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Perverse Incentives

We've had a cautious eye on Clusterstock since our old friend John Carney went over there to do "mature work." (It better pay better, because where's the fun in that?) Seems voyeuristic of us though, doesn't it? Spying on our old friend's new digs? That's why we only read Henry Blodget's pieces. (We kid, we kid).
Yesterday, Blodget penned a mostly insightful piece on Warren Buffett's bailout take. Blodget points out:

Warren Buffett, meanwhile, thinks the appropriate price would be the "market value," which he believes is below the price at which the banks are currently carrying their trash:

[If] they do [the bailout] right, I think they'll make a lot of money.... They shouldn't buy these debt instruments at what the institutions paid. They shouldn't buy them at what they're carrying, what the carrying value is, necessarily. They should buy them at the kind of prices that are available in the market. People who are buying these instruments in the market are expecting to make 15 to 20 percent on those instruments. If the government makes anything over its cost of borrowing, this deal will come out with a profit. And I would bet it will come out with a profit, actually...

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Buffett has it right on the money, but misses a practical aspect of the issue, likely because Buffett is beholden to his shareholders, and Paulson & Co. (not to be confused with the hedge fund of the same name) are instead trying to avert a collapse. The former requires actors to turn a profit. The later likely requires the exact opposite. It is easy to suspect that Paulson knows that too much "honest" price discovery will actually precipitate even more massive markdowns as the transactions with the Treasury trigger mark-to-market adjustments in like instruments. For every dollar the Treasury pays under the current marks, is, in a sense, being pulled out of the book value of the seller. It probably also pulls some multiple out of the asset side of the balance sheets for institutions with similar instruments that also have inflated marks. What good will a 20% return on $600 billion be if the Treasury puts 4-8 more institutions in receivership to get it? How would Joe Sixpack regard the appearance of profiteering by the Treasury at the expense of privately held firms? Probably with glee, in the current anti-capitalist environment, actually.
This nuance, however, stabs at the heart of the issue. Mark-to-market accounting incentivizes markets to go illiquid when asset prices sink, exactly when liquidity is critical. You create an environment where an institution isn't just poised to lose the difference between their current mark on the instrument they are selling and the transaction price, but a large multiple of that as that transaction triggers markdowns on the rest of the toxic paper. How do you handle that as a institution holding sludge? Wait. And if you see some sludge that is offered so cheaply that you couldn't normally resist buying it? Wait, if you are holding similar assets. Liquidity has been frozen up to prevent revealing that many of these institutions might be insolvent at the current market prices. That's the kind of thing that is going to happen when the institutions likely to go insolvent control most of the liquidity.
In general, huge corrections like this usually only reverse when prices get so low that value investors and their ilk creep out and cant help but start buying. The problem here is that there isn't enough price discovery to tempt them out, or that the normal buyers (Goldman, etc.) face mark-to-market triggers that prevent them wanting any transactions at all. Buffett seems mercifully free of both constraints.
I suppose that leaves the question: If it takes the Treasury manipulating markets into inflated price discovery to solve the twin problems (liquidity and solvency) that are gumming up the works, do we hold our noses and let it happen?