Bernanke squares virtuous circle

The logic of the $700bn Paulson plan is that the government should buy toxic mortgage assets from banks at prices higher than the current distressed market prices of these securities, according to Ben Bernanke.

The Federal Reserve chairman said on Tuesday that the proposed government fund could instead buy the illiquid assets at close to their estimated cash-flow based value. In doing so the government would create a new observed market price for these assets that was higher than the current firesale prices.

This would cap mark-to-market losses on these securities for banks and might indeed result in some writebacks of capital for companies that had written down their assets to the prevailing firesale prices. That would set in train a virtuous rather than a vicious cycle.

In effect, the US government would fix the problem of procyclicality embedded in the mark-to-market accounting regime by the back door. It would use its own purchases to establish new prices to which banks would mark their portfolios – prices based on expected cash flow rather than the prices private sector buyers would be willing to pay in the absence of the government scheme.

Mr Bernanke told members of Congress they should think of each security as having two different prices – a "firesale price" and a "hold-to-maturity price". A well-designed government programme could exploit the gap between these prices in a way that allowed both ­taxpayers and participating banks to benefit, he said.

Because of the complexity of the securities, and the uncertainty about the economy and the housing market "today the firesale price may be much less than the hold-to-maturity price", said Mr Bernanke.

This "creates something of a vicious circle" in which banks are forced to mark their portfolios to the current distressed market price, depleting their capital, which forces them to dump assets, pushing the firesale prices down further.

"If the Treasury bids for and then buys assets at a price close to the hold-to­maturity price, there will be substantial benefits," the Fed chairman said.

Banks "will have a basis for valuing those assets and will not have to use firesale prices. Their capital will not be unreasonably marked down." Liquidity "should begin to come back to these markets".

The combination of better information on asset values and removal of some toxic assets from bank balance sheets would "reduce uncertainty and allow the banks to attract new private capital". Credit markets would "start to unfreeze" supporting the economy.

The original words used by the Fed chief suggested that the government might itself estimate the cash flow value of securities and bid at close to this price. However, the US central bank clarified that Mr Bernanke intended to refer to the fact that the price established by reverse auctions and other market mechanisms would be higher than currently observed firesale prices.

In other words, the price at which most banks would be willing to sell to the ­government would be higher than the price at which the most desperate among them have been selling in recent months. Critics of the scheme are likely to argue that the government could achieve the same end ­without spending $700bn by simply changing the accounting regime so these securities are treated like old-fashioned loans rather than marked to firesale prices.

However, Mr Bernanke said "this would only hurt investor confidence" since in the absence of transactions to establish roughly the cashflow based value of these assets "investors would have to trust the internal estimates of banks".

In normal times these transactions would take place between private parties. However, the price at which private sector buyers are willing to purchase is influenced by the prevailing price of risk along a number of dimensions, including liquidity risk. In current circumstances – when the price of risk is very high – this means buying at firesale prices only.

According to this line of thinking, only a government buyer can establish a new and higher set of observed prices close to the cashflow-based value, because only the government remains risk-neutral and is immune to the big increase in the liquidity risk premium.

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