $700 billion to acquire equity stakes in banks. The right price may depend on how the securities are valued on the sellers’ books. Accounting rules require investment banks to write down these assets to market value, though prices quoted for valuation purposes don’t necessarily reflect what a cash buyer would pay. By contrast, commercial banks often place these securities in “hold to maturity” portfolios that do not have to be marked to market. Although there have been some write-downs, book values are still higher than current market prices, according to Ajay Rajadhyaksha, New York–based director and head of U.S. fixed income and mortgage strategy at Barclays Capital. A government purchase at book value bolsters liquidity, but only a purchase at a premium to book will shore up a bank’s depleted capital base.
Suppose an investment bank uses $75 for the “fair value” of a mortgage-backed security that a commercial bank books at $85. If the government buys the bonds at $75, then both banks get badly needed cash but the commercial bank must report a $10 hit to capital — the opposite of what the government wants (the commercial bank needs more capital, not less, to stimulate credit creation). If the bailout fund pays $85, the investment bank gets a $10 capital injection, but the commercial bank needs $95 to realize the same boost. “It is a capital issue, not just a funding issue,” explains Rajadhyaksha.
Meantime, the prospect of renewed liquidity and fresh capital for banks weighed down by losses in mortgage-related credit did not, as hoped, immediately ease pressure in the short-term money markets, forcing the Federal Reserve to step in on October 6 as a buyer of commercial paper. Against that background a surge in the mortgage-backed securities market isn’t in the cards, and in any case the government fund can’t buy anything until the Treasury hires asset managers to run the program. Troubled firms have to opt in too — something senior executives who would face limits on compensation are likely to resist.
