Every time I’ve prepared to post an update to my original post on the current financial crisis, events have passed me by. I’ve finally decided to post anyhow.
Mr. Paulson’s original $700 billion proposal addressed the liquidity freeze in two ways. First, by buying up mortgage-related assets at fair market value, Mr. Paulson could take those assets off the financial intermediaries’ balance sheets. The idea was to allow lenders to assess potential borrowers’ creditworthiness with greater confidence and, hopefully, get banks lending to each other again.
Equally importantly, however, Mr. Paulson requested authority to buy up these assets at whatever price he thought best. By buying such assets at higher prices than the market was willing to pay, he hoped to bolster the intermediaries’ balance sheets – to make them more creditworthy.
This aspect of the proposal was what made it a “bail-out.” And this was part of what led to its initial defeat in the House.
It bears emphasizing that the proposal was not intended to solve the teaser-rate mortgage problem, either now or into the future. In the transactions that created the teaser-rate mortgages in the first place, both parties had made bad decisions – the lender and the borrower. Mr. Paulson’s proposal was not intended primarily to help either party.
One of its unavoidable side effects, however, was to relieve lenders of the consequences of their bad decisions, while leaving borrowers to suffer the consequences of theirs. This made it politically less palatable.
After adding a bunch of other stuff, Congress ultimately passed the bill. As ultimately enacted, the bill had three main components.
First, Mr. Paulson received authority to buy up to $700 billion of troubled mortgages or mortgage-related assets. The bill created something called the Trouble Asset Relief Program, now known as the “TARP.”
Second, the bill confirmed that the SEC could (and should) modify the “mark-to-market” accounting rules. Bowing to Congress’s will, the SEC then created an exception to those rules for assets in which there were thin markets. FASB has since followed suit.
Third, Democrats insisted on provisions allowing Mr. Paulson to use TARP assets to purchase equity positions in banks and other financial institutions – in other words, to pump money into such institutions in exchange for partial governmental ownership.
What happened as a result of enactment of the bill? Dominoes stopped falling, at least in the United States, but the stock market tanked. And the LIBOR and TED spread actually went up after the bill passed, not down. Why? Let’s start with mark-to-market.
The Modification of Mark-to-Market
Although it has largely disappeared from press accounts, modification of mark-to-market was the first of the three bailout components to take effect. It had major consequences – one desirable, the rest undesirable.
Recall what mark-to-market required: A company owned an asset purchased originally for $100. The asset had fallen in value to, say, $40. Mark-to-market required that it record a $60 loss and adjust its balance sheets to reflect the resulting lower net worth. The purpose was to give shareholders, creditors, and the company’s board a realistic sense of how the company was doing.
Unfortunately, no one wanted mortgage-related assets. Very few trades were occurring. Those that were took place at fire-sale prices. Financial institutions holding mortgage-related assets came under pressure to mark the value of their mortgage-related assets down to those same fire-sale prices – in other words, to recognize massive losses and adjust their balance sheets to reflect a smaller net worth. This, in turn, threatened to cause more financial institutions to fail, dumping more toxic assets into the market, forcing prices further down – the classic vicious cycle.
Why modify the mark-to-market rules? If companies didn’t have to mark their assets down, they wouldn’t have to recognize the resulting losses and would be less likely to fail.
And it worked. We’ve seen very few dominoes falling since the rule was modified.
But note the problem. If a financial institution holds large amounts of mortgage-related securities that no one wants, it now no longer has to tell its shareholders, creditors, or board the scope of its problems.
Is this a good thing? Well, managers might think so, but investors, creditors and board members might not.
What lenders really want to know is this: If the potential borrower were forced to sell its assets at fire-sale prices, would it still be good for the loan? Today, a lender cannot rely on a borrower’s certified financial statements to answer this question.
Worse, the articulated problem with mark-to-market was solely in the financial sector. But the SEC and FASB both modified mark-to-market generally – for all publicly reporting entities. The result was to make all financial statements less reliable, even those in non-financial sectors.
In retrospect, therefore, it’s not surprising that the LIBOR and TED spread kept going up and the stock market kept going down. In my view, the modified mark-to-market rules are still problematic.
The Proposed Purchase of Mortgages and Mortgage-Related Securities
What about Mr. Paulson’s original idea? His original idea had been to purchase mortgages and mortgage-related securities. He got the authority he wanted from Congress. But he soon discovered that the idea wasn’t going to work.
Why? The problem is that mortgages are not fungible. One teaser-rate mortgage may be worth face because it’s secured by a house that hasn’t gone down in value; another may be worth only cents on the dollar. Mr. Paulson couldn’t just buy all the mortgages held by financial institutions. He only had $700 billion to play with.
So he needed to answer three questions: First, which mortgages to buy? Second, how to value them? Third, how to structure the purchases without forcing the institutions he was trying to save to recognize yet more losses and fail. He realized very quickly that the task was going to take months, not days. And he didn’t have months. LIBOR was still going up, the Dow was down 30%, and the world’s economic engine was freezing up.
Ten days had passed since Congress had enacted the bailout plan, and Mr. Paulson was still just hiring his staff.
The Eurozone Solution
Enter Gordon Brown, Prime Minister of the UK and former Chancellor of the Exchequer. My guess is that a century hence, economic historians will give Mr. Brown credit for having saved the world – at least temporarily.
On Sunday, October 12, 2008, Mr. Brown persuaded the members of the Eurozone to adopt a two-part plan. First, they would guarantee all interbank debt. Second, they would give banks massive capital infusions by buying equity in them.
Mr. Paulson jumped at this solution and announced that the US, too, would follow the Brown plan (although he didn’t call it that). Happily, Congress had given him authority to use TARP funds to purchase equity positions in US financial institutions – over his objection.
That Monday, he announced that Treasury would use $250 billion of his $700 billion to do just that. He and Mr. Bernanke also announced that the US government would guarantee all interbank loans.
And it worked, sort of. The Dow jumped 936 points in one day. Over the course of the following week, the overnight LIBOR dropped back into more-or-less normal territory. Banks stopped collapsing. We have reached an island of, if not calm, at least diminished crisis.
A Status Report
In my next post, I’m going to talk about recent Obama administration initiatives and the future. But before I do, it may be useful to pause for a moment and assess where we are.
As I noted in my earlier post, some $500 billion of teaser-rate mortgages are still scheduled to reset over the next two years. Unless something is done, they will likely go into default. And those are only the US teasers; I have not found the corresponding data for the rest of the world.
Huge numbers of mortgages are already in default, many in foreclosure. The overhang of foreclosed homes continues to cause housing prices to fall. This, in turn, is causing other mortgages – including fixed-rate prime mortgages – to go into default. And the TARP has not yet bought a single mortgage or mortgage-backed security.
In the meantime, the LIBOR is back into normal territory. Apparently, banks are willing to trust each other. (Not surprising, given that governments are now guaranteeing all interbank debt.)
Unfortunately, this was not the most serious part of the liquidity problem. Recall that there were two problems. One was that banks weren’t willing to lend to each other. The other was that they weren’t willing to lend to anyone else. LIBOR only measures interbank lending, not lending to nonbank borrowers.
In fits and starts, the supply of commercial paper in the US now appears to be expanding. This means that lending to commercial borrowers is up. It’s not clear whether banks are doing the new lending or whether the new money is coming directly from the government. Either way, money is getting into the nonfinancial sectors. But it's still not getting to consumers.
Most importantly, it’s now clear that the liquidity freeze badly damaged real economic activity. Almost all recent news out of the real economy has been bad. Congress is currently worrying about whether to let GM, Ford, and Chrysler go bankrupt. If it does, studies suggest that the US unemployment rate will jump by about two percentage points, to well over 8%. On the other hand, even if the government bails US auto makers out temporarily, there’s no obvious reason to believe they will be financially viable in the long run.
So here's where we are: What began as a problem in the mortgage industry spread throughout the financial sector. This, in turn, produced a liquidity freeze. And the liquidity freeze, in turn, triggered a serious hit to real economic activity. Now the principal problem is the real economy.