Wednesday, 24 September 2008

Batten down the hatches

In addition to dealing with the financial tsunami engulfing the banking system, Paulson now has to contend with a surly, mutinous crew. During yesterday’s hearing, Senators characterized Paulson’s plan for buying distressed assets as “half-baked” and a concept rather than a plan. And for good reason. A plan would contain clearly-articulated goals, strategies, and tactics. Paulson’s proposal contains a broadly-stated goal, but the strategies in pursuit of that goal appear misguided, as Paulson appears to have misdiagnosed the problem. And his proposal is virtually devoid of tactics to support his strategy. Given the reception he received in the Senate, his plan appears unlikely to come to fruition as proposed.

Let’s start with the goals. In his prepared statement yesterday, Paulson expressed his goal “…to avoid a continuing series of financial institution failures and frozen credit markets that threaten American families' financial well-being, the viability of businesses both small and large, and the very health of our economy.” I would argue that there’s little reason for the government to care about financial institution failures except to the extent it cares about job losses, tax receipts, or the financial infrastructure supporting the economy, but the goal of well-functioning credit markets certainly is laudable.

But then Paulson goes awry in his diagnosis of the problem facing the financial sector. As he states in his prepared remarks, the “…root cause is the housing correction which has resulted in illiquid mortgage-related assets that are choking off the flow of credit which is so vitally important to our economy.” The analogy here appears to be one of pipes carrying the flow of credit that have become blocked by illiquid assets. According to Paulson, the decline in house prices has caused these securities to become illiquid, and now they’re clogging the pipes. If we could simply remove the illiquid securities from the pipes, the flow of credit could continue unimpeded.

This is a serious misdiagnosis of the problems facing the financial system. It is not the illiquidity of mortgage assets that is creating the problem. Rather, it’s their price declines.

These mortgage securities are financial assets whose underlying claims to real assets are the claims on houses. As house prices have declined, the values of the mortgage securities have declined. As expectations of further declines spread, owners of these mortgages began selling, often at distressed prices. After a while, the market prices for these securities came to reflect the psychology of market participants more than they reflected the fundamentals of the housing market. And as this psychology deteriorated further and became less predictable, many investors decided there was no price at which they were willing to buy these assets. Meanwhile, many mortgage holders anticipated that the market values of these assets would increase to more closely reflect more realistic expectations regarding default rates and recovery values. With buyers and sellers holding such different views of the market, the market became illiquid.

The commercial and investment banks holding many of these mortgages have been required to mark these securities to their market prices, which are considerably lower than their purchase prices in most cases and which are increasingly difficult to determine given the relative illiquidity of these markets. Of course, this process has caused banks to record large losses. And these losses, even if only on paper, have caused reported bank capital to decline considerably. And here is the problem. Many banks no longer have sufficient capital to support their business. Banks either need to obtain more capital or they need to shrink their business. Banks won’t resume typical lending activities until their risk-to-capital ratios return to more comfortable levels. But their efforts to reduce risk are causing further declines in asset prices, which are causing further declines in bank capital.

Paulson’s diagnosis is that mortgage securities have become illiquid and are now blocking the credit pipes. As a result, his prescription is to remove the illiquid securities from the credit pipes so a reasonable flow of credit will be restored. It’s true that the removal of the mortgage securities from the banking sector can help reduce the risks on bank balance sheets. But it’s also true that this process has the potential to further deplete bank capital. For example, if a reverse auction is used to enact the transfer of the securities from banks to the Treasury, as the Treasury envisions, it’s likely that banks will be forced to record further losses on these securities, resulting in a further erosion of bank capital. In this case, it’s possible that the risk-to-capital ratios would deteriorate even further, simply exacerbating the problem. Even after transferring mortgage assets to Treasury, banks may have to sell even more assets in an attempt to reduce risks to a level commensurate with their lower capital levels.

For this process to improve the situation, the transfer of assets will have to be enacted at prices that are higher than the prices at which they’re currently marked, so the banks can record gains on the sales, resulting in an increase in capital.

In his prepared remarks, Paulson was silent on the mechanism to be used to enact the asset transfers. But in a fact sheet released over the weekend, Treasury stated, “The price of assets purchases will be established through market mechanisms where possible, such as reverse auctions.” Without significant collusion, a reverse auction is likely to lead to lower prices and a further deterioration in bank capital.

On the other hand, Chairman Bernanke yesterday gave the impression that he envisioned that this process would lead at some point to these securities being marked at prices more closely reflecting their ‘hold-to-maturity’ value rather than their fire-sale prices. If this could be accomplished, it has the potential to significantly improve the situation. But given yesterday’s reception in the Senate, it appears unlikely that Paulson will be given license to transfer these assets at these higher hold-to-maturity values, particularly in the middle of election season.

If Congress is unwilling to approve the transfer of assets at hold-to-maturity prices, Paulson’s plan is very unlikely to achieve its goals. Many in Congress and most market participants appear to be aware of this. Perhaps even Paulson is aware of this. Perhaps he believes Congress needs to consider and reject this proposal before they will consider more draconian proposals.

In particular, I can think of two proposals that might help improve the risk-to-capital ratios in the banking sector. The first is a simple capital injection by Treasury, most likely in return for preferred stock. Congress would only approve this if it were done on terms that would severely dilute existing shareholders, but if done in sufficient size it probably would be successful at restoring the flow of credit. Second, Congress could suspend mark-to-market accounting for banks. In this case, banks could report their mortgage holdings at prices that more closely reflect Bernanke’s hold-to-maturity values, resulting in reported profits and capital increases. The stock market would be unlikely to react well to this approach, but the resulting reduction in risk-to-capital ratios very likely would lead to a restoration in a reasonable flow of credit.

I suspect there is a reasonable chance that Congress will allow the Treasury to purchase distressed assets -- though on substantially different terms than those proposed by Paulson. In particular, Congress appears reluctant to approve the entire USD 700 bln requested by Treasury. But there also appears to be a reasonable chance that this plan won’t be approved at all. In particular, I suspect there will be counterproposals suggested involving both direct capital injections and the suspension of mark-to-market accounting.

While the eventual result of this political process in unclear, it is clear that Congress and the Treasury are not going to proceed in a straight line toward a quick implementation of the Paulson proposal. As a result, we’re likely to see some resurgence of the storm that hit the banking sector and the credit markets last week. While it’s unlikely we’ll see conditions on the order of last week’s tsunami, I suspect we’re in for some serious turbulence in the coming weeks. In particular, look for renewed elevation in credit default spreads, lower equity prices, a continued scramble for T-bills, elevated swap spreads, lower oil prices, and continued expectations of near-term rate cuts by the Fed.

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