CORRECTING THE FINANCIAL CRISIS AND THE NEW ECONMOMY

The battle lines are drawn. The battle is to correct bank balance sheets and thus allow the financial system to return to its normal business of financing our economy. On the one side we find the "mark-to-market" warriors and on the other we find those who share my opinion that the market no longer values assets correctly.

I watched two Republican senators on TV today arguing for using "mark-to-market" rules to make banks immediately take the hit for estimated losses on "toxic assets" and thereby restore confidence in the financial system. I then watched the darling of many economists, Sheila Bair, head of the FDIC, state that the markets are not giving the correct value for assets. She noted that 98% of banks representing 99% of all assets have sound balance sheets. But as we all know, the market for their shares has tumbled. Her call is for us to get "correct values for our assets."

Ms Bair offered two ways to get better valuation for our assets. First, would be for the Feds to use their funds to buy up the so-called "toxic assets," the original idea of the TARP fund. The Feds would also get preferred shares in the financial institutions that sell these toxic assets to the Feds. The result would be what is being called an "aggregate bank." A second option would be to use Fed funds to insure these assets. Either way Bair would see Fed funds stabilizing the market for these assets and thereby establish a "market" to which these assets can be valued correctly.

If you have been following my line you will know that I have consistently stated that the markets are no longer able to give correct value to assets. I have consistently noted that mortgage based assets have seen their values drop by some 30% or more based on fears of rampaging defaults and foreclosures on these mortgages. I have also noted that according to the Mortgage Bankers Association, the only organization that represents a major part of mortgage lending, defaults in payment of mortgages is running at 6-7% and foreclosures are running at just over 2%. I do not believe that these still low rates for defaults and foreclosures merits the massive devaluation of mortgage based assets.

More importantly, I have noted that the devaluation has not been done in strict accordance with "mark-to-market" rules. Since the market for mortgage based assets, the so-called "toxic assets," has dried up all together, i.e. there are no sales, their values should be dropped to zero. But such is not the case, various organizations doing the valuations use varying rules. The CEO of BlackRock, a major source of valuation of these assets, said they use the depressed value of the real estate market in Southern California to devalue mortgage based assets.

While devaluing the mortgage based assets has caused enough of a calamity to those holding these assets, it has spread throughout all assets. Result, the yo-yo process of shares on the major stock exchanges. Worse, it has led to a general loss of confidence in the economy and the resulting fall in consumption, loss of jobs and so on.

There is no debate about the basic problem, we must get the balance sheets of banks and other financial institutions on a sound basis. Getting rid of all toxic assets sounds like a straight forward way to do this. The problem is, at what price do you get rid of the assets? Zero or some fabricated value? Mark them to an assumed market and what is that market? Have the government buy them up or insure them and thereby create a "market" for them? Both sound plausible. But they overlook the real problem, no one knows the full extent of these assets. I have heard estimates for "credit default swaps," the elaborate schemes to insure the mortgage based assets amounting to $55 trillion.

Can we really suffer a 30% devaluation of $55 trillion in assets, or a loss of $16.5 trillion, a sum equal to the GNP of the whole USA? Leaving aside the consideration of credit default swaps, can we really afford a 30% devaluation of an estimated $15 trillion in mortgage based assets?

More sobering, can the Feds really buy up the toxic assets? Lets say the Feds only have to buy 30% of the credit default swaps and/or mortgage based assets. That would mean an expenditure of $5 to $21.5 trillion, far more than the TARP of $700 billion or any other Fed fund suggested.

No, the only way to correct the balance sheets of the banks is to suspend "mark-to-market" rules since they no longer work. Then allow the holders of the assets to value them to their long term values, i.e. the return on the underlying mortgages held to maturity. The only adjustment to this really needed is to deduct a loss due to defaults, 6%, and/or foreclosures, 2%. This would not cost a single penny of public funds. I can already hear the chorus singing, "false valuation." Well we already marking them to a false valuation, a sentiment shared by Sheila Bair. And yes, suspending "mark-to-market" would deter investors from buying the assets. So what, they are not buying them now anyway.

CORRECTING THE FINANCIAL CRISIS AND THE NEW ECONOMY

All of this does not change the tectonic change in the economy I point to as formulating our "New Economy," the Federal Government has become the single largest shareholder in the private economy. We now have Uncle Sam joining the ranks of those investing in the economy itself. This changes the whole structure. We cannot now foresee the full impact of this participation by the Feds in the private sector. Will the Feds lead the economy? Deter its progress? Alter it to serve political ends? All of these are serious questions to consider. We are at the cusp of a new course for the American economy. Truly exciting stuff.

Leo Cecchini
January, 2009