Paul Davidson | Oct
4, 2008
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A civilized society does not believe in “caveat emptor” for markets where
products are sold that can have terribly adverse health effects on the...
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By Ron 10-04-2008
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I guess no-one realizes that computer trading systems, lacking official "market
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By Lloyd Gillespie 10-03-2008
Remember that the original Paulson bailout plan and the major function of the
revised TARP rescue legislation is an attempt to prevent massive insolvencies in
financial institutions that have, on their balance sheets, "securitized" assets
(e.g., Mortgage Backed securities [MBS, CDOs, credit default swaps ,etc] that
had become virtually illiquid as the market for these "securitized" have failed.
There are three points that I wish to discuss. One: what was the cause of the
failure of these securitized markets? Two: what policies do we need to put in
place to present toxic asset problem from recurring again? Three, even with the
passage of the TARP “rescue” (bailout) plan, the U.S. economy is experiencing a
recession. What should the government due to constrain the downturn until a new
Administration takes office next January? I have written an article entitled "Securitization,
Liquidity, and Market Failure" that was published in the May/June
2008 issue of CHALLENGE . It explains at length why these securitized markets
were bound to ultimately fail.
In the good old days, before "securtization ", when a bank made a loan,
especially a mortgage loan, the loan contract was basically an illiquid asset
that was listed on the asset side of the bank's balance sheet. What value was
put on these illiquid assets on the balance sheet? If there was no market for
these illiquid assets -- one cannot mark to market the asset!! So they assets
were typically carried on the balance sheet at the value of the outstanding loan
-- until, it was paid off -- or defaulted on!
Now a good neoclassical theorist would have said that the value of the
outstanding loan contract is the computed present value of the future stream of
cash receipts including the discounted value of the pay off of the principle (in
the case of an interest only loan). Of course, the implicit neoclassical
assumption underlying this type of present value calculation is that the future
was "known" at least with statistical reliability, i.e., the future is
determined as an ergodic stochastic process. If the future stream of payments
are known with statistical reliability, then anyone who took a course in
economics can calculate the "objective" actuarial present value. (And remember
under the rational expectations hypothesis – the subjective probability
distribution equals the objective probability distribution that governs future
outcomes.) If, however, the future is uncertain, i.e., nonergodic, then the
present value depends on the subjective evaluation as to whether all the
contractually payments specified (in monetary terms) to specific dates are
actually going to be met by the borrower. A large down payment on a mortgage
loan created a cushion for the banker in case a future, unpredicted, default
occurred.
For assets that are liquid, as I specify in my JOHN MAYNARD KEYNES (Palgrave,
New York, 2007) book and the securitization" article in CHALLENGE, there
must be an well-organized and orderly markets. Liquidity requires a market maker
to assure orderly markets-- so that a holder can always make a fast exit and
sell their holdings of any liquid asset at a price not much different that the
previous transaction price.
The break down of regulations separating banks who make illiquid loans and
investment bankers whose function is to float new issue assets in orderly
(liquid) markets is the basis of the current crisis. Starting in the late 1970s
some Federal Reserve Bank decisions were made that encouraged securitization of
illiquid bank loans to a limited extent. But ultimately the firewall between
banks and investment banks was destroyed with the repeal of the Glass Steagall
Act in 1999-- by an act where Phil Gramm was the senior sponsor of the repeal.
[See my January 2008 Schwartz CEPA Policy Note entitled “How
to Solve The U.S. Housing Problem and Avoid a Recession: A Revived HOLC and RTC”]
Thus beginning with decisions made almost three decades ago the seeds were
planted and the ultimate fruition occurring in 1999 with the repeal of the Glass
Steagall Act, more and more illiquid assets were securitized -- but without a
credible market maker for these securitized assets. Securitization may have made
underlying illiquid assets look like they were liquid assets -but they were not
always going to be liquid -- thus they could become toxic – when some unforeseen
event occurs that induces herd behavior for a fast exit.
These securitized assets have no well organized, orderly market with a market
maker. Given the housing problem, there is no orderly market price to evaluate
the worth of these toxic assets. No one knows exactly how to evaluate the MBS,
and other exotic financial assets on the balance sheet of holders. The SEC had
made a rule of mark -to-market for traded securities. In these days,
however, the last market price in the disorderly markets of these TOXIC assets
might have been "a fire sale price" , for example, at 50 to 70 per cent
discount. Accordingly if the financial institutions holding these assets marks
these assets to market, they will be insolvent. The original Paulson plan [only
3 pages long] gave Paulson the right to buy these illiquid assets at a price not
to exceed the price the holder originally paid. If the price was at or near the
original holders’s purchase price, this would improve balance sheets
tremendously and take away the fear of insolvency.
But this would mean the holders of these assets might get away scot free after
making horrible investment decisions. [After all, neoclassical economists would
say that if you make a bad decision, the market should punish you -- and if that
means bankruptcy so be it. It will prevent the moral hazard problem in the
future.]
On 9/30/08, the SEC suggested possible new accounting principles for evaluating
these essentially toxic [illiquid] assets using "fair value" instead of mark to
market.. The SEC news release is as follows:
SEC Office of the Chief Accountant and FASB Staff Clarifications on Fair Value
Accounting FOR IMMEDIATE RELEASE 2008-234
Washington, D.C., Sept. 30, 2008 - The current environment has made questions
surrounding the determination of fair value particularly challenging for
preparers, auditors, and users of financial information. The SEC's Office of the
Chief Accountant and the staff of the FASB have been engaged in extensive
consultations with participants in the capital markets, including investors,
preparers, and auditors, on the application of fair value measurements in the
current market environment.
There are a number of practice issues where there is a need for immediate
additional guidance. The SEC's Office of the Chief Accountant recognizes and
supports the productive efforts of the FASB and the IASB on these issues,
including the IASB Expert Advisory Panel's Sept. 16, 2008 draft document, the
work of the FASB's Valuation Resource Group, and the IASB's upcoming meeting on
the credit crisis. To provide additional guidance on these and other issues
surrounding fair value measurements, the FASB is preparing to propose additional
interpretative guidance on fair value measurement under U.S. GAAP later this
week.
While the FASB is preparing to provide additional interpretative guidance, SEC
staff and FASB staff are seeking to assist preparers and auditors by providing
immediate clarifications. The clarifications SEC staff and FASB staff are
jointly providing today, based on the fair value measurement guidance in FASB
Statement No. 157, Fair Value Measurements (Statement 157), are intended to help
preparers, auditors, and investors address fair value measurement questions that
have been cited as most urgent in the current environment.
* * *.HOW is that for determining "fair value"? What will the Secretary of the
Treasury use to decide fair market value?
Mitigating the current recession.
The bailout bill may buy some time to prevent a complete collapse of the
financial system - but it will not prevent the recession that the US has already
entered. What is needed is at several additional policy actions;
(1), To prevent any further houses becoming vacant due to foreclosure, another
HOME OWNERS LOAN CORPORATION [HOLC] (similar to the one created in the Roosevelt
Administration) is needed. The HOLC would buy up mortgages (at a discount) and
renegotiate new mortgages with home owner-occupiers at monthly payments they can
afford possibly (a) by lengthening the life of the mortgage perhaps to 40
years,(b) by reducing principle, and c) by lowering interest rates. If the
homeowner- occupier still can not make monthly payment requirements on a
renegotiated mortgage, the HOLC should rent the house on a month to month lease
to the occupier at a rent he/she can afford until it can be sold for at least
the value of the mortgage that the taxpayers bought out. (See my Schwartz CEPA
Policy Note)
This will at least limit if not end the fall in housing prices. Until housing
prices recover, the economy will remain in a funk .
(2) A quick, temporary stimulus plan should be done in order to limit the
depressing effects of the recession and to carry the economy over until at least
February 2009 when a new Administration can develop investment policies`in
repairing infrastructure, alternative energy R&D, tax sharing with local and
state municipalities, etc. For example, as suggested by Warren Mosler, a
temporary payroll tax holiday effective immediately and lasting until February
28, 2009 should be enacted. This is equivalent to giving most wage earners a
wage increase of over 6 %. It will also provide business firms with a reduction
in their costs of production in a period where working capital loans are
difficult to obtain.
Policies to prevent future toxic assets
Given the current experience of failed toxic asset markets, it would appear that
the SEC has been lax in pursuing its stated mission of investor protection.
Accordingly the United States Congress should require the SEC to enforce
diligently the following rules:
1. Public notice of potential illiquidity for securities traded in markets
that do not have a credible market maker. Since the mandate of the SEC is to
assure orderly public financial markets, and “require that investors receive
financial and other significant information concerning securities being offered
for public sales, and prohibit deceit, misrepresentations, .... in the sale of
securities”, it is would seem obvious that all public financial markets that are
organized without the existence of a credible market maker should, either (1) be
shut down because of the potential for disorderliness, or (2) at a minimum,
information regarding the potential illiquidity of such assets should be widely
advertised and made part of essential information that must be given to each
purchaser of the asset being traded.
The draconian action suggested in (1) above is likely to meet with severe
political resistance, as the financial community will argue that in a global
economy, with the ease of electronic transfer of funds, a prohibition of this
sort would merely encourage investors looking for higher yields to deal with
foreign financial markets and underwriters to the detriment of domestic
financial institutions and domestic industries trying to obtain capital funding.
In my KEYNES [2007] book, I have proposed an innovative international payments
system, that could prevent US residents from trading in foreign financial
markets that the U.S. deemed detrimental to American firms that obeyed SEC rules
while foreign firms did not follow SEC rules. If, however, we assume that the
current global payments system remains in effect, and there is a fear of loss of
jobs and profits for American firms in the FIRE industries, then the SEC could
permit the existence of public financial markets without a credible market maker
as long as the SEC required the organizers of such markets to clearly advertise
the possible loss of liquidity that can occur to holders of assets traded in
these markets.
A civilized society does not believe in “caveat emptor” for markets where
products are sold that can have terribly adverse health effects on the
purchaser. Despite the widespread public information that smoking is a
tremendous health hazard, government regulations still require cigarette
companies to print in bold letters on each package of cigarettes the caution
warning that “Smoking can be injurious to your health”. In a similar manner, any
purchases on an organized public financial market that does not have a credible
market maker can have serious financial health effects on the purchasers.
Accordingly, the SEC should require the following warning to potential
purchasers of assets traded in a market without a credible market maker: “This market is not organized by a SEC
certified credible market maker. Consequently it may not be possible to sustain
the liquidity of the assets being traded. Holders must recognize that they may
find that their position in these markets can be frozen and they may be unable
to liquidate their holdings for cash.”
Furthermore, the SEC should set up strictly enforced rules regarding the minimal
amount of financial resources relative to the size of the relevant market that
an entity must possess in order to be certified as a credible market maker. The
SEC will be required to re-certify all market makers periodically , but at least
once a year.
2. Prohibition against securitization that attempts to create a public market
for assets that originated in private markets - The SEC should prohibit any
attempt to create a securitized market for any financial instrument or a
derivative backed by financial instruments that originates in a private
financial market (e.g., mortgages, commercial bank loans, etc)
3. Congress should legislate a 21 century version of the Glass Steagall Act.
The purpose of such an act should force financial institutions to be
either an ordinary bank lender creating loans for individual customers in a
private financial market, or an underwriter broker who can only deal with
instruments created and resold in a public financial market.