The problem in markets right now is uncertainty and the now-common government interventions are creating more uncertainty. While investors in the US and abroad try to value residential mortgage backed security and collateralized debt obligations and many, many, other failed structured finance investments based on financial fundamentals, each day’s new government programs and subjective bank “resolutions” create the additional necessity to value the probability of different unknown government interventions.
Consider the $700 billion Treasury program. Originally, the idea was to have reverse auctions of mortgage-backed securities. Then the focus changed to “troubled assets,” which was later interpreted to mean “residential or commercial mortgages and any securities, obligations, or other instruments that are based on or related to such mortgages…” or “…any other financial instrument… which is necessary to promote financial market stability.” So, if I sell an asset now for, say, $0.65 on the dollar, will the Treasury step in whenever the plan gets up and running (now four weeks, maybe longer) and support a $0.80 price? Maybe. Perhaps I should just wait and see. So markets shut down while investors wait. Surprised?
What if I don’t own a “troubled asset,” under the current TARP definition? Just wait for the Federal Reserve. The Federal Reserve has now expanded its lending facilities to almost $1.7 trillion, a much larger pool than that commanded by Treasury. (See http://cumber.com/home/Factors.pdf) In addition to the TAF, TSLF, TDWP, and the new Mutual Fund Facility, the Federal Reserve is preparing to bolster commercial paper markets. “What’s next?” is now a rational, indeed important, question to ask.
Meanwhile, the FDIC continues to pursue “stealth” resolutions with more (un)predictable results. The FDIC’s Problem Bank List is suspiciously underpopulated, partially due to other primary regulators – for instance, the Office of Thrift Supervision with Washington Mutual – refusing to downgrade banks to levels sufficient for FDIC intervention. Large banks like IndyMac, Washington Mutual, and now Wachovia, are resolved by the FDIC without ever “failing,” ostensibly because revealing their true condition to the public would lead to public “panic” bank runs.
This week Treasury is proposing to use the TARP to undertake equity investments in distressed firms. Treasury stated that it wants to build upon the FDIC’s example of such “open-bank assistance” that failed so abjectly in the Thrift Crisis that it was prohibited under a 1991 regulatory reform that made it necessary for multiple regulators and the President to approve of such action – and whose use in the Wachovia transaction with such approval has again caused more uncertainty. The G-7 announcement made this weekend will be used to justify supporting bailouts of ALL institutions as systemically important to give the impression of agreement in this regard. The problem is that the bailouts are the ONLY tool the US will use, rather than implementing the types of interbank lending guarantees the EU agreed to over the weekend.
The market “panic” in the US has – in substantial part – been whipped up by politicians and regulators to sell the plan of the day by fearful politicians. Even in the proverbial “burning movie theater” the idea is to evacuate while quelling, not heightening, the panic. In fact, the situation promoted by our policymakers is even more confusing: the public is being told TO panic but at the same time that the theater really isn’t burning. That doesn’t make sense.
Real investors want information. Hundreds of billions of dollars are waiting on the sidelines for want of market direction devoid of random government interference. Those funds are ready to buy failed financial institutions and their worthwhile assets. They are ready to invest in solvent institutions that will use the money to lend for mortgages, student loans, small business loans, and all the types of credit that has been decried as “paralyzed” as of late. But, it seems, to acknowledge that some assets are not worthwhile and some institutions are not solvent in this day and age seems just plain mean-spirited. Aren’t we all winners? Don’t we all get a trophy? No.
You don’t have to be an economist for the reluctance to engage in meaningful reform to fail the “smell test.” Indeed, few beyond the politicians are fooled. Bulge-bracket Wall Street figureheads on CNBC want free money to guarantee their bonuses. Bill Gross aid the Fannie and Freddie bailout was “the exact right thing” – because they stood to profit from the arrangement, not because it really was the right way to repair markets. Strange, isn’t it, that the Treasury Secretary who only a few months ago decried regulatory complexity now has his own new – and very rich – regulatory construct added to the mix?
Existing regulatory institutions, while far from perfect, have adequate authority and powers to resolve the current market crisis. Let’s close the offending financial institutions, ring-fence the bad assets, bolster the capital of solvent institutions, and move on to restore economic growth. Will it be costly? Yes. Debilitating? No. While the economy is not where we’d like it, at best we have just entered recession.
Even if this does become the “worst recession since the Great Depression” (which, itself requires portending the future), that remains a far cry from double-digit unemployment, much less the Great Depression’s twenty-five percent, or GDP cut by roughly half. Keeping markets locked up in denial, however, will keep us in recession. Japan’s lost decade wasn’t caused by realizing losses and moving on – it was caused by refusing to realize losses and maintaining zombie banks that did not have the capacity to lend. We can repeat those mistakes if we want to but, as the saying goes, “the definition of insanity is doing the same thing over and over again and expecting different results.”