Here we go again, bailing out firms while placing no constraints on the behavior that necessitated the bailout in the first place. While Paulson hounds Congress to act in haste, we are now at least a year-and-a-half into the crisis: you would think the Fed and Treasury would have devised a rational contingency plan by now – or at least one that was not purely reactionary.
Recently a flight attendant asked me how so many problems could arise from only two percent of financial market assets? When I replied, “which two percent?,” even the flight attendant understood. If investors do not have the ability to discern where losses lie they will rationally divest ALL assets until they find out. The present proposal does nothing to help investors figure out the situation, save adding Federal government holdings to the mix and therefore adding them to the long list of institutions potentially adversely impacted by the crisis.
I reviewed the dynamics on CNBC last summer (2007) in a one-on-one with Carl Quintanilla. We are experiencing what is commonly referred to as an ‘asymmetric information” crisis. Investors know there are losses in the financial system but cannot accurately and credibly determine the distribution of those losses. They react rationally by divesting from the entire system until they get better information.
What better information could benefit investors in today’s financial system? Well, let’s start with bond ratings. After more than a dozen Congressional hearings last summer and fall, no changes have been made to better ensure meaningful and credible bond ratings. Since securitization deals have to go to market with bond ratings that nobody believes, is it surprising that securitizations aren’t selling in today’s markets?
Following bond ratings is accounting reforms. While FASB still fiddles with whether securitizations should be strictly on- or off-balance sheet, nothing has changed. While the market craves better information, considering new reporting paradigms that reveal the total exposure, as well as valuing the optionality of taking risk strictly back on-balance sheet (a la the SIVs and ARMs), FASB remains stuck in their provincial corporate model.
Those two obvious starting points have been under consideration for years before the present crisis. Of course, more is necessary to completely reform markets and relieve investors’ information needs, including a more suitable definition of regulators as risk managers as well as regulatory rulemaking that limits financially engineered regulatory arbitrages that created the “shadow” banking sector. (Securitization was created to reduce bank assets and therefore required capital through the appearance of an asset sale, while retaining the predominant risks in the assets purportedly sold).
While I do not think it is a very good idea to risk the credibility of the Central Bank and Treasury’s financial soundness for private financial market excesses, Paulson and Bernanke are obviously willing to put the entire country’s financial solvency at risk to stem the mere chance of recession and any semblance of financial market difficulties. Are we really so addicted to bubble market returns that like crack addicts, we willing to give the dealers anything – including risking the country’s financial solvency – for another hit? It’s time for the rehab clinic, and longer we wait the more painful the recovery will be.