What’s really the problem these days?
The single best thing that could happen would be for the true magnitude
of the losses suffered by banks and other exposed parties to be
revealed and put in the P&L. Until what happens, fear of getting
stuck with the hot potato makes banks unnaturally unwilling to extend
credit against the kind of collateral that they would not have thought
about twice accepting at the beginning of the year.
Here’s the source. This is an important game to understand. Think of bank managers as being collectively averse to admitting a loss, if only because they might be blamed for that loss. So at first no one admits losses. Even though the market knows the losses are there, the market just doesn’t know exactly where. But then the market has no accurate valuations for some asset classes. Those asset classes can’t serve as collateral because just about any result — relative to an unevaluated base — could count as a loss and we’ve already seen that managers are loss-averse. Plus dealing with hard-to-value assets is difficult in any case.
The simple lesson is that bad news can be good news. "Predictability of environment" is a public good across managers. Once managers admit their losses, market liquidity can spring back to life and we can avoid a credit crunch.
Once managers admit their losses, that is.
So does this mean we need an Ansari X Prize for the first manager to report his losses? Sir Richard Branson, where are you?
This was a major part of Japan’s problem in the 1990s. They refused to write down the bank loses and left the banks to limp along rather than putting their problems behind them and resuming business as normal.
The US accomplished a quick turnaround from the real estate blowup of the 1980s by nationalizing the
losses through the RTC and FDIC. Most of the exposed institutions (savings and loans comprised the
bulk of the US housing finance market back then) were driven insolvent, all the holders lost their
investments and most the people lost their jobs, and the Treasury threw an extra half-trillion in for
good measure. The effect was to drive real estate values down so far so fast that real estate went from
a questionable asset to a clear winner in very little time.
I do think this was beneficial to the US economy vs. Japan, where the effect of the 1980s bubble still
linger (and we’ve been through two more bubbles since!) But it really sucked for those involved in
the business, plus requiring a large Federal bailout whose proceeds went to enriching some astute fellows.
Fortunately the current mess is not as large, no one is really thinking the government needs to take over
Citi and Merrill. Much of the problem now is finding out who really bears the loss – a dollar of loss on a mortgage
is a default on a mortgage security, is a default on a CDO, is a default on a CDO-squared, is a default on
a SIV, which causes a money market fund to break the buck, leading to the fund’s sponsor bailing out
the fund and finally taking that dollar of loss. So we see all these securities defaulting, but it’s
still just one finite loss being passed around the table.
We need a coordination mechanism here, a group confession or amnesty. Perhaps a big drum circle of bank managers wasted on PBR? The incentives must reward cooperation and punish delay. In some ways, forcing resignations is a good way: the old guy takes the blame, the new guy sets the base as low as possible to get the growth jump he can claim as success. Hard to fire all those managers, but what if they all rotated by one company?
“Think of bank managers as being collectively averse to admitting a loss, if only because they might be blamed for that loss.”
Admitting a loss on individual assets/securities is only a piece of this game. Increasing the expected default risk on these asset classes, especially those that were part of a “rating transformation”, can have cascading effects on regulatory capital calculations and borrowing costs (especially for loans collateralized by these assets) I’m not defending anyone that would hide losses to avoid painful writedowns, but there are forces more powerful than pride that would make a bank manager take a deep breath before running losses through the P&L.
Here’s another analogy: you work for an investment firm, under an arrangement that gives you 10% of any profits from your dealings, but no corresponding liability for losses. Under the circumstances, you are happy to make an arrangement whereby your firm gets $10M (of which $1M goes to you) every time some other party misses drawing the ace of hearts, but your firm pays $1B if the ace of hearts comes up. The other party is pretty happy with this too; in fact, he’s willing to play this game every month. For months and months things keep going your way, and now you’re a superstar at the firm. Eventually the ace of hearts is drawn; your firm holds a press conference, announces a big writedown, and fires you. You walk away with your millions, and the firm hires somebody else to do what you did. Everybody’s happy, right?
They would do if it they could. Assuming that the writedown wouldn’t threaten solvency, there is absolutely no advantage for management to take writedowns over an extended period. Especially if you are brought in as a new manager.
There isn’t a ‘number’. There are estimates and models and not much of a market. There is a lot of stuff that doesn’t have a price. I think the blame goes to financial engineering. No one really knows how bad things are, but they do know how complex they are. A worst case wipes you out, and isn’t realistic. There is really no market, no history, and inadequate accounting and regulation for this stuff.
Banks would be better off if they could undo the securitization and simply evaluate mortgage portfolios. Banks are good at this, regulation and accounting is straightforward, and the underlying mortgages may not be that bad.
As an example, wfc has $83 billion in home equity loans, and 1.3% of them are not performing. They have taken some hits and raised reserves, but not enough to be much of a problem. I woud bet if they securitized these loans they would need to take much higher writedowns, and might have severe problems. Even if they sold off the lower tranches the remaining securities would take a much bigger percentage hit then unbundled loans. This, of course, makes no sense.
The argument is really that the problem is lack of transparency. For a while, they were actually paid for complexity and the sum was sold or booked as more then the parts. Now we are in the opposite environment where the parts, if you could disaggregate them, would be worth more then the securities.
Everyone has been burned. The regulators, the rating agencies, the accountants, the customers they sold this stuff to. No one is going to cut them any slack, and they are left with a problem that is, in principal, unquantifiable.
The classic prisoners dilemma, but with the twist the first to come clean goes bankrupt. This is what is happening in the markets today. People here are assuming that the actual numbers faced by the banks are not that large, but they are due to implicit leverage and the discovery that some puts were buried in the deals. Goldman estimates a trillion, but if we have a 40 to 50% retracement in real estate prices nationwide, the losses are going to be much much higher than $1T.
If you think this is impossible, take a look at the blogs out there following Sacremento real estate prices. There are already 45% and greater losses out there, and we are nowhere near the bottom. Case in point: House sold in 2006 for 657,500 listed for 339,000 and on the market for 161 days or almost 6 months. Even this price is clearly too high. You could knock off 20% from the current price before you might get a buyer, and we are not at the peak in supply – that should be sometime in q3 – q4 2009.
http://flippersintrouble.blogspot.com/
One major investment bank will be allowed to fail, the rest will be bailed out. They are too big to fail as a group, but not individually, and we are facing a crisis where they might fail collectively. So the solution: Let one fail to appease the masses and put the fear of god where it should be, and then bail out the rest.
So there is a vested interest in not being the first to admit they are bankrupt, because the first to admit bankruptcy will be the IB forced to liquidate before the bailout comes.
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