Willem Buiter has a penchant for ruffling feathers with his blunt pronouncements. He caused a firestorm at the Fed’s recent Jackson Hole conference by, in his presentation, telling the central bank that it was a victim of “cognitive regulatory capture” and was excessively sensitive to the needs and special pleading of the financial services industry. Even though the hosts took umbrage, they should not have been surprised, since Buiter had been saying that sort of thing for months.
Buiter lobbed another bombshell today, but because it was presented on his blog and (needless to say) the market meltdow was attention-grabbing, it appears to have gotten little note:
It’s reasonable to assume that the banking system in the North Atlantic region is insolvent and would be bankrupt but for the reality of recent government bailouts and the expectation of future government bailouts. Certainly, for the system as a whole, the marked-to-market value of its assets is way below that of its liabilities. I strongly suspect that even the hold-to-maturity value of its assets is well below that of its liabilities. Although the system as a whole is broke, there are no doubt individual banks that are solvent. We may not, however be certain as to which banks are solvent and which banks are not.
This is a bold, troubling, and probably accurate assessment. Note (if you read the rest of the post) that Buiter uses the term bank deliberately; he is not referring to the larger shadow banking system that has clearly run aground, but to its core, the regulated banking sector (plus, of course, its new additions, Goldman and Morgan Stanley).
More important, Buiter suspects that the banks as a whole are insolvent even if they hold assets to maturity. In other words, the argument that bank distress is due in large degree to mark-to-market pricing meeting a panicked flight to quality is wishful thinking. While many readers of this blog would agree with that view, it’s quite another for an economist with considerable central bank/regulatory experience to voice that opinion.
Assuming that Buiter is correct, then efforts to relax mark-to-market accounting are completely counterproductive. As discussed here and in the financial media, it serves to heighten mistrust by making financial statements less verifiable, and worse, even trying to put a fig leaf over this mess will not improve the picture sufficiently.
Anonymous 
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As you say, Yves, the problem is lack of price discovery. We can see why Paulson has agreed to this MLEC on steroids, but the Federal Reserve chairman's defence is more perverse. Bernanke’s defense of the evaluation process can be interpreted in two ways. He could be saying the government’s liquidity and capacity to bear risk will create a new market equilibrium, and that Treasury will pay the new market price. Alternatively, his “hold-to-maturity” price could be the output of a long-term cash flow model. The two are not necessarily exclusive.
HOWEVER, either possibility raises problems. First, the valuation models that produce hold-to-maturity prices are highly sensitive to their assumptions, and can be used to justify virtually any price, removing any constraints on overpayment. They perpetuate a lack of price discovery. The price paid is probably above the benchmark established by Merrill Lynch’s recent sale to Lone Star, but certainly less than face value. The reality is that the Paulson plan looks like an attempt to restore confidence in the financial system — that is, convince creditors of troubled institutions that everything’s OK — simply by buying assets off these institutions. And it does not recapitalize the banking system, but merely facilitates the replacement of one dodgy asset with a better one.
One can certainly understand the rationale: The price arrived at for the bank's illiquid assets determines if there is any equity left in that institution, as well as any other institution holding similar assets. If the price is less than current level 2 & 3 marks, capital shrinks for the institutions in question, and more deleveraging must occur unless recapitalization is ready to go. Which means we are back in the vicious cycle, since deleveraging forces sales of assets, which forces price discovery, which is what triggers solvency or deleveraging issues, on and on…
It is here, at this crucial stage, as the reduced capital position is being made explicit, that one would prefer to see the public authority take a dilutive equity stake. This would have not only better safeguarded taxpayers’ interests (by minimizing the upfront costs and improving the prospects of making money on the deal), but given a more accurate gauge of what is actually required to get the banking system functioning again. Only genuine price discovery helps to provide a gauge of how much taxpayer recapitalization will be required (which is why we reject the Soros/Calomiris approach of simply recapitalizing without finding out what the Level 3 assets are worth) – if they are valued at pennies on the dollar, the taxpayer at least will not be laying out a lot initially, but the resultant write-downs will result in a much bigger taxpayer contribution. If that dilutes the existing shareholders, this is a legitimate means of punishing the players responsible for creating the crisis in the first place. If price discovery also leads to insolvency, then best to root out the bad banks straight away, whilst getting government guarantees for the depositors.
Price discovery and recapitalization, then, are intimately related. Until the suspect paper gets priced, nobody can know the size of the required recapitalization – no one, not even the Mighty Soros or Buffett.