An often-misunderstood category of finance worker, which already was showing a rising profile, may now be in line for a quantum leap.Robert Hertzberg, CFO.com USSeptember 15, 2008
The downward slide of Lehman Brothers and Merrill Lynch, culminating in this weekend's stunning announcements, seems like more evidence of the poor quality of risk management on Wall Street — alongside Bear Stearns' failure, the $7 billion loss caused by a rogue trader at Société Générale, and the loading up on mortgage-backed securities by virtually every major U.S. bank.
But in fact the troubles of Lehman, which faces liquidation, and Merrill, which agreed to be bought by Bank of America, may amount to a full-employment act for financial risk managers, a category of worker that may not have caused the most recent Wall Street meltdown, but that will likely be called on to help avert the next one.
"It's an exploding category," says Mitch Feldman, president of A.E. Feldman Associates, a recruiting firm with offices in Manhattan and Great Neck, New York. That's not just because of turmoil in the financial markets; it was hot even before the credit crunch began more than a year ago, Feldman adds.
For all of the attention being paid to it, however, financial risk management is a widely misunderstood area. It is not about eliminating or minimizing risk, as its name might imply. Instead, it is about avoiding uncompensated risk. As Aaron Brown, a risk manager at hedge fund AQR Capital puts it, "You can't be a good risk manager if you don't love risk."
The term is squishy enough so that no one knows for sure exactly how many people work as financial risk managers. One measure of the growth, however, is the increasing number of registrants for an FRM certificate, which allows financial professionals to demonstrate proficiency in areas like value at risk and the Basel accord, an international standard for banks that is driving a lot of regulatory change.
More than 13,000 people have registered for this November's FRM exam, a number that beats last year's record level by 36%, according to the Global Association of Risk Professionals, the organization that administers it.
Tens of thousands of people in the commercial and investment banking sector do some form of risk management, regardless whether the word "risk" is in their titles. Most traders and portfolio managers are in effect risk managers, says Brown, who has a degree in applied mathematics from Harvard and has also worked at Citigroup and Morgan Stanley and been a finance professor at Yeshiva University in New York.
In fact, it's the risk managers who are in revenue-generating positions who tend to be a financial firm's most sophisticated dealers in risk. Brown gave the example of a No. 2 trader on an investment bank's fixed-income desk, who might be getting a bonus of $10 million in a good year.
Indeed, financial risk management can be a lucrative field. Recruiter Feldman says the director of collateral risk management at a bank might earn a salary and bonus equal to $500,000 — and report to someone making twice that. A promising entry-level recruit joining a bank or hedge fund in a risk management position might get a guaranteed first-year package (salary plus bonus) of between $200,000 and $250,000, Brown says.
At the lower end of the spectrum are people doing things like risk reporting and credit reporting. These are back-office jobs for which meticulous accuracy, not trading skill, is the chief requirement; the positions pay far less and are rarely glamorous.
Peter Chromiak learned about back-office risk management work during the almost two years he toiled for a firm that trades energy futures. Chromiak's job was to keep track of the positions of one of the firm's top traders, and forward that information nightly to the risk manager. The risk manager would look at the open positions held by the trader, who was uncharacteristically making a lot of losing trades, and would inform the trader of positions he needed to liquidate.
"It was a constant tightening of the leash and loosening of the leash, depending on the number that was coming in," says Chromiak, 24, who is now enrolled at the Haas School of Business at Berkeley and is pursuing a master's degree in financial engineering. Chromiak didn't like the work, feeling he had no control and that the trader whom he was responsible for monitoring didn't respect him.
Such disillusionment is common, especially with new employees trying to make their mark in the risk management field. "If you're standing there with a trader who's making $100 million decisions every day," Brown says, "and the biggest risk decision you've ever made is whether to buy a one-day metro card or a one-month metro card, and you say, 'Gee, my model says you should cut all your positions to zero,' he's not even going to hear you. He's in a different place."
Some of the most important risk management work happens in what Brown calls the middle office. This is a group of senior managers and technical experts — typically physicists and other "math geniuses" skilled at complex modeling, Brown says — whose job is to look at risk on an enterprise level.
A bond trader in New York, for instance, may not know that his firm already has a big exposure to Russian bonds via the fixed-income desk in London. Or a foreign exchange trader may not realize that by going long the dollar he is doubling up on a bet his colleagues in Hong Kong have already made against the Renminbi.
It's the job of the middle office, which is generally overseen by a chief risk officer, to identify these lopsided risk positions and get the business units to unwind them. The reporting line is usually through the CFO, so being "the world's best quant," as one insurance executive puts it, isn't enough.
"The challenge is to find somebody who can pry into the mechanics of a very complex simulation engine and also distill elements of that in a very succinct manner and communicate it to very senior management and the board," says Michael Mahaffey, vice president of enterprise risk management at Nationwide Insurance in Columbus, Ohio. "If you have a blend of those two things, you're golden."
Mahaffey teaches a class in risk management at the Fisher College of Business at Ohio State University, and he says that for a young person interested in entering the field, a multi-line insurance company like Nationwide offers the broadest exposure to risk.
Regardless whether that is true, financial risk management is certainly moving beyond Wall Street. Richard Dowd of Dowd Associates Executive Search in White Plains, New York, says the treasury departments of some big consumer companies are now looking for managers to help them manage interest rate and currency risk. The corporations are especially interested in people with technical undergraduate degrees and MBAs in finance, usually from top-20 schools. Strong candidates can command base salaries starting at $150,000 to $200,000 plus bonuses, Dowd says.
Rajat Gupta is one of the financial risk managers Dowd recruited. Gupta, who was trained as an electrical engineer in India and has an MBA from the Thunderbird School in Arizona, has worked in treasury management for about 16 years, the last three at Bunge Ltd., the agriculture and food giant. He says non-financial companies often encounter risks that "come embedded in the business."
These can be anything from balance-sheet assets of a foreign unit that must be translated back into the home currency, to the much more complicated situation where a company has supply-chain partners operating in multiple geographic regions, and doing business in different currencies.
"That could create a very substantial exposure, and potentially move margins by several hundred basis points," says Gupta.
"In some ways," he says, "it's much more of a challenge than doing the same thing at a financial firm."
Sunday, October 19, 2008
Thursday, October 16, 2008
John H Cochrane
The monster returns
John H. Cochrane
http://faculty.chicagogsb.edu/john.cochrane/research/Papers/mortgages.htm
Like a monster from an old horror movie, the Treasury plan keeps coming back from the dead. Yes, we are in a financial crisis that needs urgent, determined, and clear-eyed help from the Government. But this plan is fundamentally flawed. It won’t even work, leaving aside its horrendous cost and long-lasting damage to the financial system. Every argument for it appeals at some point to magic. Buy a few mortgages and magically the value of all of them will rise. Spend $700 billion to "do something," without stating how that action will help, and by magic "confidence" will be restored. The additions and sweeteners in the Senate version, and those on the table in the house, are counterproductive, horrendously expensive, or a comical pinata. Counterproductive: protecting homeowners and renters may or may not be a good policy idea, but if you don't make people pay back mortgages, the value of those mortgages falls even further. Horrendously expensive: The bill mandates that purchases be made to preserve tha value of retirement accounts. The uncertainty that this bill introduces is already making matters worse.
A workable plan has to be based on fundamentally different principles: recapitalizing banks that are in trouble, including allowing orderly failures, and providing liquidity to short – term credit markets. These are not new and untested ideas; these are the tools that governments have used for a hundred years to get through financial turmoil. However, they have to be used in forceful and decisive ways that will step on a lot of powerful toes. Since the bailout plan won't work, we will be back to these steps eventually. We might as well start now.
The problem
The heart of the problem now, as best as anyone I know can understand it (we are all remarkably long on stories and remarkably short on numbers), is that many banks hold a lot of mortgages and mortgage-backed securities whose value has fallen below the value of money the banks have borrowed. The banks are, by that measure, insolvent. Credit market problems are a symptom of this underlying problem. Nobody knows really which banks are in trouble and how badly, nor when these troubles will lead to a sudden failure. Obviously, they don’t want to lend more money.
A “credit crunch” is the danger for the economy from this situation. Banks need capital to operate. In order to borrow another dollar and make a new loan, a bank needs an extra (say) 10 cents of its own money (capital), so that if the loan declines in value by 10 cents the bank can still pay back the dollar it borrowed. If a bank doesn’t have enough capital – because declines in asset values wiped out the 10 cents from the last loan -- it can’t make new loans, even to credit-worthy customers. If all banks are in this position (a much less likely event) we have a “credit crunch.” People want to save and earn interest; other people want to borrow to finance houses and businesses, but the banking system is not able to do its match-maker job.
Solving the problem
Ok, if this is the problem, then banks need more capital. Then the people, computers, buildings, knowledge, and so forth that represent the real business can borrow money again and start lending it out. The core of any plan must be to recapitalize the banking system. How?
Issue stock, either in offerings, in big chunks as Goldman Sachs famously did with Warren Buffet last week, or by merging or selling the whole company. There are trillions of dollars of investment capital floating around the world, happy to buy banks so long as the price is good enough. Banks don’t want to issue stock, because it seems to “dilute” current stockholders, and might “send bad signals.” Lots of sensible proposals amount to twisting their arms to do so. In many previous “bailouts” the Government has added small (relative to $700 billion!) sweeteners to get deals like this to work.
Let banks fail, in an orderly fashion. When a bank “fails,” we do not leave a huge crater in the ground. The people, knowledge, computers, buildings and so forth are sold to new owners – who provide new capital – and business goes on as usual. A new sign goes on the window, new capital comes in the back door, and new loans go out the front door. Current shareholders are wiped out, and some of the senior debt holders don’t get all their money back. They complain loudly to Congress and the Administration – nobody likes losing money – but their loss does not imperil the financial system. They earned great returns on the way up in return for bearing this risk. Now they get to bear the risk.
We saw this process in action last week. On Monday, we heard many predictions that the financial system would implode in a matter of days. At the end of the week, JP Morgan took over Washington Mutual. Depositors and loan customers didn’t even notice. As someone who argued publicly against the Treasury plan on Monday, I felt vindicated.
This process does need government intervention – “in an orderly fashion” is an important qualifier. Our bankruptcy system is not well set up to handle complex financial institutions with lots of short-term debt and with complex derivative and swap transactions overhanging. Until that gets fixed, we have to muddle through. An important long-run project will be to redesign bankruptcy, delineate which classes of creditors get protected (depositors, brokerage customers, some kinds of short term creditors), and how much regulation that protection implies, and to design a system in which shareholders and debt holders can lose the money they put at risk without creating “systemic risk.” But not now.
What is simple to describe economically –wipe out shareholders, write-down debt, marry the operations to new capital – is not straightforward legally and institutionally. If we just throw everyone into bankruptcy court, the lawyers will fight it out for years and the operations really will grind to a halt. In the heat of the crisis, we need the same kind of greasing of wheels and twisting of arms that went into the last few bank failures.
Fancy ideas. The main point of any successful plan is to marry new capital with bank operations. There are lots of creative ways to do this, including forced debt-equity swaps, and various government purchases of equity. (My colleagues at the University of Chicago are particularly good at coming up with clever schemes. See http://research.chicagogsb.edu/igm/.)
The second part of the solution is to maintain liquidity of short-term credit markets. The Fed is very good at this. Its whole purpose is to be “lender of last resort.” We are told that “banks won’t borrow and lend to each other.” But banks can borrow from the Fed. The Fed is practically begging them to do so. Even if interbank lending comes to a halt, there need not be a credit crunch. If banks are not making new loans, it is because they either do not have capital, or they don’t want to – not because they can’t borrow overnight from other banks. (And the “other banks” are still there with excess deposits.) If the Fed is worried about commercial paper rates, it can support those.
The one good part of the current proposals is a temporary extension of federal deposit insurance. The last thing we need is panicky individuals rushing needlessly to ATM machines.
By analogy, we are in a sort of “run” of short-term debt away from banks. We have learned in this crisis that the whole financial system is relying to an incredible extent on borrowing new money each day to pay off old money, leading quickly to chaos if investors don’t want to roll over. It doesn’t make sense to threaten that overnight debt winds up in bankruptcy court, which is at the heart of the need for Government to smooth failures. In the short run, guaranteeing new short-term credit to banks as a sort of deposit insurance could stop this “run.” If we do that, of course, we will have to limit how much banks and other financial institutions can borrow at such short horizons in the future.
Banks vs. the Banking system
Banks can fail without imperiling the crucial ability of the banking system to make new loans. If a bank fails, wiping out its shareholders, and its operations are quickly married to the capital of new owners, the banking system is fine. Even if one bank shuts down, so long as there are other competing banks around who can make loans, the banking system is fine.
I think many observers, and quite a few policy-makers, do not recognize the robustness that our deregulated competitive banking system conveys. If one bank failed in the 1930s, a big out of state bank could not come in and take it over. Hedge funds, private equity funds, foreign banks, sovereign wealth funds didn’t even exist, and if they did there’s no way they would have been allowed to own a bank or even substantial amounts of bank stock. If a bank failed in the 1930s, a competitive bank could not move in and quickly offer loans, or deposit and other retail services, to the first bank’s customers. JP Morgan could not have taken over WaMu. But all those competitive mechanisms are in place now – at least until a new round of regulation wipes them out. This is, I think, the reason why we’ve had 9 months of historic financial chaos and only now are we starting to see real systemic problems.
There is a temptation for regulators and government officials to hear stories of woe from failing banks, their creditors, and their shareholders and mistakenly believe that these particular people and institutions need to be propped up.
The Treasury Plan
The treasury plan is a nuclear option. The only way it can work to solve the central problem, recapitalizing banks, is if the Treasury buys so many mortgages that we raise mortgage values to the point that banks are obviously solvent again. To work, this plan has to raise the market value of all mortgage-backed securities. We don’t just help bad banks. We bail out good banks (really their shareholders and debt holders), hedge funds, sovereign wealth funds, university and charitable endowments – everyone who made money on mortgage-backed instruments in good times and signed up for the risk in bad times. This is the mother of all bail-outs.
There is a storm out on the lake, and some of the boats are in trouble. Commodore Bernanke has been helping to bail water from some boats until they can patch themselves up, encouraging other sound boats to help, and transferring passengers on sinking boats to others. But it’s getting tough and the storm is still raging. Someone has a great idea: let’s blow up the dam and drain the lake! Ok, it might stop the boats from sinking, but there won’t be a lake left when we’re done. That’s the essence of the Treasury plan.
Short of that, it will not work. Suppose a bank is carrying its mortgages at 80 cents on the dollar, but the market value is 40 cents. If the Treasury buys at 40 cents or even 60 cents on the dollar, the bank is in worse trouble than before, since the bank has to recognize the market value. Unless the Treasury pushes prices all the way past 80 cents on the dollar up to 90 or even 100, we haven’t done any good at all. And $700 billion is a drop in the bucket compared what that would take.
There is a lot of talk about “illiquid markets,” “price discovery,” and the “hold to maturity price;” the hope that by making rather small purchases, the Treasury will be able to raise market prices a lot. This is a vain hope – at least it is completely untested in any historical experience. Never in all of financial history has anyone been able to make a small amount of purchases, establish a “liquid market” and substantially raise the overall market price.
Since the Treasury will not be able to raise overall market prices, it will end up buying from banks that are in trouble, at prices fantastically above market value. This is transparently the same as simply giving the banks free money. Make sure the taxpayers get a thank-you card.
There is other talk (reflected in the Senate bill) of abandoning mark-to-market accounting, i.e. to pretend assets are worth more than they really are. This will not fool lenders who are worried about the true value of the assets. If anything, they will be less likely to lend. Conversely, if prices are truly artificially low, then potential lenders to banks know this and would lend anyway. We might as well just ban all accounting if we don’t like then news accountants bring. No, we need more transparency, not less.
Many of the changes in new versions of the Bill make matters worse, at least for the central task of stabilizing financial markets. The Senate adds language to protect homeowners – “help families to keep their homes and to stabilize communities.” That’s natural; a political system cannot hope to bail out shareholders to the tune of $700 billion dollars without bailing out mortgage holders on the other end. But it makes the bank stabilization problem much worse. Mortgages are worth a lot less if people don’t have to pay them back. This will directly lower the market value of mortgages that we’re trying to raise.
Yes, we need to do something. But “doing something” that will not work, with potentially dire consequences, is not the right course, especially when sensible and well-understood options remain.
John H. Cochrane
http://faculty.chicagogsb.edu/john.cochrane/research/Papers/mortgages.htm
Like a monster from an old horror movie, the Treasury plan keeps coming back from the dead. Yes, we are in a financial crisis that needs urgent, determined, and clear-eyed help from the Government. But this plan is fundamentally flawed. It won’t even work, leaving aside its horrendous cost and long-lasting damage to the financial system. Every argument for it appeals at some point to magic. Buy a few mortgages and magically the value of all of them will rise. Spend $700 billion to "do something," without stating how that action will help, and by magic "confidence" will be restored. The additions and sweeteners in the Senate version, and those on the table in the house, are counterproductive, horrendously expensive, or a comical pinata. Counterproductive: protecting homeowners and renters may or may not be a good policy idea, but if you don't make people pay back mortgages, the value of those mortgages falls even further. Horrendously expensive: The bill mandates that purchases be made to preserve tha value of retirement accounts. The uncertainty that this bill introduces is already making matters worse.
A workable plan has to be based on fundamentally different principles: recapitalizing banks that are in trouble, including allowing orderly failures, and providing liquidity to short – term credit markets. These are not new and untested ideas; these are the tools that governments have used for a hundred years to get through financial turmoil. However, they have to be used in forceful and decisive ways that will step on a lot of powerful toes. Since the bailout plan won't work, we will be back to these steps eventually. We might as well start now.
The problem
The heart of the problem now, as best as anyone I know can understand it (we are all remarkably long on stories and remarkably short on numbers), is that many banks hold a lot of mortgages and mortgage-backed securities whose value has fallen below the value of money the banks have borrowed. The banks are, by that measure, insolvent. Credit market problems are a symptom of this underlying problem. Nobody knows really which banks are in trouble and how badly, nor when these troubles will lead to a sudden failure. Obviously, they don’t want to lend more money.
A “credit crunch” is the danger for the economy from this situation. Banks need capital to operate. In order to borrow another dollar and make a new loan, a bank needs an extra (say) 10 cents of its own money (capital), so that if the loan declines in value by 10 cents the bank can still pay back the dollar it borrowed. If a bank doesn’t have enough capital – because declines in asset values wiped out the 10 cents from the last loan -- it can’t make new loans, even to credit-worthy customers. If all banks are in this position (a much less likely event) we have a “credit crunch.” People want to save and earn interest; other people want to borrow to finance houses and businesses, but the banking system is not able to do its match-maker job.
Solving the problem
Ok, if this is the problem, then banks need more capital. Then the people, computers, buildings, knowledge, and so forth that represent the real business can borrow money again and start lending it out. The core of any plan must be to recapitalize the banking system. How?
Issue stock, either in offerings, in big chunks as Goldman Sachs famously did with Warren Buffet last week, or by merging or selling the whole company. There are trillions of dollars of investment capital floating around the world, happy to buy banks so long as the price is good enough. Banks don’t want to issue stock, because it seems to “dilute” current stockholders, and might “send bad signals.” Lots of sensible proposals amount to twisting their arms to do so. In many previous “bailouts” the Government has added small (relative to $700 billion!) sweeteners to get deals like this to work.
Let banks fail, in an orderly fashion. When a bank “fails,” we do not leave a huge crater in the ground. The people, knowledge, computers, buildings and so forth are sold to new owners – who provide new capital – and business goes on as usual. A new sign goes on the window, new capital comes in the back door, and new loans go out the front door. Current shareholders are wiped out, and some of the senior debt holders don’t get all their money back. They complain loudly to Congress and the Administration – nobody likes losing money – but their loss does not imperil the financial system. They earned great returns on the way up in return for bearing this risk. Now they get to bear the risk.
We saw this process in action last week. On Monday, we heard many predictions that the financial system would implode in a matter of days. At the end of the week, JP Morgan took over Washington Mutual. Depositors and loan customers didn’t even notice. As someone who argued publicly against the Treasury plan on Monday, I felt vindicated.
This process does need government intervention – “in an orderly fashion” is an important qualifier. Our bankruptcy system is not well set up to handle complex financial institutions with lots of short-term debt and with complex derivative and swap transactions overhanging. Until that gets fixed, we have to muddle through. An important long-run project will be to redesign bankruptcy, delineate which classes of creditors get protected (depositors, brokerage customers, some kinds of short term creditors), and how much regulation that protection implies, and to design a system in which shareholders and debt holders can lose the money they put at risk without creating “systemic risk.” But not now.
What is simple to describe economically –wipe out shareholders, write-down debt, marry the operations to new capital – is not straightforward legally and institutionally. If we just throw everyone into bankruptcy court, the lawyers will fight it out for years and the operations really will grind to a halt. In the heat of the crisis, we need the same kind of greasing of wheels and twisting of arms that went into the last few bank failures.
Fancy ideas. The main point of any successful plan is to marry new capital with bank operations. There are lots of creative ways to do this, including forced debt-equity swaps, and various government purchases of equity. (My colleagues at the University of Chicago are particularly good at coming up with clever schemes. See http://research.chicagogsb.edu/igm/.)
The second part of the solution is to maintain liquidity of short-term credit markets. The Fed is very good at this. Its whole purpose is to be “lender of last resort.” We are told that “banks won’t borrow and lend to each other.” But banks can borrow from the Fed. The Fed is practically begging them to do so. Even if interbank lending comes to a halt, there need not be a credit crunch. If banks are not making new loans, it is because they either do not have capital, or they don’t want to – not because they can’t borrow overnight from other banks. (And the “other banks” are still there with excess deposits.) If the Fed is worried about commercial paper rates, it can support those.
The one good part of the current proposals is a temporary extension of federal deposit insurance. The last thing we need is panicky individuals rushing needlessly to ATM machines.
By analogy, we are in a sort of “run” of short-term debt away from banks. We have learned in this crisis that the whole financial system is relying to an incredible extent on borrowing new money each day to pay off old money, leading quickly to chaos if investors don’t want to roll over. It doesn’t make sense to threaten that overnight debt winds up in bankruptcy court, which is at the heart of the need for Government to smooth failures. In the short run, guaranteeing new short-term credit to banks as a sort of deposit insurance could stop this “run.” If we do that, of course, we will have to limit how much banks and other financial institutions can borrow at such short horizons in the future.
Banks vs. the Banking system
Banks can fail without imperiling the crucial ability of the banking system to make new loans. If a bank fails, wiping out its shareholders, and its operations are quickly married to the capital of new owners, the banking system is fine. Even if one bank shuts down, so long as there are other competing banks around who can make loans, the banking system is fine.
I think many observers, and quite a few policy-makers, do not recognize the robustness that our deregulated competitive banking system conveys. If one bank failed in the 1930s, a big out of state bank could not come in and take it over. Hedge funds, private equity funds, foreign banks, sovereign wealth funds didn’t even exist, and if they did there’s no way they would have been allowed to own a bank or even substantial amounts of bank stock. If a bank failed in the 1930s, a competitive bank could not move in and quickly offer loans, or deposit and other retail services, to the first bank’s customers. JP Morgan could not have taken over WaMu. But all those competitive mechanisms are in place now – at least until a new round of regulation wipes them out. This is, I think, the reason why we’ve had 9 months of historic financial chaos and only now are we starting to see real systemic problems.
There is a temptation for regulators and government officials to hear stories of woe from failing banks, their creditors, and their shareholders and mistakenly believe that these particular people and institutions need to be propped up.
The Treasury Plan
The treasury plan is a nuclear option. The only way it can work to solve the central problem, recapitalizing banks, is if the Treasury buys so many mortgages that we raise mortgage values to the point that banks are obviously solvent again. To work, this plan has to raise the market value of all mortgage-backed securities. We don’t just help bad banks. We bail out good banks (really their shareholders and debt holders), hedge funds, sovereign wealth funds, university and charitable endowments – everyone who made money on mortgage-backed instruments in good times and signed up for the risk in bad times. This is the mother of all bail-outs.
There is a storm out on the lake, and some of the boats are in trouble. Commodore Bernanke has been helping to bail water from some boats until they can patch themselves up, encouraging other sound boats to help, and transferring passengers on sinking boats to others. But it’s getting tough and the storm is still raging. Someone has a great idea: let’s blow up the dam and drain the lake! Ok, it might stop the boats from sinking, but there won’t be a lake left when we’re done. That’s the essence of the Treasury plan.
Short of that, it will not work. Suppose a bank is carrying its mortgages at 80 cents on the dollar, but the market value is 40 cents. If the Treasury buys at 40 cents or even 60 cents on the dollar, the bank is in worse trouble than before, since the bank has to recognize the market value. Unless the Treasury pushes prices all the way past 80 cents on the dollar up to 90 or even 100, we haven’t done any good at all. And $700 billion is a drop in the bucket compared what that would take.
There is a lot of talk about “illiquid markets,” “price discovery,” and the “hold to maturity price;” the hope that by making rather small purchases, the Treasury will be able to raise market prices a lot. This is a vain hope – at least it is completely untested in any historical experience. Never in all of financial history has anyone been able to make a small amount of purchases, establish a “liquid market” and substantially raise the overall market price.
Since the Treasury will not be able to raise overall market prices, it will end up buying from banks that are in trouble, at prices fantastically above market value. This is transparently the same as simply giving the banks free money. Make sure the taxpayers get a thank-you card.
There is other talk (reflected in the Senate bill) of abandoning mark-to-market accounting, i.e. to pretend assets are worth more than they really are. This will not fool lenders who are worried about the true value of the assets. If anything, they will be less likely to lend. Conversely, if prices are truly artificially low, then potential lenders to banks know this and would lend anyway. We might as well just ban all accounting if we don’t like then news accountants bring. No, we need more transparency, not less.
Many of the changes in new versions of the Bill make matters worse, at least for the central task of stabilizing financial markets. The Senate adds language to protect homeowners – “help families to keep their homes and to stabilize communities.” That’s natural; a political system cannot hope to bail out shareholders to the tune of $700 billion dollars without bailing out mortgage holders on the other end. But it makes the bank stabilization problem much worse. Mortgages are worth a lot less if people don’t have to pay them back. This will directly lower the market value of mortgages that we’re trying to raise.
Yes, we need to do something. But “doing something” that will not work, with potentially dire consequences, is not the right course, especially when sensible and well-understood options remain.
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