Thursday, September 25, 2008

The Bernanke Argument: a laxative

I have been reading a bunch of commentary lately about the rescue bill being discussed in Washington. Most of the economist are very negative on it.

The Theory seems fairly simple, in fact I reached the "buy the distressed assets" conclusion a year ago in one of my very first blogs as I started covering this. While the theory is simple the practice isn't.

Remember that this mess we are in, can be characterized as a illiquid market (for mortgage securities in the beginning)with a strong downtrend. If your asset goes down, below what you think it is worth then you hold. No one buys and you have thin trading. The problem with thin trading is that price discovery is not thorough. No one knows what stuff is really worth as "bid/ask" spreads increase. To compound the problem, thin trading can lead to low prices that reflect poorly on mark to market accounting. The situation deteriorates with selling of more assets to meet regulation requirements for example further bringing the price down. Markets in these conditions are in a negative reinforcing spiral where nothing moves.

I call it "a constipation". The market is holding a lot of shit and it is not clearing out. Pardon my crass description, but I do believe it is truly accurate. The plan as explained by Bernanke is effectively a laxative. The scholar of past financial crisis, knows that a SETTING THE PRICE is the first step to unlocking the markets. You obviously want to set it higher than the current market, which will recapitalize the banking system somewhat, but you don't want to set so high that you giving a deal to Wall Street. This is what was done during the LTCM crisis and the Resolution Trust Company, which auctioned off the distressed assets.

Once you buy the assets, a lot of the prices will be reset, the mark to market accounting will kick in and ease or increase the pain on balance sheets. Those that have mark to market will see a plus, those that have mark to model will see a minus, but we will have a benchmark, a clarity of price on a large pool of assets ($700B?). other side of the loop, where it feedback positively. The debt mortgage market is $10T so we are talking about a 7% rescue. It is both a lot and not much. A lot of US Govt and not much compared to the overall size of the market. Will it be enough to get that "release shit"?

The way Bernanke talks about it, he wants to change a negative death spiral into a positive spiral, to stabilize the market. Their actions seem targeted at removing negative feedback loops (like the ban on short trading for example) so as to not completely overshoot on the way down.

Some critics are afraid that there is little way for the Treasury to get the money back, much less turn a profit on it. Further high level criticism is the debt amount taken on which will contaminate the Treasuries. Dollar down, oil up.

10 comments:

Andrew Meyer said...

Marc,

there's one other factor you may have considered or that I may not have picked up in reading what you've written.

No one knows who is going to pay their mortgages and who is not until the end of the month. That's why there's going to be huge write downs every quarter for the next couple years. It's only after the month completes and the accountants close the books that you find out who paid and how didn't. No one can tell beforehand.

So, to use your analogy, it's only at the end of the month that companies discover what's nutritional and what's toxic.

Sorry, I'm not as crass as you are. Of course, I'm not as rich either.

Working on being pleasant,

Andy

Army No Va said...

Andy is right....there are a lot of ticking foreclosures out there (millions) that will happen from 2009-12 as people begin to realize that the prices of 2005-06 are not coming back anytime in the foreseeable future esp for bubble areas. If you are $100K, $200K, $300K underwater, etc... you are likely to be more underwater in 2 years. Then you walk or pay down your mortgage. Keep in mind it takes 10 YEARS to pay down 20% of a 30 year mortgage so....with a lot of people that far under, heck, better to punt, rent and rebuild credit which will happen quite a bit quicker and you'll have more money in the interim to save and live on.

We've had what - 2 million foreclosures over the last 2 years? 10-13 million more to go +/-.

Juha Lindfors said...

Soo... is mark-to-market the only real culprit to the constipation? The underlying assumption with it is that markets are the most accurate measure of value (hence the free market ideology). The reality is that market can be most irrational in valuing an asset. Nobody complained about it when it was bubble-building time. Now it's clogging things up.

What's the better way to measure asset value? Where's the fiber for financial markets?

Marcf said...

Andy and Pierre,

Yeah, you are probably right that the final underlying asset is completely opaque and not well understood at the moment. That adds to the lack of transparency on price. There is few people pricing and sellers and buyers don't REALLY know the price either.

Marcf said...

Juha,

MTM is not the ONLY culprit. It is a feedback loop between assets and debt levels. Right now it is a negative spiral and therefore add instability by non-linear dynamics.

Mark To Paulson, as it is now known aims at restoring stability.

The main problem is that's market pricing is unreliable as it depends on last sales and only distressed sales at low-volume contribute. This is as much a distortion as the Mark to Paulson.

Agreed on cheering on the way up, but not on the way down. Dynamic feedback loops are tricky that way. Bubble are cool but their dual is a black hole. Having one without the other is a bit like having your cake and eating too.

I suspect you will see arguments to limit spiral on the way up, the old Alan greenspan argument however is that it is tough to identify bubbles and they may be an intrinsic part of the financial system anyway.

Juha Lindfors said...

Picked up from news today: SEC is easing the MTM rule.

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