Your humble blogger has been saying for some time that efforts to prop up bank asset values are prolonging the financial crisis, and the the various incarnations of “bad bank” plans inevitably entail buying dud assets at above market prices. That has the ugly side effect, which some no doubt see as a virtue, of letting banks that hold similar assets mark them at phony prices. The mechanism is different, but failing to write down bad assets is straight out of the Japan playbook.
The financial system grew too large by lending money to people and businesses who could not afford them (at least, if anything remotely bad happened, and bad things happening is part of the human condition). That means it CANNOT be restored to status quo ante (unless you are willing to see it fall apart again in short order). But the plans in motion seem to be an effort to do just that.
Instead, we need a program for shrinking and rationalizing the financial system. That imeans understanding how far underwater the system and its various components are. We then need to do triage: figure out which concerns are beyond repair, and how to wind them up, which are reasonable bets with some combination of cleanup, restructuring, and new capital, and which are more or less sound (ie, they may be impaired, but not enough to put survival in doubt) This process also involves making shareholders and when appropriate, bondholders take losses, and also developing mechanisms to write off and restructure bad loans (and lend to viable borrowers, but this is getting priority at the expense of the other steps).
Roger Ehrenberg is of similar views. Excerpts from his post:
Almost all of the bailout plans being discussed fail to consider a simple fact: without the homogenization of accounting rules, any plan will represent a piecemeal approach to the problem…..The system is broken, and current proposals do nothing to address the overarching issue: we don’t know the true tangible book value of ANY financial institution, and therefore are unclear as to which have strong capital positions, which are on the verge of failure, and which are essentially bankrupt but have been propped up temporarily with taxpayer dollars. As has been suggested by many, draconian steps must be taken to repair the system. Problem is, the only thing draconian so far is the damage done to the wallets of every US citizen today and tomorrow.
What needs to happen, right now, is to make EVERY financial institution apply mark-to-market accounting to their portfolios. No readily observable market? Have an administrator apply an independent third-party valuation that takes into account polling possible buyers. The only circumstance under which mark-to-market accounting can be avoided is if an institution has the intention of holding an asset to maturity and has the term financing in place to carry it. The two biggest problems with the current accounting regime relate to leverage and illiquidity. Banks have been financed largely with short-term capital, piled on top of a sliver of equity. But when assets have maturities extended either due to a changing rate environment (e.g., rising term rates cause mortgage-backed securities to experience longer maturities) or to rising illiquidity (e.g., CDOs, CDS’, high-yield bonds, leveraged lending commitments, etc.), the lack of term capital puts them in a very precarious position almost overnight. These kinds of surprises could have been avoided by forcing mark-to-market treatment, as we would have seen a precipitous decline in carrying values much faster than we did and dealt with the problem far more quickly.
As it stands today, those who argue against mark-to-market treatment say “This will just exacerbate the capital problem at troubled banks. And after the markets unlock, those assets will be salable at far higher prices.” Exactly. Let’s smoke out the problems NOW, and figure out the magnitude of the problem NOW. The fact that assets might fetch higher prices in the future is immaterial if you don’t have the balance sheet to get to the future, and it is certainly not the taxpayer’s responsibility to support those institutions’ common stockholders and bondholders in this mission….
But in the absence of policy clarity, aligned motives and strategic thinking, we will limp out of this crisis like a terminally wounded animal. Alive, but destined to never regains its former swagger. We can get our swagger back, a better swagger, a swagger built on real value and not on vapor, if only we have the guts to effect real change. And it all starts with something as mudane as accounting…..We simply can’t afford to wait any longer.