Extreme Measures V and VI; Drop Mark-to-Market; Beg Oil Producers to Rescue Banks

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.

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11 comments

  1. anon

    There’s some sense in considering a variation on marked to market accounting.

    Accounting marks affect capital, capital adequacy, and the real urgency of capital replacement. But the underlying path of actual cash flows will take many months to materialize (or not materialize). In the meantime, there is excessive volatility and maximum pessimism being factored into marks and their effects on accounting results and capital requirements.

    Transparency could still be achieved by disclosing “fair value” without necessarily incorporating it fully into accounting results. With transparent disclosure, that leaves the risk interpretation of such real time fair value to the investor. Historic cost accounting is an opposite extreme, but that seems too regressive and dangerous in the other direction. The best accounting solution would be to somehow smooth out the volatility of the marks in the accounting results, allowing for some reasonable time period for accounting results and capital positions to catch up with the actual cash flow losses, as opposed to forcing an immediate accounting and capital response to illiquid and still opaque asset valuations.

  2. sk


    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.

    That is so accurate in its result, IMO – but I think each particular foreigner class will be more interested in the political/military(will they bomb/protect us ( or our enemies))/trade posture towards each individual THEM then in the posture towards domestics concerns of housing and financial services.

    -K

  3. fmo

    pardon the stupidity.

    if there’s no bid for X, or the bid is way low, so X doesn’t sell, and the guy who owns X dk’s on his mortgage or loan which he’s using to carry it, so the value of his loan should be marked down cause there’s no bid for X, etc

    (think all for the want of a horseshoe nail)

    exactly what is the GAAP or OCBOA value of X please?

    im just a plain folks tax lawyer and quant, but i thought the definition of market value was what a willing seller would pay a willing buyer.

    if thats some fraction of X, gee, isn’t that what it is?

    and if you lower the capital ratio requirements, in a time of stress, gee, isnt that, what’s the word…

    oh yeah

    PROCYCLICAL ie the guy operating with lower capital is even riskier now than otherwise with lower capital so we have to mark down his paper and…

    how come no one understands there’s no solution?

    if the problem is there’s no bid then unless there IS a bid what am i missing ie no way out…

  4. st

    Here’s another extreme idea to avoid contagious bankruptcies. Set up a government body that “buys” contracts in default (i.e. CDS with counterparty failures). The government pays as much as the full (without failure) value of the contract and receives in return from the seller a claim to hybrid capital. This hybrid capital does not need to be paid if the firm is facing financial difficulty, but must be paid before shareholders receive a penny.

    This would achieve capitalization of the firms that need capitalization while carefully targeting the problem of counterparty failure. It may also reduce the panic by making it clear that the financial sector will not be caught in a chain of failures.

  5. st

    By the way, I think the Economist counts as having proposed an extreme measure, too. They argue that governments should put a floor on asset prices. My concern with such a policy would be that, if the situation continues to deteriorate, governments may find themselves in a position comparable to trying to defend a pegged exchange rate when the fundamentals are against you.

    Whatever the governments decide to do, it is essential that they address the fear of contagious failure.

  6. st

    re: 12:06 idea
    To avoid being taken for a ride, the government would have to limit the contracts it would buy to those that were created by a certain date in the past.

  7. Anonymous

    There have been bids for this bad paper. Wall Street simply doesn’t want to accept the valuations.

    JPM put a bid on Bear’s Alt-A paper. The E-trade buyout late last year put a bid on their paper.

    Of course, if Wall Street accepted those valuations, they’re all insolvent today. I think they all should be in receivership this afternoon… but that’s just me.

  8. Anonymous

    Insight into MTM requirements: the wallstreet firms are suffering due to their own actions. it used to be that a firm would buy a security, put it on at cost (held to maturity) and then once it appreciated, mark it to market to recognize the “trading” gain. This manipulation is tiresome to all regulators… and here we are with MTM accounting for their entire portfolios.

    additionally, there are models out there for this stuff and there is information about underlying assumptions imbedded in indices like iTraxx and ABX. Frankly, CDOs and the like were never really “traded” to begin with after they were issued. The only indicative bid was the newest issuance… so if you want to get a good “bid” for a CDO, issue a new one and see what spread a trader will take for it. While there may have been some seasoned trading in the structured finance market, the most volume was in new issuances. Why would I buy something that has started to show wear and tear when I can get a fresh new one.. now you can’t get a new one, so you are wondering what the old one is worth… oops!

    The fundamental problem is that there is too much leverage and too much borrowing short and going long (didn’t we learn from that in the S&L crisis?!?!? SIV what!??)

    And if you look at why people did that, it all flows back to compensation. When compensation is not in sync with risk management, you will have a biased view of potential profit and you will take on more risk than you expected. Additionally, without real skin in the game (mortgage originators) you won’t care what happens down the line. It happened at Enron as well (30 year power projects = big bonus today = retire early -> watch the project fail because you underestimated cost).

    The extreme measure that needs to be taken is to let all of this wash out of the system. Mortgages typically run 5-7years. About a year more of this and we’ll be back on solid fundamental footing. Absent an economic disaster like a war in Iran… that is.

  9. Anonymous

    fair value has always been disclosed for all financial assets and liabilities. check the 10-K, “fair value balance sheet” usually near the end of the footnotes.

    has always been there.

  10. Anonymous

    Yves,

    It seems that many people are saying that part of the problem here is lack of transparency. Somehow the published financial statements of major financial institutions that are prepared in accordance with GAAP are not giving the markets enough information to allay concerns about counter-party risk. Since you have opened the door for “extreme solutions,” what would happen if the government required all the major regulated financial institutions to disclose in complete and excruciating detail all of their portfolios and trading positions, leverage etc. – all of the information available to their internal risk committees or the federal regulators – as of a certain day, say the last day of March? A national “open kimono day,” if you will. I guess this is really a thought experiment, not a serious suggestion. But I wonder, would this kind of “extreme disclosure” help alleviate unfounded concerns about counter-party risk? Or would it be insanely risky? If there are major insolvent institutions out there, do we even want to know?

  11. Anonymous

    At the end of the day all these bail outs leave something very important off the table-the American Consumer cannot service their debt, they do not get it for some reason. All this FED mojo and still the basic underlying issue remains-American SFH and soon commerical RE is overvalued, leveraged beyond its fundamental value and the folks holding the mortgage paper are basically insolvent.

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