Chewing Through the Credit Crunch
Getting to the bottom of the continuing crisis.
Where to begin? Maybe with a "minor" change of the rules on how we value assets, then a look at the proposed changes in regulations, some comments to my hedge fund friends, a quick look at the employment and ISM numbers which are clearly showing we are in a recession and then finish up with some thoughts as to what it all means. There's a lot of ground to cover, so we'll jump right in without a "but first" today.
If the Rules are Inconvenient, Change the Rules
Several times in the past few months I've reminded readers of the problem that developed in 1980 when every major American bank was technically bankrupt. They had made massive loans all over Latin America because the loans were so profitable. And everyone knows that governments pay their loans. Where was the risk? This stuff was rated AAA. Except that the borrowers decided they couldn't afford to make the payments and defaulted on the loans. Argentina, Brazil and all the rest put the US banking system in jeopardy of grinding to a halt. The amount of the loans exceeded the required capitalization of the US banks.
Not all that different from today, expect the problem is defaulting US homeowners. So what did they do then? The Fed allowed the banks to carry the Latin American loans at face value rather than at market value. Over the course of the next six years, the banks increased their capital ratios by a combination of earnings and selling stock. Then when they were adequately capitalized, one by one they wrote off their Latin American loans, beginning with Citigroup (C) in 1986.
The change in the rule allowed the banks to buy time in order to avoid a crisis. It didn't change the nature of the collateral. They still had to eventually take their losses, but the rule change allowed both the banks and the system to survive. I have made the point that the Fed and the regulators will do whatever they have to do to manage the crisis.
All the major new multi-hundred billion dollar auctions at the Fed where the Fed is taking asset backed paper as collateral for US government bonds does not make the collateral any better, of course. It just buys time for the institutions to raise capital and make enough profits to eventually be able to write off the losses.
Thus it should not come as a surprise to you, gentle reader, that the rules have been changed in much the same way as in 1980. In an opinion letter posted on the SEC website last weekend clarifying how banks are supposed to mark their assets to market prices is this little gem (emphasis mine):
"Fair value assumes the exchange of assets or liabilities in orderly transactions. Under SFAS 157, it is appropriate for you to consider actual market prices, or observable inputs, even when the market is less liquid than historical market volumes, unless those prices are the result of a forced liquidation or distress sale. Only when actual market prices, or relevant observable inputs, are not available is it appropriate for you to use unobservable inputs which reflect your assumptions of what market participants would use in pricing the asset or liability." (The full letter is available here.)
So, now banks can simply say that the low market prices for assets they hold on their books are actually due to a forced liquidation or distress sale and don't reflect what I believe is the true value of the asset. Therefore I'm going to give it a better price based on my firm's models, experience, judgment or whatever. In today's Continuing Crisis, nearly every type of debt and its price can be classified as a forced liquidation or distressed sale.
Does this make the asset any better? Of course not. But it buys time for the bank to raise capital or make enough profits to eventually take whatever losses they must. And who knows, maybe they'll get lucky and the price will actually rise?
There are two problems with this rule. First, it clearly creates a lack of transparency. The whole reason to require banks to mark their assets to market price rather than mark to model was to provide shareholders and other lenders transparency as to the real capital assets of a bank or company.
Second, can a forced liquidation or distress sale be from a margin call? Obviously the answer is yes. But as Barry Ritholtz points out, this opens the door for some rather blatant potential manipulation. If a bank makes a margin call to hedge funds or their clients to make the last price of a similar derivative on their own books look like a forced liquidation, do they then get to not have to value the paper at its market price? Is this not an incentive to make margin calls? One price for my customers and a different one for the shareholders? If a hedge fund was forced to sell assets and then it found out that the investment bank is valuing them differently on its books than the price at which it was forced to sell, there will be some very upset managers and investors. Cue the lawyers.
Is this a bad ruling? Of course. But is it maybe necessary? It just might be. My first reaction was that this tells us things are much worse than we think. The struggle to get the mark to market ruling only to abrogate it in certain circumstances less than a year later has to gall a lot of responsible parties. It seems like it's 1980 and Latin America all over again. Let me repeat: The Fed and the Treasury (which oversees the SEC) will do what it takes to keep the game and the system going.
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