Requires Deeper Analysis
Jim Prevor’s Perishable Pundit, September 26, 2008
The government’s plan to “fix” the financial crisis is built on an incorrect premise and probably won’t work. In any case, it is either unnecessary or immoral.
The government identifies the problem as a lack of liquidity. So the government proposes to buy up to $700 billion of distressed assets, which supposedly will restore liquidity to the marketplace.
But this is an incorrect diagnosis of the problem because there is no absence of liquidity in the market. There are plenty of buyers for real estate, for mortgages, even complex paper after mortgages have been sliced and diced in tranches of different levels of risk — the problem is that sellers don’t like the price.
This past spring a real estate broker working with a professional auction house held an auction of properties near Pundit headquarters in South Florida. Out of 75 “lots” for sale, only two actually sold. Why? There were bids on every house but only two "lots" were sold. In fact, one of the “lots” for sale consisted of 50 condo units being sold individually. Ten units of the lot were sold at “absolute” auction — meaning no minimums and no reserves — and they sold easily. The other 40 units were not sold because they did not meet the seller’s secret reserve.
Ben Bernanke, chairman of the Federal Reserve, came under attack for saying on Tuesday that the government would pay more than “fire sale” prices for the assets it would buy. By the next day, he was backtracking saying, “I am not advocating the government intentionally overpay for these assets.”
But he can’t have it both ways. If the government is going to buy these assets at the same price the seller could realize by selling them into the market, then there is no point to having the government buy these assets. If, however, the government is going to pay more than the market price for these assets, then this is just a bail-out for people or companies that happened to invest in these particular assets.
In a sense, it is just a pay-off to powerful political interests.
Our opposition has little to do with ideological purity or an opposition to government intervention in the markets. We basically have six concerns:
- To the extent there is a problem with credit between financial institutions, it is a reflection of the difficulty potential buyers or lenders have in valuing the assets held by other financial institutions. The more the government buys these assets, bails people out so they don’t have to sell these assets, etc., the longer this period of evaluation difficulty continues. Had the government allowed Bear Stearns to go broke, its assets would have all been sold and this would have helped establish actual market values. With this information we could easily see if other financial institutions have a positive net worth or not.
- The case for bailing out Fannie Mae and Freddie Mac was the strongest because they have been portrayed as quasi-governmental entities. Yet we think, exactly for that reason, it would have been desirable to let them fail. There is no legitimate place in our constitutional system for “quasi-governmental entities.” If politicians want to subsidize mortgages, they should either have to tax or borrow the money to do that. There should not be an “off-budget” item with the implied guarantee of the US government.
It would have been a very good thing for investors around the world to know that no President or Congress can bind the government of the future except via issuing debt backed by the “full faith and credit” of the United States. Every person, business or government that bought a Fannie Mae or Freddie Mac bond did so for one reason only — they wanted to get more interest than they could by buying a US Treasury bond. That is called speculation, and it would have been healthier for the system for such speculators to lose money. Thus the principle that the US government can be bound only by law, not by implication, would be clearly established for future lenders.
- The problem is not mortgages, nor liquidity; it is leverage. If Bear Stearns had $90 billion and bought $90 billion worth of mortgages and the paper dropped to 10 cents on the dollar, Bear Stearns would lose $81 billion. This would, of course, be sad for Bear Stearns’ shareholders. But people lose money all the time and it would not be a great threat to the financial system. The problem is that entities like Bear Stearns had $3 billion and were leveraging to buy $90 billion worth of mortgages. So if the mortgages go to 10 cents on the dollar, not only do these entities lose all of the $3 billion they started with, they can only pay back $9 billion of the $87 billion they borrowed.
The reason the financial system was freezing is because of doubt that the bad paper could be sold at a price sufficient to cover the borrowings undertaken to buy the paper. The government’s plan does not specifically deleverage the financial institutions. In fact, healthy institutions holding toxic paper could sell it to the government as easily as insolvent institutions. The mechanism in our society for eliminating unaffordable debt is restructuring or liquidating under Chapters 11 (restructuring) or 7 (liquidation) of the Bankruptcy Act. The sooner companies go bankrupt, the sooner the companies will deleverage either through liquidation and paying what they can to creditors and writing off the rest or through restructuring in which creditors would receive stock in exchange for debt. In any case the sooner these companies go bankrupt, the sooner the creditors to the company will know their situation. This clarification of value will allow for lending and investing.
- The decision to stand behind all money market funds for a while is reasonable as this was, literally, going to cause a “run on the bank” by worried consumers. But this is one area where only short term relief is required as those who seek a Treasury guarantee can easily buy money market funds that only invest in US Treasury Securities. In the future, nobody should be able to buy a money market fund that invests in non-US government securities without signing a statement acknowledging that he or she has been informed that voluntarily electing to invest in a non-US-government-secured money fund is electing to speculate on credit quality in the hope of obtaining higher yields. The buyer recognizes that these securities could default and that the buyer of these types of money market mutual funds can thus lose their entire investment.
After a few months of making all new account holders sign this statement, all existing money market mutual fund holders who do not return the signed statements should automatically be transferred to a money fund that only invests in US Treasury securities. Once this procedure is completed, anyone who elects to buy a money market fund investing in private securities deserves both the upside and the downside of the risk he has elected to take.
- A bailout allowing the Treasury Secretary to act at his discretion to buy assets at any price from anyone he chooses and sell them at any price to anyone he chooses is simply bizarre. It is a recipe for corruption and abuse of the taxpayer. Here is Section 8 of the Treasury proposal: Decisions by the Secretary pursuant to the authority of this Act are non-reviewable and committed to agency discretion, and may not be reviewed by any court of law or any administrative agency.
Unfortunately the debate seems to be focused on issues such as restricting the paychecks of executives whose companies apply for help. This is probably a useful thing, mostly because it will reduce the number of companies turning to the Treasury for help — it is, however, a peripheral issue. If we want to intervene in the market, we would be better off intervening directly by providing, say, a special tax credit to encourage people who don’t own houses to buy one that had been completed by a certain date — thus increasing demand for housing and absorbing the surplus supply.
This would increase the value of housing and thus the mortgages that depend on that value. If we simply must buy securities, we should set up a Dutch auction or other mechanism that is transparent to purchase the paper and then set up a public auction down the road to sell the paper. Otherwise the corruption will be incredible.
- This business of banning short-selling is a terrible strategy. Shorts give the market valuable information, and banning them reduces market confidence in the accuracy of market pricing. If you want to build confidence in markets, you allow all traders and you extend market hours to allow more opportunities for trading. Banning short-sellers simply makes people feel the government is desperate and the situation worse than we know.
Once we get beyond critique of this particular proposal and things the government is doing now, we can start thinking about broader changes that would make it less likely that we would have such problems in the future.
We think these five points would be a good start:
- Change FDIC insurance to facilitate transactional accounts. The FDIC program to insure deposits in banks is limited to $100,000 per depositor, per bank, with the limit $250,000 for certain retirement accounts. These numbers are both too big and too small.
Because the government recognizes eight different ownership categories (a single account, a joint account, a retirement account, for example), it is easy to exceed the $100,000 maximum. And even $100,000 is enough to have launched a whole industry of deposit brokers who gather deposits in $100,000 increments that go to the banks willing to pay the highest interest rates — i.e., the weakest banks in America.
Perhaps there is a public interest in allowing poor people to go to any neighborhood bank and open a passbook account without worry, but one suspects that $10,000 in coverage would more than suffice for that purpose. We need to keep these numbers low enough so as to make this CD brokerage business unprofitable. The bigger problem here, though, is that those who simply have money in a non-interest-bearing checking account are needlessly being exposed to risk, and they are the ones who will pull their money at the first sign of a problem and cause a bank panic.
One doesn’t have to be a very large business to have $100,000 cash in a checking account. In the produce industry, a wholesaler that has a lot of cash business with small retailers and pays his suppliers in ten days could have many times that balance — although the money isn’t really his, it is owed to his suppliers. We would propose that non-interest-bearing checking accounts should have unlimited FDIC insurance. In other words, if the purpose of an account is simply to facilitate transactions and there is therefore no temptation to put money in a weak bank to get a high interest rate, the public interest is best served by allowing people and businesses to transact with confidence.
- Separate investment and speculation from providing services. Much of the “crisis” has come about because companies that provided valuable services decided to goose earnings with proprietary trading. Now there is nothing wrong with people or companies investing their own money and trading. But it really has nothing to do with any business and, in fact, creates the potential for a lot of conflicts of interest. So we would propose that if a company, say Merrill Lynch, is going to be a stock broker, it should not be allowed to do proprietary trading. In other words, its only function would be to engage in the legitimate business functions such as buying and selling securities for customers and earning a commission or managing money for consumers and earning a fee on that. Those companies that want to engage in trading to make profits could have an investment trust — public or private — set up for that purpose.
There are all kinds of potential conflicts with both serving customers and investing for oneself: Front running, using the order flow of customers to gauge market direction, using a firm’s own sales force to dump positions you want liquidated, etc. Goldman Sachs, one of the few Wall Street firms that lightened up on its exposure to subprime mortgages before the crisis hit, has been attacked for, basically, shorting the same mortgage securities it just sold its customers. If Goldman believed that these securities were going to fall in value, shouldn’t it have told its customers rather than shorting them for its own account?
The conflicts of interest are real and inherent and so proprietary trading has to be completely separate, done by separate people under separate ownership. In addition to avoiding conflicts of interest, a side benefit of this policy is that these investment funds will, by their nature, not interact with consumers. So if ABC Investment Trust goes broke, it just won’t have the emotional impact of Merrill Lynch or Lehman Bros..
- Agreements should be required to contemplate the inability of a party to execute the agreement. The bailout of AIG was prompted, principally, because AIG and its counter-parties had entered into agreements with terms that were self-evidently stupid. AIG would insure that, say, the value of a particular firm’s mortgage holdings would not fall below a certain level. This is called a credit default swap and for this “insurance” AIG got paid a fee. If, however, AIG’s credit rating were to fall, AIG was required to put up more collateral. This was a very big business, and every time its rating fell AIG had to come up with tens of billions of dollars. Now, obviously, the only time AIG’s credit rating would fall would be because it was in financial trouble so, just as obviously, it would not likely be able to raise all the money required by these collateral agreements.
It was irresponsible of AIG to enter into such agreements on such a scale. It was irresponsible of the counter-parties to not realize this, and it was unforgivable that the ratings agencies did not wave a red flag around these deals.
These types of guarantees are so disruptive and likely to cause bankruptcy that companies ought to be compelled to limit their exposure to this type of draw to a very small portion of their capital and thoroughly and specifically disclose these contingent liabilities. Even with disclosure, however, if both parties want to enter into this type of agreement, in order to avoid burdening the bankruptcy court system and causing shock to the financial system, the agreements should contain within them the answer to the question: “What happens if we can’t post more collateral?”
Perhaps there would be a pledge of a specific asset, such as a building, or maybe the company would have to issue common stock to compensate for the decline in its credit rating. In any case, the answer should be intrinsic in the agreement and thus smoothly implemented in times of distress, rather than causing a panic.
- Many have claimed that a big part of the problem is the legal requirement that organizations “mark to market” assets. They have half a point. We doubt that the accounting is all that crucial; people fear to lend not because one’s official financial statement is bad but because one judges the situation to be bad. So if accounting rules allowed firms to keep assets on their books for prices they can’t sell them for, it would simply make it harder for people to feel confident in the financial statements — it might make people quicker to withdraw credit.
Still under certain circumstances “marking to market” can be deceptive. If we were to buy zero coupon Treasury bonds to pay the Jr. Pundits’ (now age 5 and 6) college tuition with bonds due to mature when tuition will be due, then the fact that interest rates zoom and the sales value of the bonds thus fall is really not relevant. We bought the bonds to hold to maturity, and the vagaries of the credit market neither help us nor hurt us.
So, if a business buys bonds for a specific purpose — say to ensure it has the cash to execute a non-qualified retirement agreement to pay the CEO money upon his reaching age 65 — and if the bonds drop not because their ability to pay is impaired but because interest rates have risen, it might make sense to allow some leeway in the “mark to market” requirement. However none of this would apply in the current situation where, first, most of these positions were acquired for trading and, second, the decline in value has little to do with interest rate fluctuations and much to do with the belief that the mortgage debts will never be repaid and thus these holdings are permanently impaired.
- The single most important reform required is that the two groups checking against excessive valuations — the real estate appraisers and the bond rating agencies — need new incentives. We wrote previously about the need to reform appraisers. The problem with the rating agencies is basically the same: Both get hired by people with skin in the game. A mortgage company makes money issuing mortgages which it typically sells. If an appraiser consistently kills the deal by coming in too low, the mortgage company doesn’t want to hire that appraiser any more. Equally, ratings firms, such as Standard and Poor’s, Dun & Bradstreet and Fitch’s are paid by people who want to sell debt. If they consistently give the debt low ratings, lenders will try to discredit the particular ratings officer that made the call or avoid using that agency.
What we need is a system in which the appraisers and the rating agencies are not selected by anyone who has a stake in seeing business done. Maybe a board of appraisers locally or a board of debt-rating services nationally gets a fixed fee each year and then, upon submission, assigns an appraiser or a rating officer to issue an appraisal or a rating. But because the mortgage company or the debt issuer no longer has any say in who does the appraisal or rating, there will be less incentive to try to make everyone happy.
Obviously there is much more to explore on this subject but the key is that the Treasury plan has many flaws, both short term and long term, and we should think hard about the kinds of reforms that can actually help our financial system weather this storm and can lead to greater prosperity in the years to come.