What is to be done

By: Satyajit Das

The current focus is on reforming the financial system. This is like discussing lifestyle changes with a patient admitted to ER in full cardiac arrest. What is needed is the defibrillator paddles!

 

While the system will need to de-leverage over time, it is imperative that immediate steps be taken to restore functioning of banks and the supply of credit.

 

The first step is to establish certainty - the holdings and values of risky assets held by banks and investment banks must be accurately determined. The need for greater certainty of values applies to sub-prime securities and leveraged loans as well as other risky assets. Without certainty about what is held by whom and their values, it will be difficult to restore confidence in financial markets.

 

Risky assets must be valued on a hold-to-maturity basis (in absence of clear trading intent) at 100% (the security will pay back) or 0% (the security will not pay back). Mark-to-market accounting should be suspended reducing volatility in asset values, earnings and capital.

 

This reverts to an old fashioned banking concept. Stripped of all the hyperbole all we have is loans behind all the structures. You make a judgement as to whether the obligor pays back or not. You could be wrong but it is no worse than the current market prices, which are meaningless anyway. So you substitute repayment likelihood for an arbitrary price. You could be wrong but are less likely to be so as you are stripping out all manner of market distortions. On average you will probably be correct and eliminate the constant volatility of prices.

 

The 100% or 0% rule comes from the fact that loans are binary - they either pay back or not. One could have placed a recovery value in case of default. The issue is the volatility of recovery values is very high. This avoids that.

 

Of course, this is not ideal but we need certainty of some kind. Otherwise the quarter to quarter volatility of earnings and asset values makes it important to stabilise the banking system.

 

This is what everybody applied in Asia in the aftermath of the 1997-1998 crisis, when unfashionable insolvency practitioners, employed by the IMF, established asset values for distressed Asian banks in this precise way.

 

 

Market values (based on increasingly unreliable or meaningless indices or quotes) or model based prices (to 16 decimal places) should be abandoned. There is no market for many risky assets currently. The models have not performed and are what got us here in the first place.

 

The manifest problems of valuation can be easily illustrated. Bank holdings of Level 3 assets have increased in recent months. These are assets or liabilities that cannot be priced using observable inputs and requires the use of modeling techniques and substantially subjective assumptions – also referred to as “mark-to-make-believe” or “mark-to-myself”. There is concern about the accuracy of these valuations.

 

The increase in Level 3 assets may reflect a re-classification of assets previously classified as Level 2 assets. These are instruments that are valued using observable inputs that can be put through an accepted model to establish values (i.e. mark-to-model). This reclassification is consistent with deteriorating market conditions and unavailability of market prices.

 

Market values may be distorted. In recent months, investment banks have sold leveraged loans on the basis that the bank lends the buyers 75-80% of the price at below market rates. In this way, the sellers were able to avoid marking down its positions.

 

There is also significant disagreement between banks as to the values. A comparison between some US and European banks shows substantial differences in where similar assets are valued.

 

Even central banks, it seems, can’t agree on the current price of difficult to value assets. For example, market sources indicate that under its special term lending arrangements the Bank of England is placing a market value of 75 to 90% per cent on highly-rated non-government collateral, depending on type and the availability of prices. In contrast, the Fed is placing market values of 80 per cent to 98 per cent for similar securities. Greater certainty regarding positions and values are essential.

 

Once the true positions are known, then the capital levels that banks must hold against these assets can be set.

 

Capital levels should be set on a bank-by-bank basis by regulators rather than based on an inflexible formula that is frequently gamed by banks. Capital requirements should be eased, where appropriate. A “desired” long-term capital ratio for banks should be set. Banks should be allowed to transition to these levels over time. If all asset positions are known with clarity and confidence, banks can operate with lower than the normal capital requirements for a period.

 

Proposals to accelerate Basel II or increase bank capital are ill considered in the present market conditions. The banking system needs significant amounts of capital to cover losses. It also needs additional capital to cover assets returning onto balance sheet. Increased capital ratios would accelerate the de-leveraging already under way worsening the contraction in economic activity.

 

The final step is a government guarantee of all major bank liabilities. The step is not as radical as it appears. The Federal Reserve (for example, in the case of Bear Stearns), the Bank of England (Northern Rock and the Special Liquidity Scheme (“SLS”)) and Germany (the Landesbanken) have de facto already done this.

 

The extent of central bank support is significant[1]. For example, the US Federal Reserves 7 May 2008 statement shows that it holds $537 billion of US Treasury bonds  out of a total of US$795 billion in securities. This amount to 68%, a fall from 98% a year ago. Closer scrutiny reveal that the US$537 billion includes US $143 billion of Treasury bonds lent to dealers under the liquidity support schemes. The US$143 billion is “fully collateralized by……. highly-rated non-agency mortgage-backed securities”.  In effect, the Federal Reserve has provided over US$400 billion (around 3% of US GDP) in funding to banks and (now) investment banks. This funding is at subsidised, negative real interest rates.

 

Term lending through the support facilities means that the central bank is doing more than providing liquidity. The central banks are underwriting the solvency of banks. If at maturity, the bank can not repay the advance, the central bank will be forced to continue to fund the borrowing bank to avoid triggering default. Bank’s generally fail due to liquidity risk. It is sobering to consider that Bear Stearns was technically solvent when a withdrawal of liquidity brought it to the brink of a bankruptcy.

 

An explicit guarantee has many advantages. It avoids inflationary money supply expansion and the need for money market sterilisation operations. It would directly help restore confidence in banks and in the inter-bank market.

 

The Central Bank would charge explicitly for the guarantee based on the underlying risk. In this way, the taxpayer is properly compensated for the risk assumed. Central banks currently are providing a similar underwriting of financial risk at money market rates. This contrasts with the high costs being paid by banks on their equity capital raisings. For example, banks are paying 7% to 11% on hybrid capital raisings. Similarly, bank equity offerings are at substantial discounts to already low stock prices.

 

Support of the global banking system will be difficult to avoid. The originate-to-distribute and risk transfer models did not, as we now know, distribute risk through the financial markets. Instead, it linked the financial solvency of all financial market participants in a complex web. Government underwriting of the banking system is now critical to resuscitating normal financial activity.

 

The proposed actions are contrary to free market orthodoxy and raise familiar concerns about moral hazard and rewarding greed. There seems to be no choice. There will be a high price to be paid but that will come later. As Charles Kindleberger noted in his history of financial crisis: “today wins over tomorrow”.

 

Credit markets have become dysfunctional. As Walter Bagehot observed: “Every banker knows that if he has to prove that he is worthy of credit, however good may be his argument, in fact his credit is gone”. The outlined actions would help restart the credit heartbeat in the US and global economy. Vital life signs need restoration before longer-term lifestyle changes are contemplated.

 

Implementation of the three steps outlined above allows monetary policy, interest rates and fiscal policy to be directed to ameliorate any economic slowdown. Falls in asset values can be sustained where the borrower has sufficient income and cash flow to service the debt. Initiatives in the US mortgage market to help those with salvageable debt positions to avoid foreclosure are also valuable in this regard. Attempts by governments in the USA and England to maintain supply of “normal” housing finance are also targeted at this objective.

 

The defibrillator shocks must be accompanied by far reaching and fundamental changes in financial architecture and global capital flows. Regulation of banks, capital regimes, risk transfer, asset valuation, risk management, use of collateral, counterparty risk, model risk, rating agencies and financial accounting need radical surgery. Fundamental economic imbalances - excessive reliance on US consumption and excessive savings by other nations – must be addressed.

 

Present proposals by various bodies are tepid and do not address the fundamental problems. Many of the suggestions, such as derivatives clearing houses, have been doing the rounds for 20 years. Giuseppe di Lampedusa (author of “The Leopard”) would have seen the proposals for what they are: “everything must change so that everything can stay the same”.

 

Failure to address the major structural problems of financial architecture and global economic imbalances may mean that any improvement is short-lived. It will also sow the seeds of future, perhaps more serious, financial crises. The present problems and government steps already are creating problems in commodity and emerging markets.

 

Resolution of the crisis requires brave and decisive steps that transcend geography, jurisdiction, regulatory silos, nationalism and rigid economic formalism. John Maynard Keynes knew the problem well: “the difficulty lies not so much in developing new ideas as in escaping from old ones”. But as John Kenneth Galbraith observed: “faced with the choice between changing one’s mind and proving there is no need to do so, almost everyone gets busy on the proof.”

 

 

© 2008 Satyajit Das All Rights reserved.

 

Satyajit Das is a risk consultant and author of Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives (2006, FT-Prentice Hall).

 

 

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