What would you pay, sight unseen, for a house that nobody wants, on a hard-luck street where no houses are selling?
That question is easy compared with the one confronting the Treasury Department as Washington works toward a vast bailout of financial institutions. Treasury Secretary Henry Paulson is proposing to spend up to $700 billion to buy troubled investments that even Wall Street is struggling to put a price on.
A big concern in Washington – and among many ordinary Americans – is that the difficulty in valuing these assets could result in the government buying them for more than they will ever be worth, a step that would benefit financial institutions at taxpayers' expense.
Anyone who has tried to buy or sell a house when the market is falling, as it is now, knows how difficult it can be to agree on a price. But valuing the securities that the Treasury aims to buy will be far more difficult. Each one of these investments is tied to thousands of individual mortgages, and many of those loans are going bad as the housing market worsens.
“The reality is that we are not going to know what the right price is for years,” said Andrew Feltus, a bond portfolio manager at Pioneer Investments, a mutual fund firm based in Boston. “It might be 20 cents on the dollar or 60 cents on the dollar, but we won't know for years.”
The troubled investments are not traded on any exchange. The market for them is opaque: Traders do business over the telephone, and days can go by without a single trade.
Not only that, but many of these instruments are extremely complex.
A big challenge for Treasury officials will be deciding whether to buy the troubled investments near the values at which the banks hold them on their books. That would help minimize losses for financial institutions. Driving a hard bargain, however, would protect taxpayers.
“Many are tempted by a strategy of trying to do both things at once,” said Lawrence Summers, a former Treasury secretary in the Clinton administration. As a hypothetical example, Summers suggested that an institution could have securities on its books at $60, but the current market price might only be $30. In that case, the government might be tempted to come in at about $55.
Many financial institutions are so weak that they must sell their troubled assets at prices near the value on their books, said Carlos Mendez, a senior managing director at ICP Capital, an investment firm that specializes in credit markets. Anything less would eat into their capital.
“Depending on your perspective on the economy, foreclosure rates and home prices, the market may eventually reflect that price. But most buyers are not willing to make that bet right now,” he said. “And that's why we have these low prices.”