Is it a rescue if you don’t overpay?

September 23, 2008 at 6:24 am | Posted in credit, economics, Housing | 1 Comment
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There are various rescue proposals out there. The Paulson plan has run into some serious opposition, with Congressional Democrats offering alternative suggestions. I believe whatever solution is implemented, it must overpay for the assets acquired, and thus, there will be losses in the $700B (or whatever) real estate fund. The question is – how bad will the losses be?

But the fundamental question is- Is this credit crisis a liquidity crisis, or a solvency crisis? I think it is increasingly obvious this is a solvency crisis.

Say you put in $10, borrowed $90, and invested the whole $100. But a couple of investments went bad, and the $100 is now worth just $80. What do you do? You have assets worth just $80, and owe $90. Borrowing more won’t help – If you borrowed $10, you would have $90, but would owe $100. You could sell some of the assets, but if you sold half and used the money to pay off your creditors, you would have assets of $40 left, and still owe $50.

How does one get out of this solvency crisis? Well, either the current owners of the firm put in new money to meet the shortfall, or we get new owners to come in. Or we get a “rescue”. The current owners may not have enough money to meet the shortfall. The current or potential new/ additional owners may not want to put in new money, because they know that the new money will not be invested in something productive that may generate a profit – It will be used to meet the shortfall in what we owe our creditors.

It seems pretty clear that we are in a solvency crisis. Lending money to troubled institutions will, in many cases, only postpone the day of reckoning.

When the US government (or anyone else, for that matter) “rescues” an institution, they are the last-resort savior. So, clearly, they are the highest bidder – they are willing to pay more than anyone else was – for the firm, for parts of the firm, or for some of the assets of the firm, or as a guarantor of some of the assets. They may even be the only bidder.

The government is paying more than anyone else thinks it is worth. But, as we saw, what others think it is worth (the firm or its assets), is less than the debts – thats why we have a solvency problem.

The only way a rescue could work is if the rescuer paid whatever was necessary to solve the problem. In this case, enough above what others think it is worth to close the asset-liability gap.

If the market said the assets were worth $80, and the firm owed $90, we saw there was a solvency problem. The rescuer can solve this problem by basically being willing to pay $90 or more for the assets, allowing the firm to pay off its liabilities and stay solvent. Here, $10 of every $90 the US government spent is a dead loss – unless, eventually, it turns out the market was wrong in valuing the asset at $80; it was really worth more. The rescuer is could buy the asset for $80, but is choosing to pay $90 for the asset as a favor to the institution.

Whatever the final rescue package looks like, whatever securities the rescue fund buys, or invests in equity, or whatever else; whether the fund buys mortgages, or mortgage backed securities, or derivatives, or whatever else – It will all be distressed.

Since the government is only going to buy the junkiest of junk – the stuff that absolutely needs rescuing, the only way a rescue works is if the government pays much more than the market price.


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