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.