A sign of the times: we haven’t sighted an Extreme Measure since October, and here we have two in one day (note that day was Thursday; we started on this last night but there were so many news-driven items that we are getting to this only now).
By way of background, an Extreme Measure is a recommendation to take a radical and, upon examination, unworkable approach to a pressing problem. Not surprisingly, the Extreme Measures have attempted to address the US housing crisis or the credit contraction.
The first was from Bill Gross at Pimco, who suggested that the US government “rescue” the 2 millionish homeowners who stood to lose their homes. A second came from Gillian Tett, the capital markets editor at the Financial Times, who argued that investment bankers should decompose CDOs and other structured credits into their constituent parts. Third was an article by Cambiz Alikhani of Arundel Iveagh Investment Management in the Financial Times, “Banks should form a bail-out vehicle to ease the credit crisis.” The last (till today’s outcropping) came from Sheila Bair, chairman of the FDIC, who proposed that mortgage servicers freeze all adjustable rate mortgages facing resets at their current rates.
We got a little cautious after the Bair sighting, because, as ridiculous as it was, it was actually implemented in a sufficiently watered-down form as to be cosmetic via the New Hope Alliance program announced with much fanfare last December. And we must also note that while the particular proposal by Gross has not gotten any traction, the idea of somehow bailing out beleaguered homeowners is very much alive and well. That signaled that we may be entering a phase in which as Financial Times columnist Lucy Kellaway said regarding management fads, “No idea is too ridiculous not to be put into practice.”
The normally sensible Paul De Grauwe . This first part of his article argues that solvency and liquidity issues can’t be easily picked apart:
This interconnection between liquidity and solvency problems is em bedded in the activities of banks and financial institutions that fund long-term investments with short-term loans. Withdrawals trigger solvency problems, which in turn become signals for further withdrawals, creating liquidity problem
While this statement is true, when most commentators argue that the current credit crisis is a solvency, not a liquidity crisis, they are not referring to financial institutions, but the underlying borrowers, in particular overstretched homeowners who cannot make their mortgage and consumer loan payments. Thus to shift the focus to solvency versus liquidity at an institutional level is because they hold bought assets that are now overpriced due to the deterioration in creditworthiness.
The failure to acknowledge the problem with the underlying holdings is where his argument runs afoul:
Today the accounting rule of marking to market is driving us at high speed into the abyss. A speed limit must be imposed. It can be achieved only by temporarily allowing financial institutions not to mark to market. This will make it possible to keep the assets on their books for a while at their previous values (or historic costs). If this is done, the spiral will be slowed down. Prices of many financial assets will recover because they are fundamentally sound. Their value is artificially pulled down by the liquidity-solvency spiral.
Slowing the spiral will prevent more innocent bystanders from being caught by the whirlwind. It will, of course, not solve all financial problems. Confidence in the financial system must be restored so that the market can start co-ordinating again towards a good equilibrium.
As nice as this sounds in theory (and De Grauwe isn’t alone in advocating this idea), it won’t provide the desired benefits. Yes, it will put brakes on troubling “financial accelerator” by which writedowns lead to balance sheet shrinkage which leads to further deleveraging (witness tougher margin requirements imposed on hedge funds, which leads them to deleverage, or sell assets, and some of the selling may depress prices of assets held on balance sheets elsewhere to lead to further margin calls and/or writedowns).
But there is no obvious way out of this box, for the cure is as bad as the disease. The first and second acute phases of the credit crunch (August-September and November-December) occurred because banks were hoarding liquidity and were reluctant to lend to each other. In crude terms that was because they perceived risks to be high (hhm, wonder why, probably the state of their own finances) and couldn’t tell who was sound and who wasn’t, therefore no one could be trusted very much.
Less transparency will only make that worry even worse. It might alleviate the pressure in certain sectors of the market where lending is collateralized (ie, among brokers and hedge funds) but will exacerbate the interbank worries. And it will send a bag signal to the greater world, that things are so bad that the rules have to be suspended. This will deter outside investors from recapitalizing troubled firms, since they won’t trust their books.
We also have the recent and painful experience of Enron and other accounting fraud at corporations, something that simply never took place before on such a large scale basis (at least after the securities regulatory framework was established in 1933 and 1934). While mark to market is far from ideal, the alternatives are worse.
John Dizard suggested “regulatory forbearance” which is a fancy way of saying let firms operate with less capital than the regs normally allow. That’s a simpler and more easily reversed finesse. And he also indicated that the powers that be are working on a :
I have made enquiries in the relevant official circles about the state of thinking on the enforcement of mark-to-market rules. While the central banks are not inclined to suspend the rules, they are having meaningful discussions with the accountants about their application, if you get my drift. Basically, for straight corporate credits, including the merger and acquisition loans, mark-to-market of the tradeable securities will stay in place. However, for structured credits, such as CDOs, where valuations are being done on the basis of illiquid and arguably oversold indices, the accountants would be encouraged to find ways to value the securities that don’t result in a cycle of mark-to-illiquid-market followed by liquidation, followed by more marks, and so on.
The other Extreme Measure comes from Anil Kashyap and Hyun Song Shin, “.” While the US will probably eventually be bailed out in whole or in part by foreign investors, the timing is seriously off. Too many high profile players were badly burned in last fall’s round of equity infusions; prices will have to at least look like they have bottomed before anyone is likely to step forward again. China’s Citic having barely avoided putting $1 billion in Bear Stearns no doubt has instilled much more caution. Remember, these players are governmental entities, so avoiding losses is far more important than maximizing gains.
In fairness, the article does provide a good analysis of why other routes to recapitalize banks don’t look so hot. But its ideas regarding Middle Eastern investors can only be regarded as fuzzy-headed:
But since the January meeting of the Fed’s open market committee, when the central bank made it abundantly clear that it will try everything possible to stave off collapse, oil prices have risen from roughly $92 a barrel to $109 (as of March 18). Other commodity prices have also risen over this period. Given the deteriorating prospects for the global economy over this time, a plausible interpretation is that some of the financing that might have gone to the financial institutions has instead been directed towards buying commodities such as oil. This portfolio reallocation represents a pure windfall for the oil producers.
Middle Eastern oil countries produce roughly 25m barrels of oil a day. If they could be persuaded to recycle $4 a barrel of the $17 price run up since the January Federal open market committee meeting, this would represent $4bn of capital that could be deployed; Bear Stearns was sold for $250m. Admittedly, this is a conversation for Condoleezza Rice, secretary of state, and not Hank Paulson, Treasury secretary, to have.
$4 billion? What are they smoking? Banks have taken over $150 billion of writedowns so far, with more to come. $4 billion is a rounding error. And par for the course, the authors conveniently neglected the Fed’s $30 billion first loss position in the Bear deal. That $4 billion is an order of magnitude too little.
Plus the idea that special pleadings by a lame duck administration will succeed is also quite a stretch. Bush and Cheney can’t get the Saudis to pump more oil, so why should Condi be able to persuade them to write checks? I doubt any foreigners will stump up much cash until they see who the new occupant of the Oval Office will be and have a sense of his or her posture towards housing and the financial services industry.