What Type of Uncertainty is Treasury Addressing?

Treasury seems to have balked today at doing something that could really make a difference. But their misgivings clearly demonstrate their own uncertainty, some two years into the crisis, about the nature of the problem and appropriate solutions.

Many have argued that the problem is “uncertainty,” but many remain unclear what KIND of uncertainty matters. By now, Wall Street can value mortgage-backed securities and collateralized debt obligations even if they don’t like the values that result. Indeed, deals have typically been done for portfolios of IndyMac, Wachovia, and the like at the usual roughly 27 cents on the dollar. So, contrary to the assertions of those in Washington, in general, and Treasury, in particular, for the most part it is not asset PRICE uncertainty that is holding up markets right now.

Instead, it is uncertainty about the DISTRIBUTION of losses among Wall Street firms. This element is important, because it is the one element that Treasury talked up as part of its TARP II, postponed today, but one that seems to be lacking from the revised proposal. Instead, more accounting gimmickry is being advanced to purchase assets of troubled banks, most likely at an above-market price, and aggregate them in a “bad” bank (but for marketing purposes let’s call this an “aggregator” bank) and have the government pick up the losses. While there was discussion last week of identifying and resolving insolvent banks, that language seems to be gone now. Pity, because that prolonged insolvency – and the regulatory forbearance that is pushing the recognition of that insolvency down the road – is precisely the element that dragged out the Thrift Crisis and is dragging this one out, too.

The distributional uncertainty pushes other uncertainty onto the investor and consumer. Particularly, as insolvent banks and other financial firms restructure, the TERMS OF THE FINANCIAL INSTRUMENTS they sold to investors is changed in the negotiation process. Those changes usually involve a crystallization of losses and a lengthening of maturities that maybe able to help a marginally solvent firm (if we knew which those were – see above) survive the crisis and recession. Most people know their 401-k’s are down about forty percent now, but they don’t know how deep that will go and when they will be able to access the previously liquid funds. Treasury seems to have confused investments in the firms with investments in the asset-backed securities. What they are starting to realize is that the securities were never really sold, anyway, and that the asset-backed security can’t stand if the firm that originated the loans fails. Hence, target the firms – not through forbearance but to foster a smooth transition of servicing, which is best achieved before the originator digs themselves so deeply into trouble that they cannot originate loans to honor representations and warranties that keep the asset-backed securities from rolling back on originators’ books. There are many examples of such lessons from the home equity crisis of the early 2000s, but nobody wants to pay attention to those, now.

If consumers can’t reckon their investment account values and plan for retirement – especially those baby boomers that are near retirement – they RATIONALLY WAIT TO CONSUME. Of course, that paradox of thrift feeds upon itself to drag down economic growth and prolong the recession leading, in our case, to more forbearance of insolvent banks and more investor uncertainty about the value of retirement assets.

Oh, and while we are on the topic of pension funds, the pension fund crisis that will follow will make the social security crisis look small, in comparison. Pension funds face record payout obligations as baby boomers retire in the next two decades, and will therefore not have sufficient time to recover asset values in normal market growth. Any sensible plan will see that and perhaps give public pensions primary access to investment gains from government bailouts. Good luck to us all.