Are Bailouts The Answer?

Two excellent articles by Alan Reynolds and William Isaac, respectively.

Both of these articles, and others I've read, expound on the terrible effects of "mark-to-market" accounting rules.

One analogy from the WSJ: Imagine you owned a home on Galveston island right before Hurricane Ike was to hit. If you had to sell the house right then, the value of it would be greatly depressed. But the house will be worth much more just days later.

Apply that to the current situation with AIG, Fannie Mae, Lehman Brothers, etc., and you have a self-feeding death spiral. Yes these companies caused their own problems. But having to temporarily and drastically mark down the value of assets they hold kills their credit rating and their agreements with lenders - which simultaneously squashes their ability to raise cash and makes lenders and customers demand their money back. That's not so much a death spiral as it is falling off a cliff.

So marking down these mortgage instruments now is liking selling your house right before a hurricane.

These two articles are the best I've seen in explaining what is happening and how federal bailouts may just make the problem worse...

Reynolds discusses WHY BAILOUTS SCARE STOX.

Salient quotes:

In essence, these bailouts give bondholders more protection than they'd otherwise see - at stockholders' expense.

It's probably true that "something had to be done" in the case of AIG, the nation's largest insurance company with operations in 130-plus countries. But doing something could have meant doing something else - such as offering a secured bridge loan while AIG engaged in some orderly asset sales.

Left alone, financial markets usually work out the best possible deals among competing interests. Whenever the feds have gotten involved, by contrast, they've taken sides in the tension between stockholders and creditors - invariably throwing stockholders overboard.

So mortgage-backed securities are illiquid: They can't quickly be converted to cash without taking a big loss. Firms holding too many hard-to-sell but solvent securities may likewise be illiquid, but not truly insolvent. Mark-to-market, in other words, is artificially turning a big problem into a disaster.

So let's be careful about looking to more government regulation as the solution - and ponder the unintended consequences of "bailouts" of foreign creditors at the expense of domestic stockholders.

Mr. Isaac ponders, How to Save the Financial System.

Quotes:

At the outset of the current crisis in the credit markets, we had no serious economic problems. Inflation was under control, GDP growth was good, unemployment was low, and there were no major credit problems in the banking system.

The dark cloud on the horizon was about $1.2 trillion of subprime mortgage-backed securities, about $200 billion to $300 billion of which was estimated to be held by FDIC-insured banks and thrifts. The rest were spread among investors throughout the world.

The likely losses on these assets were estimated by regulators to be roughly 20%. Losses of this magnitude would have caused pain for institutions that held these assets, but would have been quite manageable.

The biggest culprit is a change in our accounting rules that the Financial Accounting Standards Board and the SEC put into place over the past 15 years: Fair Value Accounting. Fair Value Accounting dictates that financial institutions holding financial instruments available for sale (such as mortgage-backed securities) must mark those assets to market. That sounds reasonable. But what do we do when the already thin market for those assets freezes up and only a handful of transactions occur at extremely depressed prices?

If we had followed today's approach during the 1980s, we would have nationalized all of the major banks in the country and thousands of additional banks and thrifts would have failed. I have little doubt that the country would have gone from a serious recession into a depression.

Again, we must take three immediate steps to prevent a further rash of financial failures and taxpayer bailouts. First, the SEC must suspend Fair Value Accounting and require that assets be marked to their true economic value. Second, the SEC needs to immediately clamp down on abusive practices by short sellers. It has taken a first step in reinstituting the prohibition against "naked selling." Finally, the bank regulators need to acknowledge that the Basel II capital rules represent a serious policy mistake and repeal the rules before they do real damage.

Understand more, at The Pantheon Journal.

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