Reader Question Roundup, 10/20/08

Besides the questions we get in comments, we got a bunch in email last week because of our op-ed in the Washington Post. (By the way, I’m behind in responding to comments on the blog, so if you see one you can answer, by all means go for it.)

Here are a few.

1. Is mark-to-market accounting part of the problem? Should it be replaced by discounted cash flow valuation?

In my opinion, maybe and no. (For those who don’t know, market-to-market accounting means that I have to hold assets on my balance sheet at the value for which I could sell them today, based on comparable transactions in the market. The alternative would be to allow me to use my internal projections for long-term cash flows to determine what my assets are worth.) People see mark-to-market as part of the problem because, on this view, banks are being forced to write down assets below what they are “really” worth, giving them paper losses and, more importantly, reducing their capital. Assume Bank A and Bank B are holding the same security (say, a CDO). Bank A has liquidity problems and has to sell that security at a “fire sale” and only gets 20 cents on the dollar. However, Bank B is convinced the thing is really worth 50 cents on the dollar. Nevertheless, Bank B is supposed to write it down to 20 cents on its balance sheet.

First, I generally tend to the belief that if 20 cents is what it traded for on the market, that’s what it’s worth. For many of these securities, the idea that there are no buyers is not really true, or at least it wasn’t true before September 15; there were lots of private equity firms who would be happy to buy at low enough prices.

More importantly, whatever the problems with mark-to-market, the alternative is worse. The alternative is to let banks use their own internal valuation models to decide what their securities are worth. Nominally I suppose these models would be overseen by auditors, but … I don’t think I need to finish that sentence. I just think the incentive structure is all wrong to allow banks to value their own assets. Maybe there are people out there who can suggest more sophisticated alternatives that avoid this problem.

2. I’ve seen this question in a few forms in email and in the comments. Basically, it goes like this: Yes, in the short term a reduction in spending will be painful. But isn’t what we need in the long term after decades of living beyond our means (at least in the US)?

We are going through a de-leveraging, in which the amount of money available relative to the amount of assets we have will go down. In the US, the most visible sign of that has been the housing market, where falling prices have crimped households’ ability to spend. I agree that, for our long-term economic health, those asset values have to fall down to where they “should be” (and I’m not going to try to predict where that is). However, I think there are better and worse ways of getting to that outcome. One way would be that credit completely dries up, everyone who is delinquent on a mortgage gets foreclosed on, companies lose access to short-term credit and dump assets to meet payroll (or go out of business), credit card limits get slashed, and so on.

Imagine that your credit card banks revoked your cards. For most people even with good credit, this would mean they would have to come up with the cash to pay off the balances, perhaps by selling stocks. Even for people (like me) who pay off their balances in full every month, this would amount to a one-time reduction in my cash, because I could no longer count on deferring a couple thousand dollars’ worth of purchases by 30 days. Imagine the same thing happening to almost every company in the country, which would suddenly have to build up two months’ worth of cash reserves to replace the short-term credit it used to lose. Needless to say, the dislocation would be tremendous, and asset values would probably fall far below their long-term values.

The alternative is a more gradual decline to a sustainable level of debt and spending that avoids most of these dislocations. Imagine instead your bank reduces your credit limit by a few hundred dollars each month, and you know that in advance so you can plan for it by either slowly liquidating assets or slowly reducing your spending. The hope is that this will prevent asset values from crashing too far on the downside. Now it’s not obvious how we make this preferred scenario happen, but I just want to point out that there are different ways to unwind the leverage that our economy has been built on.

3. (Paraphrasing ruthlessly:) Given that the taxpayer is now bailing out the financial sector, shouldn’t this change the relationship between the government and the banks? How can we be sure the money won’t just be stolen? Why are people from Wall Street running the bailout? How can we be sure banks won’t just repeat the egregious practices that created this mess?

Great questions to which I don’t have a great response. I think I can say honestly that we were very early to point out the governance and incentive issues with the original bailout plan. The oversight was much improved in the final bill, thanks to the efforts of people like Barney Frank, but still it largely involves Congressmen having hearings after whatever has been done is done. I think that transparency is vitally important here. There are thousands of highly qualified economists, lawyers, and other people who could spot corruption if they could see the details of the deals that will be done between the government and the banks; the more information that is provided, the better.

To some degree, people from Wall Street are running the bailout because they are the only ones with the expertise to do it. The problem is that we are dealing with highly arcance securities invented on Wall Street, and even most financial economists would agree that they do not have the ability to properly value those securities. This is a problem. This is one reason we recommended using private sector auctions to set the values and then have the government pay those prices; it’s also a reason that we and others recommended bank recapitalization as a better use of the money. Recapitalization does not solve the problem entirely, though. One can argue that the terms of the deal announced last week are too generous to the banks. (I think they were generous, but I think Paulson had to offer them because he needed the first nine banks to accept immediately; the government could not have forced them to agree against their will.) In any case, I would expect either McCain or Obama to shake things up as a show of providing additional oversight, but I also expect them to turn to Wall Street veterans as well.

As for the last question, we need more and better regulation. There is a debate now over whether the regulatory structures were lacking, or whether it was just that the individual regulators were asleep on the job. Christopher Cox at the SEC, in particular, seems to have done absolutely nothing (except prohibit naked short-selling, which arguably was already illegal). For a particularly aggressive regulatory proposal, see the one by Crotty and Epstein.

5 thoughts on “Reader Question Roundup, 10/20/08

  1. Re: Alternatives to “mark to market”

    How about treating financial assets like goodwill? You would carry them at what you paid and would be required to test them quarterly for “impairment”. You could mark them down, but never up…

  2. In response to question 2, it would seem that the US debt situation (problem) is not sui generis, but part and parcel of a larger problem commonly referred to as global imbalances. I heartily agree that an orderly unwinding is preferable to a disorderly one. However, that process will likely be a function of how key global economic actors (China, Gulf States, etc.) etc react along with the US to a changing global economic equilibrium.

    For example, the Treasury will likely be issuing substantial debt to pay for recent bailouts. China and other agency purchasers will likely want higher rates to pay for an increase in the risk premium. This, in turn, will lead to higher interest rates (particularly in the 10-year bond). If, however, China was to remove its currency peg (or GCC countries remove or re-peg)it would disturb the existing equilibrium potentially leading to lower surpluses and appetite for Treasuries.

    I am not saying that the US or other economic actors wants a disorderly unwinding of these balances. However, this crisis is not a mere one-off event, and the government’s fiscal response will likely make reforms even more painful over the long-term.

    In the long-term, the US will need higher interest rates (to encourage savings), a weaker dollar (against a basket of currencies), and more balanced fiscal spending.

  3. My simple suggestion is get rid of your credit cards COMPLETELY. Most of my problems were due to my credit cards and my infatuation with using them to buy shoes.

  4. I haven’t bought a new pair of shoes in years, so I think I’m safe.

    To the previous comment: I agree that there is a long term that we need to worry about. To my mind, the biggest factor in the long term (besides climate change, whose financial impact is virtually impossible to calculate) is the retirement crisis. Besides Medicare and Social Security, I have this suspicion that most people are just not saving enough for retirement (now that we have this “ownership society” where you own the responsibility of saving for your retirement). I believe I heard that the average 401(k) balance is well below $100,000, and it is probably 25% lower after the last month. (I don’t feel like looking up the exact figure right now.) A couple decades from now, my worry is that we will have a choice as a society between letting seniors go hungry or raising taxes on everyone else to feed them. At that time, some will argue that those seniors got themselves into this mess themselves, because they over-consumed instead of saving when they were younger. But I think we will have a responsibility as a society to bail them out anyway. I certainly hope it doesn’t come to this, and retirement funding isn’t my area of expertise, but I have this lingering worry.

    That said, in the short and medium term, I think we need to get the economy going again, in part to raise the tax revenues that our governments need, which puts me in favor of deficit spending. It could certainly lead to higher interest rates, but I think that’s part of the price of getting out of this recession.

  5. I have a question which I hope will make sense. I’m a complete novice who is trying to take advantage of this crisis to learn the economics I never took in college. Anyway, here is my attempt to understand what’s becoming prevailing wisdom, I think, and then my confusion about the implications of that wisdom:

    At some level, this crisis is about confidence. But there is no way to control for people’s reaction to bad news, right? So at another level, this crisis is about what made people panic — which is that people couldn’t pay their debts and no one was sure precisely who was affected by that fact, but everyone was sure that quite a few people/institutions fell into that category.

    Regardless, wouldn’t that mean that this crisis is ultimately at some level about American overconsumption and a widespread tendency to live beyond one’s means, with no cushion whatsoever? Presumably one could fix some of that by regulation (governments crack down on shady mortgage lending) or fear (credit card companies and others get much more cautious about throwing around consumer credit).

    Yet at the same time, wasn’t the economic boom in part fueled by American consumption? Or was that bit about Americans’ patriotic duty to shop and spend our tax rebates simply masking a boom that really was driven by huge gains in productivity thanks to technology?

    If the boom really WAS about American consumption, but if our crisis is ALSO precipitated by American consumption, I’m confused. Do we curtail consumption, or encourage it? If people had to take on debt to consume at the levels they were consuming (houses, cars, shoes, etc.) to the point where they could not pay back that debt when things didn’t go quite as planned (housing prices didn’t just keep going up), then clearly that was not a sustainable economic model. What, exactly, are those with some knowledge of these things hoping will replace it? What will personal finance look like after the dust settles (however long that takes) and how will that impact what our economy looks like?

    Well, that was a long question. But I expressed it in a slightly different form today to a friend who used to work for the Treasury Department and she admitted she wasn’t sure of the answer. Thanks.

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