Bernanke Tosses Script, Discusses Asset Pricing

You’ve got to give Federal Reserve chairman Ben Bernanke his due; the man isn’t afraid to leave the comfort of a prepared speech behind, a point he proved on Tuesday’s Congressional testimony, perhaps the most important testimony of his tenure thus far. The Fed chief ditched his prepared remarks to the Senate Banking Committee in order to discuss instead critical pricing issues surrounding the Treasury’s proposal to buy up distressed and impaired assets from U.S. financial institutions. A transcript of his improvised remarks is available at Rueters. HW’s sources have repeatedly suggested that asset pricing will by far be the single largest hurdle faced by the historic financial bailout authority being sought by the Treasury, whether whole loans or mortgage-backed securities and related derivatives. Billions — and perhaps trillions — of dollars’ worth of impaired mortgages and related securities are clogging up balance sheets of nearly every major financial institution in the U.S., and pricing is the single largest hurdle preventing an easy clean-up. That’s not an issue unique to the government; it’s an issue for private market participants as well. HW’s key sources have repeatedly cited a gap between what banks can (or are willing to) sell at, compared to what many would-be purchasers are willing to pay. That disconnect exists for various reasons, of course: purchasers have a need to buy at fire-sale prices to provide a return, while some sellers end up unfairly low-balled on some offers given investor knowledge of a seller’s financial distress; many banks also simply can’t sell their illiquid assets at the price points being pegged by investors, since doing so would create a steep capital challenge in an environment where fresh liquidity is hard to come by. Other banks believe the so-called “intrinsic” or “fundamental” value of illiquid assets isn’t reflected by current bids. It’s a challenge Bernanke clearly is aware of, from his remarks — although his remarks did little to suggest that the Fed or Treasury have a solution drawn up. “I believe that under the Treasury program, auctions and other mechanisms could be devised that will give the market good information on what the hold-to-maturity price is for a large class of mortgage-related assets,” Bernanke. “If the Treasury bids for and then buys assets at a price close to the hold-to-maturity price, there will be substantial benefits.” Bernake argued strongly against pricing assets at a fire-sale price, suggesting that doing so undervalued the assets in question and would unduly damage liquidity at ailing financial institutions — and, obviously, part of Bernanke’s plan is to recapitalize said institutions, not force them into insolvency. He also said that any Fed purchase at a value above current market prices will allow other financial institutions to value assets they don’t sell, without being forced to use fire sale prices. But he also cautioned that buying at the fundamental value of mortgage-related securities will be hard to do. “To make this work, we do need flexibility in design of mechanisms for buying assets and from whom to buy,” he said. “We do not know exactly what the best design is. That will require consultation with experts and experience with alternative approaches.” One such approach may be a so-called “reverse descending clock auction,” as covered in a recent Reuters/Hedgeworld report. A description, from the report: “Through that process, the government would announce a target for how much of a particular security it is seeking to buy in dollar terms, and an initial buying price. Sellers would indicate how much they would sell at that initial price, and if there were too many sellers, the government would lower its price until the amount of securities that banks are willing to sell equals the government’s target.” “I’ve conducted dozens of these auctions for assets valued at billions of dollars, and they are extremely effective in determining a competitive market price,” Peter Cramton, a professor of economics at University of Maryland, told the news service. While he did not discuss specifics of the auction format with legislators, Bernanke did say he believed the Treasury can establish what he called “reasonable hold-to-maturity prices” for many mortgage-backed and related securities through an auction process, currently stuck in the Level 3 asset bucket at many financial institutions. Here at HW, there seems to be no shortage of ideas on how to derive a value for such assets: we’ve been inundated with requests from collateral valuation and ABS/MBS pricing data providers asking us how to pitch their services to Treasury officials, if that underscores the likely effect of the legislation here — instead of pitching services to servicers, as has long been the industry norm, many companies in the default and collateral risk space have quickly realized that the entire industry may soon be answering to one boss. (And for those firms contacting us: while we’re sure you do amazing work, keep in mind vendor selection is a managed process for government contracts.)