I keep telling my partners here (in San Francisco) that I grew up in what used to be considered a banana republic that used all kinds of funny logic to justify the most amazing “heterodox” economic plans (i.e.; economic plans that address everything but the key issue of pretty much any financial issue: don’t spend more than you make), I know what a banana republic looks like, how it behaves and the stories their leaders tell. I feel fairly comfortable in saying that I find myself currently living in one (I won’t even exaggerate for effect and admit that I actually live in California, lest you think I’m mistakenly including Sub-Saharan Africa in the definition of “banana republic”). It’s like déjà vu.
So the markets seem to have gained some level of comfort that banks won’t be nationalized and that there are objective measures in place now to assess the adequacy of their capitalization, the newly introduced “stress test”. I must say it sounds much like the bank holiday of initiative of the 30s. Close down the banks for a few days, pretend you have now diligently inspected them, reopen with grand fanfare and say that all is in order. The hordes of unsuspecting depositors all of a sudden feel reassured and the risk of an immediate run on the bank is over. Brilliant.
Despite this being a much more complicated environment, infinitely bigger institutions and arguably still more leveraged, I admit this gimmick might still work at a psychological level. Stress test… bare with me while I detour a bit to tell you a very relevant story. In one of my past lives, my firm participated in one of the first privatizations of a commercial bank in Asia during the Asian crisis of the late 90s. It goes without saying that the institutions being transacted where literally hundreds of times smaller than any of the banks making headlines today and these were the simple days before SIVs, CDOs, CDSs, pervasive securitizations, vast derivative books, etc. Well, in those simple days, it took literally a team of over a hundred hired professionals from the best financial advisory, law and auditing firms (not to mention a big team of investment professionals from the equity investors) well over six months of non-stop on-site work to complete the due diligence for the transaction. Even then, the conclusion was that it was very uncertain how many bad loans would come out of the bank’s portfolio (mostly plain vanilla corporate loans) and, for the transaction to be viable from a risk perspective, a good-bank-bad-bank structure (a la RTC) would have to be set up with the sovereign as a counterparty for period of a few years. This was not over the top due diligence, it what was required for a very knowledgeable private investor to make an educated assessment of the situation. Now, fast forward to today… we’re asked to believed that a woefully understaffed (and arguably underqualified given the complexities at hand) US Treasury staff will quickly and efficiently “stress test” the existing financial behemoths (not to mention the thousands of smaller regional banks). I am greatly reassured…
This biggest gimmick of them all is not forcing mark-to-market (and full transparency) on all financial institutions and allowing the market to stress test these banks. A lot has been said of how inefficient the markets have been as of late. This is probably a whole different debate as it has was not the free markets that have failed as they were never free to begin with. Unless you think free markets include money printing governments that hold interest rates at artificially low levels and don’t provide the minimum amount of supervision for the financial institutions they were supposed to regulate in the first place. As I said, separate discussion. Let me go back to letting the markets stress test the institutions. The main argument as of recent has been that many assets would be artificially marked down simply because there is no liquidity. This may certainly be the case in some instances but I beg to differ as a whole. Let me make another small observation to illustrate my point. We invest in many asset categories, one of them being bank debt (the simple most senior stuff on a corporate balance sheet). Even in these very simple instruments, it is not at all uncommon to see bid-ask spreads of over 10%! This is unheard of. This has nothing to do with market inefficiency, it is the result of sellers unwilling to sell at the offered prices. In many cases, the reasons are simple, sellers (i.e.; banks, insurance companies, pension funds represent a larger portion of these) do not want to take the writedowns on these sales and the implied writedowns on other similar assets as it would expose the magnitude of their plight. Just ask any distressed investor out there, there is lots of capital on the sidelines but we have not hit a clearing price yet for these assets.
So what to do? I marvel at so many academics and politicians out there with such firm views on what to do and what not to do in face of such a complex set of circumstances. I can help it but recall a quote from Goethe: “ We know accurately only when we know little; with knowledge doubt increases”. Remember my little story above of the bank restructuring we participated in. So my first wish would be that we start to back away from gimmicky policies like “stress tests” and start facing up to and solving the problems. First, let the markets expose the size of the problem by forcing mark-to-market on all institutions and assets. Let’s admit that the collective assessment of the smartest private capital out there is likely to be more efficient and accurate than civil servants. Is that too much of a leap of faith to ask for? Second, I hate seeing my hard earned tax dollars go to support those who have done stupid things to themselves but I am under no illusion that this will cost us all a lot of money. We cannot afford to risk a run on the major banks. In this regard, instead of all the TARPS and other fancy acronym programs, I wish the administration would provide a full and explicit guarantee to all individual and corporate deposits (checking, savings, 401k accounts). The US government will need to underwrite stability once mark-to-markets illuminate the insolvency of a large swath of financial institutions. Now what? Want to be bold? Pay a lot of money to bring together a team of the best in the private sector to slice, repackage and sell as many assets as one can as quickly as possible. Think of something akin to the massive wave of privatizations that East Germany went through immediately post unification. Sure mistakes will be made, corruption will occur but, then again, is that much different than what we have now or what has been in the past? Besides, despite all that has transpired, I would still rather see my tax dollars being spent by the best minds in the private sector than in the public sector. Or would you prefer something akin to the House Financial Services Committee spending money on your behalf?
Yes, a lot of equity and debt value will be eliminated in this process and there will be a lot of pain a result. However, in this uncertain world, I still come out on the side (please allow me to have some doubts in a situation like this – unlike many self-proclaimed experts out there) of not delaying what is likely to be inevitable pain. Take your strong medicine now and cleanse the system. The risk of not doing so is a hugely prolonged process, potentially much more expensive (just think Congress deliberating and horse trading on your behalf) and, in the end, arguably the same outcome (there is certainly no conclusive evidence to the contrary).
As my 100 year old grandfather who happened to be one of the few to witness the crash of ’29 first hand (and perhaps as a result had a profound contempt for Alan Greenspan and his policies for the last 15 or so years) recently said, “God bless our children and grandchildren for they will be paying for our sins for years to come…”.