Why the Progressive Solution Won't Work

There's a draft memo going around that makes proposals regarding the bailout. unfortunately it won't work. Here's why.

Here's the relevant part:

According to a bill summary, the legislation would require the FDIC to survey the banking industry and issue short-term loans (through an exchange of "net worth certificates" and bank promissory notes) to those banks that qualify. In exchange for the short-term infusion of capital, banks would "be subject to strict oversight by the FDIC including oversight of top executive compensation and if necessary the removal of poor management." As Isaac noted, this exact program was enacted by Congress during the S&L scandal of the 1980s and helped "resolve a $100 billion insolvency in the savings banks for a total cost of less than $2 billion."

According to a bill summary, the legislation would require the FDIC to survey the banking industry and insure banks additional loans by basically buying IOUs from banks that qualify. But because this program would technically be an exchange of FDIC "net worth certificates" and bank promissory notes, no money would change hands unless a bank failed. Banks could simply assume they have the capital loans from the FDIC for purposes of their own lending and balance sheets. In exchange for this short-term infusion of capital and government guarantees, banks would "be subject to strict oversight by the FDIC including oversight of top executive compensation and if necessary the removal of poor management." As Isaac noted, this exact program was enacted by Congress during the S&L scandal of the 1980s and helped "resolve a $100 billion insolvency in the savings banks for a total cost of less than $2 billion."

The tricky part of the plan deals with the accounting rules.

Right now, federal law mandates that banks assess their assets on a "mark-to-market" basis - that is, what their assets could be sold for right now, rather than what they could be sold for in the future. The theory is that during a housing and financial crisis, the "mark to market" value of mortgages is artificially low, even though those mortgages represent houses with actual value (for instance, because no one wants to buy mortgages right now, many mortgages are valued at zero on a mark-to-market basis, even though they represent homes that could ultimately be sold for value). Because what a bank can lend out is a multiple of the assets they own, proponents of the accounting change argue that the mark-to-market system is forcing banks to devalue their assets and therefore contract credit. They say that changing the accounting rule to allow banks to list their assets at an "economic value standard" (ie. higher than mark-to-market) will therefore loosen up credit.

The problem with this accounting change is that it would allow banks to leverage even more against assets whose value is still unknown. That, says some opponents, could simply push off - and potentially make more intense - an inevitable day of collapse in the banking system.

Let's take this a in reverse order.

Mark-to-market exists for a very important reasons: it tells us what an institution is worth. The whole argument that some assets are undervalued in a particular environment is true; right now there are some assets that are valued below what you could sell the for in a roaring economy. The question now becomes, what assets would sell at higher prices in a strong economy and which ones wouldn't? The answer is simple: we have no idea. And anyone who tells you they can tell is lying because there is no way to perform that analysis with any degree of accuracy. There area simply too many variables to consider. People have been trying to do that for years. In market parlance, they are called value investors. Most aren't that good.

And that leads to the second problem, which is tied to the above issue with mark to market. The plan calls for a cash injection directly into the banks. That's fine. The problem is financial institutions have been getting infusions for the last year and their stock prices keep dropping. The reason is the issue with bank's assets, which keep dropping in value, thereby requiring more cash. Essentially, financial institutions have turned into a bottomless pit, a financial black hole into which investors have been throwing money. There has already been a ton of money poured into the financial sector in the form of equity injections. And banks still need the money. If memory serves, we've already seen over $300 billion going into banks with no end in sight. In other words, there is no guarantee this will cost less than the Paulson plan.

Right now everybody wants to get rid of mark to market. The SEC just eased the rules. This is like their short-selling ban -- let's prevent the market from working like it should. Now financial institutions will be able to say, "this is really worth more because at some future date it might sell for X." And that's crap. Because that is a complete unknown.

I'm not sure what a good plan would be. But everyone seems hell bent on altering basic market rules like mark to market because they don't like the results. Tough. The rule exists for a damn good reason.

Comments

[veracitatus]

The bailout cannot work because the economy will never come back. We are running out of net energy to do useful work. That is why 'financial' markets exist. No one knows what else to do.

This author has been writing about the evils of fractional reserve banking and borrowing against the future vs. past produced wealth.
http://questioneverything.typepad.com/question_everything/2008/03/index.html

Start there and then follow the trail of bread crumbs.

[jrh0]

CPAs value assets by reference to a known value. Hence, assets might be valued at cost, or at current market value. The general rule is lower of cost or market. Clearly, in a situation such as the present crisis, where everyone knows cost valuation of mortgage derivatives is irrelevant, the assets need to be marked down to market. There is really no other defensible way to value them. Alternative valuation methods would involve as much financial engineering and credibility deficits as the assets we're trying to evaluate. The solution is not to shade the truth, but to deal with it. If the government wishes to ease the capital requirements for banks when the market is broken for troubled assets, it should ease those requirements openly, not by sanctioning creative accounting with a wink and a nod.

[BrighterStar]

except the current market grossly undervalues the assets which is leading to the crisis.

[outnow]

Derivatives are junk bonds in disguise. Same principle, same people, same corporations. The house of cards will fall taking down the world economy, no bailout will fix institutionalized fraud. The "financial gains" of the past several decades have been built on a faulty foundation. The de-leveraging should be done in bankruptcy court but too many do not want their misdeeds and fraud exposed. The bailout will help conceal and perpetuate the fraud. Does anyone really believe that the "real economy" can be ignored in favor of "financialization" and "securitization"? What "product" is being produced?

You can't bail out fraud. Assets bubbles in a virtual market must be deflated or concealed. Get rid of the FED for starters. How about a single-payer system for healthcare like other first-world countries? Or is it better to have 60 million uninsured? America needs limited growth, renewable energy, sustainable policies. The two-party system with "campaign contributions" from corporations has doomed us to maintain the status quo until we fail.

[strangelet]

Hale -- As usual, you get right to heart of the matter. Relaxing the mark-to-market rule is politically popular because it holds out the possibility of unfreezing interbank lending without actually spending any government money at all. The problem, of course, is that without some kind of powerful regulatory framework, the re-valuation of the impaired assets will be left up to the same brainiacs whose (no) -risk models caused the mess in the first place. Thus, at best, we will push Armageddon out for a few more months, when it will be even worse (ArmaCon 5 instead of 3?).

Of course, it may actually have NO effect, because all the banks are so spooked about not knowing the value of their trading partners' assets (or their own), that they"ll just ignore the pumped-up values.

BTW, I believe that pure mark-to-market for financials is a bad idea, because it must cause uncontrolled downward positive feedback if the asset base valuation becomes questionable (as has happened). But an even *worse* idea is letting the foxes decide the value of the chickens. I would support a mark-to-estimate accounting policy IF AND ONLY IF valuations were determined by an extremely independent third party. Yes, ich bin ein Regulator.

So, I supported (as an imperfect stop-gap) the House bill that failed. Now, I must oppose the new Senate bill because it rolls back MTM without regulation. Since I oppose it, it will probably pass. Oh well.

[outnow]

How about a compromise? The rules of accounting should allow some fraud and some reality. You could mark to semi-fantasy" as a means of withdrawing from the toxic derivatives. Eventually, we could have less and less fraud and more and more transparency. We could have a Department of Half-Truths. That would a "sunset of the Department of Half-Truths" in say a few decades, and then we could could have "sunshine", blue skies and a "real economy" rather than usury and paper-scams on Wall Street. The down side is that many people would have to get real jobs but those are all outsourced. What do you tell the children?

[BrighterStar]

I might be said that M2M is the worse way to value assets except for all the others. The reality is the M2M can help lead to some of the problems you mention. In good times it leads to the overvaluation of assets. This leads to CEOs claiming more bonuses than they have earned in reality. Maybe the solution is to keep M2M but have a mechanism to reduce valuations in boom economies and increase valuations in times like these.

[BrighterStar]

The problem is the M2M is the fuel for the current crisis. It requires banks to value their assets below their worth. When this causes some banks to have solvency issues they sell assets at even lower levels causing other banks to have to value assets lower again causing more insolvency. It is one big snow ball that is threatening crush our economy.

[TRex86]

I note that the arch conservative opponents of the bailout claimed to be acting on free market "principles." They only support changing the "mark to market" rule and adding more to FDIC insurance. In their slippery way they are advocating for an artificial inflation of the value of toxic financial assets. Some "principles" those are. How about the "mark to whatever I say" principle. I've got some very valuable bridges to offer...

[jbatch]

Mr. Stewart:

I'd like your opinion of the proposal Steve Wallman of the San Francisco Chronicle outlined the other day. It has many of the features you describe and debunk, but at its core is the notion that the root cause of all this - distressed mortgages -- is also where the best solution lies.

As Wallman points out, underwriting the securitized paper held by Wall Street solves the symptom, not the problem.

Offering government guarantees to the actual distressed mortgage holder, on the other hand, addresses the problem, and the symptom -- and it could be recoverable.

Why isn't that better than buying paper that is one step removed from the problem?

I know this has been linked with the mark-to-market revisions you rightly critique, but it doesn't have to be -- to the extent that it would stem the loss of value in mortgage-backed securities, the value issue would take care of itself.

[katok]

Thank you for keeping them honest. It is telling, that after one week, no one trustworthy or speaking for those who do not have 250k in bank, can explain the "real" problem. I am not saying it is not real, but it is telling

[jhNY]

Some significant percentage of perceived worth depends on a generally agreeable projection of bullshit on the part of buyer and seller, as in, housing values will always go up fast enough that with refinancing, a buyer could never be trapped into a loss he couldn't afford, and a seller wouldn't be stuck with property which lost value. This particular bullshit was instiututionalized, packaged into bonds, sold and resold several times over, and with every sale of bonds, as had been the case of the properties on which they were based, every transaction made the bond or property more expensive.

Sadly, as these assets changed hands, what did not increase was commensurately fast was value, and once the respective markets had realized their high-watermark of price, the price began to drop as markets tried to adjust price to value, and they continue to do so now, ever lower, probably past any reasonable assessment.

Now, nobody has any positive bullshit that anybody else will sign on to, only negative. There is no consensus of value or future valuation to counteract the fear that the real estate or the bonds are practically worthless. We are presently unattached to any sense that over time, price will rise at sufficient rates to attract investment now. The bullshit of of a rosy future is all behind us. And now we live in a world in which the bullshit of no value is everywhere apparent.

[avraamjack]

GOOD PLAN:
.
Would it not be easier to create new banks with the .7 trillion ?
.
You could create 20 hefty banks and in 5 years sell the stock to the public.
.
This would be much more popular with the voters.
.
No more credit crisis, No moral hazard, Main Street gets loans. All stated goals are met.
.

[Herrington]

More exactly right than even your usual exactly rightness Stewart. Getting rid of mark to market would not only allow lending institutions to carry losses forward forever, unrealized, but they could project any future price on them, appearing then to grow their net worth without any basis in reality. Talk about your moral hazard.

If the purpose of accounting is to estimate the actual net worth of a financial entity, for purposes of valuation of company shares or to estimate credit worthiness, then eliminating mark to market basically eliminates the need for accounting. My company is worth what I say its worth.

By the way, House Republicans appear to like eliminating mark to market as well as or more than do progressives. Interesting confluence of ideologies.

[AshevilleVoice]

Changing the mark-to-market rules is also part of the Republican alternative plan, so pinning this idea solely on progressives is misleading.

Although troublesome, there is some merit to advocating this change. In this bad housing market, mortgages against homes are given $0 value. Anyone can see that this is unrealistic. Banks should be able to claim more than $0 value, even if the amt is difficult to determine.

The Progressive Plan has other components not mentioned in your article- ones that will work better than any other proposal on the table. It includes throwing out Paulson's plan, going back to the drawing board, and constructing a plan that creates a Reconstruction Finance Corporation-type agency to buy some bad loans; nationalizes and restructures failing banks; invests heavily in job-creating infrastructure programs; provides direct aid to homeowners; includes new regulations for Wall Street (ie. banning short-selling shenanigans, reinstating and updated the Glass-Steagall Act, etc.); reforms bankruptcy laws to help homeowners renegotiate their loans; expands the FDIC's scope and authority; and pays for any taxpayer losses with a tax on the financial industry.

http://www.ourfuture.org/blog-entry/2008094030/strategy-memo-turning-wall-street-giveaway-economic-rescue-all-americans

Progressives need to get behind this, or support the bipartisan No Bailout Plan.

[23000Days]

Thanks for the link. It's a very thorough look at this situation.
BTW, I'm from Asheville too.

[rmreddicks]

Doesn't this strike you as (to paraphrase Sen. McCain) tactics not strategy. I'm inclined to believe that the best way to fix this mess - albeit more slowly seen yet more deeply solved- is (instead of a sell out to financial markets) a legislative package that creates decent paying jobs, provides for an educational future, develops green alternatives in the energy field (which may end or - make more difficult - wars of choice), and fixes some of the ailing parts of the U.S. infrastructure. The markets will follow the money that goes into the hands of working people. Markets are now following the money that is in the hands of various other markets. Top up death that supposedly demands the sacrifice of people.

[RTIII]

Great article, right on the mark.

NO BAILOUT, NO WAY!

NO "RESCUE", either.
.

[WASanford]

Hale, I"m not an economist. I"m just some Joe on the street who"s trying to understand what"s happening. Here are some of the things I think I"ve figured out from this.

1) Home buyers took on mortgages they could not afford based upon the theory that housing values would continue rising forever and they could live in their house as long as they liked by simply periodically re-financing it. 2) They were encouraged to do this by their real estate agents, mortgage brokers, and bank loan managers. 3) As a result the housing market became seriously overvalued, after all the sky was no limit. 4) This went on until prices hit a limit, which theoretically didn"t exist. 5) As a consequence, this house of cards collapsed. 6) Those of us who had the good sense to stay away from this melodrama should now bail out those witless players? 7) And more of the same is going to somehow fix this?

My understanding of "mark to market" is that it"s far too generous. In my economy at least, if I owe $500,000 for something that"s only worth $135,000 then I have a $365,000 "liability" rather than a valueless "asset." Any other way treating this is either simple denial or out-and-out lying.

If I"m wrong, someone please help me out with this.

(222 words)

[TRex86]

The housing bubble was also propelled by the ability of lenders to dump their mortgages into a bin with other mortgages that could be packaged and resold as AAA bonds. The securitizing of those dubious assets is a significant part of the problem. Various financial institutions bought this AAA manure and used it as equity to buy more and lend more taking us to the point at which their writedowns wiped out all their capital. In truth only about 3% of mortgages are in forclosure (a large increase over the usual state of affairs), but the devaluation of these assets created a downward spiral of collapsing portfolios that fed on itself .
At every point on the root cause analysis better (any?) regulation could have restrained the feeding frenzy. Bondad has pointed out how this led to a doubling of household debt over the past eight years from about 7 trillion to over 13 trillion dollars. Exploiting the bubble has brought down iconic financial institutions and banks. The unwinding will not stop until these low quality assets stabilize at true value. If the bailout involves the taxpayers buying these toxic assets cheaply, stabilizing the market and then selling them for a profit I say, "Go for it."

[ImmanuelGoldstein]

Yep, you pretty much got it down pat. The whole concept rested on the completely faulty doctrine that housing is a value added investment like a factory or a coal mine.
Take a look at this chart of inflation adjusted vs nominal housing prices in the USA:
http://mysite.verizon.net/vodkajim/housingbubble/united_states_1890-2007.png
Focus on the part from 1950-present. Notice any smooth continuous upward swoop of actual housing value (as opposed to prices)? On the contrary they are remarkably stable, Booms have had a historical tendency to regress to the sam floor on value.
If this bust follow historical patterns there is no reason to expect housing values to stabilize any time soon.

[dcree77]

TRex86 has identified the missing part of your analysis. It was the bundling of A-Paper loans with subprime loans and selling them to unsuspecting investors that caused the problem. If the subprime loans were left segragated from A-Paper loans, then the rating agencies could have determined the proper rating based on the probability that the loans would be repaid. Now, investors are unwilling to purchase the bundled loans because they don't know what the mix of bad loans and good loans are. They have no forecasting models with which to determine the appropriate value. Sub-prime loans have a value. They may not be the face value of the mortgages but they have a value.