Bailout: cause & effect
WARNING: we are not typically focused on macroeconomics except in scenario planning. However, we see strong tendrils of the situation that are really about investor expectations, the efficiency of the market, and the quality of public disclosures.
Here is our brief description of the background of at least the current portion of the crisis (not the subprime problem itself, which is very different):
1. Banks have capital requirements so they won’t be as likely to fail.
2. Part of bank capital is loans and portfolios of loans as well as fuzzier items, such as swaps and other derivatives.
3. The value of the fuzzier items concerned regulators, in part after seeing big drops in startup stock after the dotcom bust.
4. Regulators then required banks to carry those items at market value (just as they would for regularly traded securities) rather than book value. The purpose of this was to get some idea, as fuzzy as it may be, about the value of the assets that the banks wanted to use to fulfill their capital requirements.
5. Market values of CDOs (collateralized debt obligations) dropped as the estimates of subprime defaults differed from original estimates on which the price of the CDOs were set.
6. Banks reduced the value of the CDOs and other assets on their books according to the rules set by FASB for making those estimates when there isn’t a regular market for assets (i.e., anything different than traditional stocks & bonds).
7. When the fuzzy assets were counted this way, the banks didn’t meet the capital requirements. That led to banks raising a lot of capital at lower stock prices (Citi raised $10b(?), mostly from overseas), which obviously led their share prices lower.
8. Lower share prices & lower market values for the fuzzy assets & mark-to-market led to more capital raising, and so on.
The idea we’ve read in various places that mark-to-market by itself is somehow responsible for the underlying change in value of the assets is silly and violates causality. The assets in question are now so fuzzy that the market transactions I’ve read have imposed huge discounts, of 20-40%, on the assets. The real issue for the equity holders is being grumpy about the fact that they need new capital, which is coming in a discount, meaning dilution.
Ending mark-to-market would give everyone less information — yeah, that’s a *good* idea. Everyone, including the market, understands that it’s hard to put values on fuzzy assets, and that risk is priced in accordingly. Now, if the regulators want to shift the capital requirements that are directly causing the need for sales of distressed assets and equity, that might make sense, but we recently just read a different item in the NYT on how similar reductions in capital requirements preceded the S&L bailout. Maybe that idea doesn’t make sense after all. [NB: added text] Other alternatives proposed also focus on the capital requirements, but from the investment angle rather than the regulatory angle. No matter how you slice it, the capital requirement is the issue, not the valuation method of the capital per se.
What will happen, what indeed must happen in the end, is that these illiquid assets will end up in the hands of people who can afford to own illiquid assets. Illiquidity is kryptonite for banks, who had it bad enough back when they were taking in demand savings & checking deposits and making 5-year car loans and 30-year mortgages. Newer instruments seemed to improve things, and probably did, but changes in value seem to have been exponential rather than linear, at least over the small changes I’ve seen quoted, such as doubling the default rate on subprimes from 1.5% to 3%. While that could eliminate profits on thin margins, that shouldn’t destroy more than 3% of the portfolio value if you owned all the mortgages and recovered ZERO from any default.
So that, to us, is one view of the situation.