I asked a friend who knows Wall Street types what price Paulson intended to buy mortgage backed securities at. He said “80% of face value,” which seemed awfully high to me. I asked whether there had been any intention to discount poorer quality pools more than better ones, and the answer was no. My friend agreed that this would reward riskier behavior, even within those institutions with toxic waste to sell.
I asked why anyone would set it up this way rather than taking equity or intervening mortgage by mortgage. The answer was (1) “speed” and (2) “it’s a good approach if you want to avoid responsibility“
But there is a further wrinkle. We know that because of information asymmetry (George Akerlof’s “market for lemons”), if financial institutions can select which assets to sell, they can decide how much profit they want to make (even more so if the purchase price is fixed). But mortgage securities have the peculiar feature that they are not a fixed basket–presumably the Government is only buying slices of income from a pool of mortgages and not the whole mortgage. The result is that the mortgage servicer, who knows a good deal about which loans are good and which aren’t and is in direct contact with the borrower, has an incentive to refinance the good loans to recapture the income stream, while leaving the bad loans in the pool. This may be a reason why the mortgage backed securities are “toxic” in the first place.
I may be missing something in how these securities work, but if this picture is accurate then the paper the government purchases is subject to something like adverse selection even after the purchase. It’s like buying a tank of gas and leaving a siphon in the hands of the seller. The paper may really be completely worthless even if only a few of the mortgages are bad.
I sure hope the oversight and other changes added by the Congress fix some of this. Democrats really have to emphasize that they are making a Bush proposal better and passing it to keep the economy together but it isn’t necessarily what they would have done.
Readers who know better than I are invited to set me straight on this.