The financial house of cards has collapsed. What remains is a game of 52 Card Pickup. A strategy is required for how you want to arrange all the cards once they have been picked up, but the task of picking them up is a matter of "52" individual efforts. No two banks are the same, have the same exposure or will be amenable to the same solutions.
Krugman makes the case that moral hazard will prevent the Geithner bank rescue from working. He is probably right about that. It is a clumsy plan and expensive plan, trying to provide incentive for private capital participation in buying toxic assets by guaranteeing their value with tax dollars. Expensive for the tax payer, because the objective appears to be to pay banks what they want for the asset waste rather than what they are really worth. Clumsy because it does nothing to resolve the original question. What are the assets worth? In terms of a solution, it is little if any better than letting the open market price the assets. And time is the critical issue. But we are going to do it anyway.
The do nothing alternative is to let banks fail on the basis of regulatory requirements. Were there consensus on the value of bundles of mortgage securities, good with bad, this banking calamity would not be front page news. The credit default swap quagmire would not be so intractable, and the banks, each with tentacles into hundreds of other banks, intertwined in each other's business, would not be facing death and dismemberment as the gross solution. Left to their own devices, banks can, and would have to, sort all this out in order to keep the industry alive. That would take a very long time, and in the meantime the economy is starved of operating funds.
Paulson and Geithners original plan, in the late summer of '08, was to buy up the unmarketable mortgage securities that Mark to Market accounting had rendered valueless. The only problem is that they weren't really valueless, and everybody knew it. To use a bond analogy, they were not really in default, they were only not meeting the obligation for cash flow. But unlike a bankrupt corporation or municipality, debt service is not from a single source and cash continues to come in, just not enough to meet the original obligation. But by accounting rules that meant they were in default and therefore total junk.
So Paulson goes to buy up the toxic assets and finds that the banks don't want to sell them at the current market knowing full well that they would, like a stock, recover much of their value in a more favorable economic climate. So they remained on the books of the banks, making the banks technically insolvent and causing write downs, apparently staggering losses in profitability when viewed through the lens of accounting practices.
Rather quickly, Paulson dropped the notion of buying the assets because they could not be priced to anyone's satisfaction, in government or in the banking industry. So began the unwinding of hundreds of billions of dollars in demands by counter-parties in CDS contracts, sinking AIG, the biggest baddest bank, and others, in fact instead of just in accounting theory. Paulson decided that instead of buying assets, he would simply give money to the banks to be used for settlement of the CDS obligations, hence payments to other banks and CDS contract holders including foreign banks. This acknowledged and, to an extent, compensated counter-parties for the losses on mortgage securities, in effect, buying of some interest in them by the U.S. Treasury and allowing them to stay on the books of the banks. Now if we go to buy the toxic mess up, we will have ended up paying for them twice.
Geithner's plan, will allow private investors to hold onto the probable upside of the recovering value in mortgage securities, overcoming bankers objections to having arms severed in the clean up. But it boils down to an illustration of why applying bank accounting rules to conglomerates of banking, investment and insurance is a bad idea. If it were not for the banking rules, there would not have been a baking problem as organically separate insurance and investment firms would have just had to eat a few quarters of losses, and the Credit Default Swap would go the way of the Edsel. Instead, we have a lending crisis that exacerbates the hell out of an already steep recession.
But ultimately, we are stuck in a perception problem. Mortgage backed securities are valueless and are, at the same time, valuable. We have been negotiating terms for the purchase of the these securities since August of last year, and have made no progress. All the combined business law and accounting power of all the banks is devoted to getting the best deal for each and every bank. To analogize, every card in the deck poses a different problem in the picking up. In the meantime, the economy fails. So Rome will burn not while we fiddle, but while we negotiate over the value of assets that are burning while we do so.
What is fundamentally an accounting problem, perceived value, calls for an accounting solution. Because the losses on defaulted loans in securitized bundles are not really total, but are total by accounting convention, Mr. Geithner, simply freezes all resolution of CDS instruments and creates a government clearing house for claims, many of which will simply disappear if the housing market recovers. Let the CDS demands remain on the bank books as receivables. Force banks to create a separate account for securitized mortgages gone bad, and let them retain cash flow into the bank capitalization without the liability for something that can't be priced. Then, the cash flows can be valued as separated from the theoretical default. Most of the toxic assets have been written down already but we are making more of them every day that the economy is choked by a weak credit market. Take the obligations off of the bank's books, not by buying them, but by simply, one off, taking them out of the accounting process for bank solvency. Call a moratorium. Give the banks a Mulligan and begin a process of deconstructing the bundling of bad and good loans.
The economy can't wait while accountants and attorneys squabble over precise valuations of these bundled securities as they exist, when no such thing is possible. Inject as much money into banks as it will take to get credit flowing. Let the economy recover and create a floor under the valuations whose free fall is the source of the falling value of the mortgage securities and of CDS claims. When the economy has recovered, a new generation of contract law attorneys will reap the harvest of unwinding trillions of dollars worth of derivatives. Banks will recoup their loses over time and pay the public cash infusion back. We do not need to sacrifice the economy while they do their job.
Many have argued, and correctly, that the banking community would resolve these ills on their own. Let them. Just don't let them take down the country while trying to save themselves.