Question du Jour on the Über-Bailout

Francis Cianfrocca wrote on RedState:

So the most important questions for Paulson are: What will be the value at which you will purchase these distressed assets? Who will make the decision, and how will they be compensated?

These are the critical questions because they illuminate the underlying policy objective.

Does Mr. Paulson intend to systematically purchase MBS at higher prices than current market values would suggest?

This would save Wall Street’s bacon. A great many firms would be relieved of the burden of their past errors and mismanagement, and would get a fighting chance to stay in business and attract new capital.

Is that fair and right? No, it’s not. It would also put the taxpayers in a position to absorb Wall Street’s losses, through higher taxes, higher inflation, or both. (Politically, of course, this is dynamite.)

I saw this and got to thinking: folks like Francis may be basing part of their objections on a bad assumption.

There seems to be a perception among some that if Paulson were to buy toxic liabilities at/below current market value, while it would stop the hemorrhaging from the balance sheets of the entities that own them, it wouldn’t do much to improve those entities’ fiscal soundness…other than, perhaps, reducing future volatility.

A complementary assumption being made is that Paulson might buy the troublesome securities at more than market value, “overpaying” for them and essentially creating a handout to the holders of those securities.  That is not perceived as fair.

However, there is a problem with that assumption.  It relies on a belief that in a free market, the market value of an asset reflects its real value.  Unfortunately, that belief/theory holds true only in a purely rational market.

Folks, if you haven’t noticed yet, let me let you in on a little secret – the market ain’t always rational.

I think it could be argued that these toxic assets’ lack of value in the market is in no small part due to investor’s somewhat justified hysteria over recent developments with such instruments.  It is not unreasonable to expect that an entity, with a greater tolerance for (or lower cost of) risk, might value these derivatives at something closer to a “true value” equal to (1-probability of default) × (nominal value) × (discount for time-value of money).

In theory, the U.S. Government is infinitely tolerant of risk.

So putting the pieces together, I see potential that the feds could buy off the problem assets from impacted institutions at an amount greater than hysteria-influenced market value, but still less than that true value mentioned above.

As long Paulson does not exceed that true value amount, I can easily imagine that the fed could pay more than market value for those assets, but still be honestly said to be getting a good deal,