I am in favor of some form of government bailout, and I am also in favor of some major changes in the way that we regulate the banks. But even simple, seemingly obvious changes are trickier than they look.
Mark-to-market accounting, for example, was mandated by Sarbanes-Oxley. The idea was that we wanted to keep companies from playing games with the securities they owned by forcing them to update the balance sheet at the end of the day with the new values.
Seems obvious and good. But mark-to-market was a major factor in the bank collapses. When markets for various securities froze up, the book value of those securities was basically zero, even though many of those securities would eventually pay off. That collapsed the value of balance sheets. This not only panicked investors, but also threatened their credit rating. For a bank, a credit downgrade is death. They borrow a lot of money short term to smooth their cash flows. Also, a lot of regulated entities have strict rules about the credit rating of the institutions they're allowed to lend to. The result is a drying up of capital all out of proportion to the underlying financial condition of the institution.
Or take capital requirements. I'm in favor of higher ones. But a high capital requirement, perversely, hurts companies in a downturn. This sounds bizarre. But say you have a broker-dealer that is only allowed to leverage itself 5 to 1--a very, very safe capital ratio. (12-to-1 is, IIRC, about standard).
Now say that the bank suffers a major setback, like a bunch of totally illiquid mortgage backed security whose nominal value has dropped to near zero. Having a lot of capital protects the creditors in bankruptcy, who now get 20 cents on the dollar instead of six. But the firm still goes into bankruptcy, because they can't dip into their other capital to make good the debts. Indeed, the higher their capital requirements, the more they have to deleverage in a crisis, because they need to unwind more positions to shore up the bad ones they can't sell. That deleveraging dries up capital in other markets, decreases the value of whatever securities they're dumping, and thus threatens other institutions.
This is not a brief for doing nothing. Only a caution that even things that sound simple and obvious are neither.
Copyright © 2009 by The Atlantic Monthly Group. All rights reserved.
This is not a brief for doing nothing.
No, it's a brief for showering 700 billion dollars on Wall Street with no strings attached. That's something, all right.
Let the record show that when it came time to stand up and be counted, Megan McCardle favored privatizing profits and socializing losses.
I'm in favor of a bailout, not this bailout, which I'm so far against.
Systemic problems in capital requirements can easily be managed by just allowing the leverage ratio to temporally be allowed to drift lower. Alternatively, such a limit could be a soft limit where you have a fixed amount of time (say 2 weeks) to lower your leverage instead of overnight.
The problems of hold to maturity accounting are far greater than the problems of mark-to-market accounting. Japan's recent experiences are a glaring example of how holding to maturity and crossing your fingers is a recipe for banks to avoid lending and sorting out their problems.
This sounds like a great time for an "If I were Queen" post.
If you were in charge of things, what sort of bailout package would you put together, Megan?
It's amazing all the problems you run into when the foundation of your fiscal system involves creating money from debt, huh?
I'm not sure what impact market to market accounting should really have here. Pricing a collection of sub-prime mortgages as being worth $0 is extreme but shouldn't the market know that? Shouldn't it know the investment banks whose balance sheet drops from $500B to $5.25 is really worth quite a bit more?
I can understand some stock investors might only read the bottom line but the smart money is supposed to be out there looking deep into the financial statements and whether 'exotic' investments are priced on market to market, or convoluted quant theory, or guess your own price (which may not be different from the previous one)....it's supposed to know that those assets need to be taken with a grain of salt.
Lane Honda, I take the contrarian view debt is the only thing that can ever really be money. When I do work, I don't care about some yellow metal -- what I really want is for someone to do something for me later.
Boonton, that's one of my great confusions in this whole thing; the crisis seems to be demonstrating that the elaborate valuation exercises that you sometimes see for IPOs or mergers are just NY kabuki justifying I-banking fees. Where the rubber meets the road, everyone's just sort of following the herd. Really, WTF? Even I could do that, and I have 1/2 semester worth of finance education (the other half was accounting).
My wife has offered to let me speculate with $5000, so I'm considering finding some CDOs to buy for the hell of it...
This MTM stuff has me puzzled. Not because I don't understand mark-to-market accounting. I have been involved with it for many years in the commodity biz. But my understanding has been that you mark an instrument to market when there is one (a market, that it). When there is no market to speak of, you go to accrual. And even where there is a market, you take a reserve against the MTM value for credit and liquidity, which you recognize over time - essentially an accrual again. What changed? Did SarbOx actually require marking to market even where no market exists?!
It seems ironic to me that many are now calling for marking instruments at some theoretical value (e.g. NPV) rather than market. Back in the days when we were hankerin' to string up Jeff Skilling this was derisively called "mark-to-model". Now we think it's a good idea?
A bank doesn't have to mark everything to market, only parts of its portfolio, among them the trading book. Note that some crammed everything in the trading book to lower capital requirements and are now screaming that marks don't reflect "intrinsic value" or some other such nonsense.
"Did SarbOx actually require marking to market even where no market exists?!"
Pretty much yes. You have to mark to market to whatever extent it actually exists.
The rule was put into place to keep failing firms from limping on and on with speculative assets that aren't really worth anything. The argument was that they were failing so slowly as to be essentially defrauding any new investors that might come along in the last 2-3 years.
The downside of the current rule appears to be that it is forcing otherwise non-failing firms into failure by causing them to rate assets which are clearly worth something as if they were worth essentially nothing because the temporary market is thin.
That is what happened with AIG (and believe me I am NOT a fan of AIG). Their assets are clearly worth much much more than the current mark to market value would indicate. Under the old system they would just not sell any of that stuff until the market recovered. But under the current system, they get severely downgraded credit ratings for holding on to it, which hamstrings all of their other operations.
"The downside of the current rule appears to be that it is forcing otherwise non-failing firms into failure by causing them to rate assets which are clearly worth something as if they were worth essentially nothing because the temporary market is thin. "
This is what's confusing me. Say AIG has a $10B CDO that it has to value at $0 because there's no market for it at that point. Are you telling me Rob Lyman can pick up that CDO for $5,000 his wife lends him? Certainly not.
There's billions of dollars of cash out there. China & the Middle East collects dollars from its exports to the US. Every month millions flow into 401K's. Many businesses are cash positive and have to park that cash in banks of one type of another.
All that smart, big money out there shouldn't be fooled by an accounting rule that says AIG's CDO is worth $0 anymore than they should be fooled by an accounting rule that prices the CDO at what AIG paid for it ($10B historic price).
Megan: Yes, you've raised a critical issue.
The system we are in now finds it very easy to lever -- despite capital requirements -- through SIVs/Conduits etc. etc., but it seems to be IMPOSSIBLE to safely delever.So we have these cycles of expansions where banks print money through credit, creating credit bubbles, which then pop and need to be shored up by the Fed running the printing press, diluting those idiots who saved, and hoping that the new money they print cancels out the old money that has been destroyed, so there is no net inflation.
Does that seem like a feasible system to you? Does it sound even sane?
-winterspeak
I assume that this is the begining of an extensive McArdle list of easy answers that aren't (Do you get credits, or any sort of rake off, from professors who pirate your excellent teaching material?).
Since you have started with two of the few that I have got a quarter of the way with:
Mark to market valuation always needed to be accompanied by some sort of (illiquid if positive) reserve in the balance sheet showing the difference between current market value and likely workout for all obligations which have workout dates. Without that, the balance sheet is not a true and fair view. I hoped that this subject would be on the agenda of the main accounting standards bodies when they stopped their niggly everlasting dispute between US and International standards. How you specify that reserve properly is beyond me.
Capital requirements for financial institutions have to be set counter-cyclically. The nest of devils is in the detail.
One possibility that shouldn't be overlooked, for what might be done, is to lessen margin requirements, capital requirements, reserve requirements, and the like. All these requirements (they all being different names for the same general idea) are put in place with the idea that in an emergency, the financial company has enough cash on hand to fulfill its obligations. Yet the laws which mandate such pots of cash don't actually let them be used in emergencies. Instead, when the pot of cash dips below the required level, the company is deemed to have failed. There should be a way, instead, for the government to declare "Okay, this is an emergency, so you can actually use your emergency funds -- and you won't have to declare bankruptcy until you've actually exhausted them."
I am not an expert on this stuff but I have a question:
"When markets for various securities froze up, the book value of those securities was basically zero, even though many of those securities would eventually pay off."
I don't get this - how can the value of something be "basically zero" even though most likely it would eventually pay up? Isn't something being worth basically nothing mean that the market believes the security is unlikely to pay up?
Two cases, either the market is valuing things (ie these securities of which you speak) correctly or incorrectly.
If correctly, then it is not that the banks' losing money is some mirage, it is that their assets really are worthless, in which case the mark-to-market thing seems to only make the pain happen now, rather than later when everyone realizes the assets are worthless.
If incorrectly, then what is your reason for saying it is wrong (and I guess, you or the Fed or various economists or whoever else is right)? During the whole oil bubble speculation thing, you said "the best estimate of the future price is the current price" - does that not apply to these securities? I don't mean that rhetorically, I am really asking.
Why do credit default swaps exist? What's wrong with credit risk being priced into the return on the security? Is there something more accurate about a third-party pricing risk for a transaction?
Why do credit default swaps exist?
If I understand it correctly, for the same reason that homeowners' insurance exists: to make known small financial sacrifice to protect against a large but unlikely financial loss. That is, to reduce the risk of a given security in exchange for a reduction in return.
guy,
Let's take an easy example like an ordinary municipal bond. It has a face price which it will be worth at maturity, some 20 or 30 years from now. It has a face interest rate (assuming it's a fixed rate bond), so if you buy the bond, you will receive the interest on a regular basis, and when the bond matures, you receive the principal (the face amount).
What price you pay for the bond depends on how the bond's interest rate compares to the current market interest rate, and how many years to maturity. If the bond pays 6% interest and the market interest rate is 8%, you buy the bond at a discount. Otherwise, why would you buy a financial instrument that pays only 6%?
If you want to sell the bond, it's worth only what other people are willing to pay for it. If market interest rates are at 10%, you would have to sell it at quite a discount. Even though if you hold it to maturity, you get the entire face amount.
Just to toss some numbers around for the sake of example, i.e., these numbers bear no relation to reality, you could end up buying a $5,000 bond for $3,000, and if market interest rates go up, you might have to sell it for $2,000.
So how do you value this in your portfolio? At the $3,000 you paid for the bond, at the $2,000 which is the current market rate, or at the $5,000 the bond will be worth if you hold it to maturity (assuming there are no rumors that the municipality might go bankrupt, which will have a detrimental effect on the market rate)?
Mortgage backed securities are even more complicated, but the basics remain the same.
And if you can't talk ANYONE into buying your bond, is it now worth zero? Even though you can hold it to maturity and collect the principal amount?
Rob - swaps are a bit different from homeowners insurance. With a swap, the security holder owns something that already pays for the credit risk - i.e. the interest. A portion of the interest paid by the mortgagor compensates the lender for the risk of default (at least it used to).
My question is, how can a third party more accurately price this risk? Makes no sense to me.
To gain a prospective on "market to market" one should examine the rest of the World. Does this sort of accounting operate in the UK where the Halifax, previously the World's largest home lender, went down? The same applies to Europe and fortunately not to Australia as yet. Our share market has taken a severe beating because of events in the USA dropping even further in percentage terms.
It appears to me that long term debt (Mortgage backed securities)cannot be dressed up as a negotiable security unless it is Govt guaranteed. Utilising it as a negotiable security and permitting it to be leveraged like any bank deposit by factors of 5 or 10 as suggested is the heart of your problem and now it is ours (Australia).
Unravelling the leveraging runs up against the debt created particularly if they are also long term. It is not possible in the short and medium term and hence the Bank failures.It is not the accounting. A bank can fail in a few days well before the issue of financial accounts. If you do not replenish the base with the bailout, you will fail the World not just yourselves.