Gillian Tett in the Financial Times points out a nasty conundrum. For the credit markets to get back to some semblance of normalcy, prices of instruments have to fall their clearing price. Only a very few will buy before a bottom has clearly been reached. But reaching liquidation prices will entice the capital that has been sitting on the sidelines (or piled into commodities) to start buying.
However, under a mark-to-market regime, realizing those prices will render a lot of firm technically bankrupt. It isn’t just that this is politically unacceptable. Some of these firms are too big to fail in a practical sense; the damage to the confidence in the financial system would offset the salutary effects of reaching the market clearing price level. In addition, they are an essential part of the modern financial infrastructure. Lose, say, a Citi and a UBS, and you have impaired global intermediation capacity, much like losing part of a road system or electrical grid. You can probably still get from A to B, but with more cost and less speed (of course, with firms sitting on the sidelines in the agency market maybe the difference won’t be as evident as the policymakers believe, but fewer big entities intermediating means less intermediation under most circumstances).
From the Financial Times:
This weekend the Group of Ten central bankers will convene in Basel for one of their regular pow-wows. The discussions will be fraught.
Almost three months ago, a similar gathering paved the way for an unprecedented bout of collective action in the money markets that was supposed to halt the sense of financial panic.
But three months later, the grisly truth is that market anxiety is seeping back with a vengeance. Thus the crucial question confronting the central bankers this weekend, as they fly in to snowy Switzerland is twofold: first, are we on the verge of a new downward lurch? And second, is there anything the G10 bankers can actually do to stop this?
A downward lurch does look a real danger now, not least because the central bankers themselves are looking increasingly impotent when it comes to tackling the fundamental reasons why sentiment is so fragile.
The western financial system is caught in a trap. On the one hand, there is an urgent need for clearing prices to be established for impaired assets to restore confidence; on the other hand, if this is done in a mark-to-market world, there is a risk that some banks will run out of capital. Policymakers are in the unenviable position of knowing almost any step they take risks denting sentiment further.
First, a bit of background. History suggests a crucial component for ending a financial crisis is to establish some sense of clearing prices. Once goods look cheap – and it does not seem they will soon become cheaper still – buyers tend to rush back in. This, after all, is Economics 101, and it applies as much to houses and cars as collateralised debt obligations.
Now, in theory, there are plenty of reasons to expect investors to start rushing into the credit markets soon, in a manner that could stabilise sentiment. After all, many credit prices have slumped dramatically. And while banks may be capital constrained, plenty of investors are sitting on pots of free cash, such as sovereign wealth funds and even mainstream asset managers and pension groups.
But these groups are notably not buying credit yet, either because they are still paralysed with shock or, more realistically, because they have a nasty feeling that while a leveraged loan, say, looks cheap, it could be cheaper in the future.
How can you combat this? Fifteen years ago, the US government devised a clever trick in the aftermath of the savings and loans crisis, by conducting firesale auctions of S&L assets. This was brilliantly effective in establishing clearing prices and turning sentiment around, because as soon as investors saw some assets being sold at knockdown prices they starting jumping in, meaning that within a few months, prices were rising again.
But these days the US government faces a crucial impediment to repeating this trick. Back in the days of the S&L crisis, US banks were not forced to mark their books to the firesale prices. But now the mark-to-market creed has taken hold. And it is a fair bet that if US banks were forced to mark their books to the initial clearance price for a CDO squared, say, some would run out of capital. Hence the trap: in the modern financial system, you can have mark-to-market accounting systems, or quick action to establish clearing prices, but probably not both, without blowing up some banks.
Of course one way to exit this trap would be to abandon the mark-to-market rules for a while, or loosen capital adequacy standards. Some furtive discussions between policymakers along these lines are already occurring.
But I would be surprised if any action occurs soon. So the risk now is that we will remain trapped in this climate of grinding fear for months – at best. Few institutions have much incentive to voluntarily create clearing prices. However, hedge funds are now being forced to make asset sales in an ad hoc, opaque manner that is adding to the sense of fear. This is forcing the banks to mark books lower and pull in their horns, sparking even more hedge fund sales and fuelling concern about banks. It is a viciously unpleasant spiral.
Let us all hope the G10 have some amazing new tricks up their sleeves; if not, we are moving into dangerous waters.