Tuesday, September 30, 2008

Subject: Re: Capital crisis vs. trust crisis   [Rich Lowry]

Ok, another e-mail (I know I’ve been remiss in posting anti- e-mails, so hit me with—yet more—of them and I’ll post the best responses to this pro- one):

Rich:

Former Lehman banker here.  I must express strong agreement with your other reader on this being as much a crisis of trust as one of capital.  What we're seeing is a huge collective action problem.  There are private buyers for the bad assets in the system.  Distressed debt funds make their living off situations like this.  Merrill Lynch for instance sold a portfolio of approximately $30 billion worth of bad mortgage debt to a private fund in July — at $0.22 on the dollar.  The problem is that while there would be a tremendous public benefit if financial institutions would collectively sell their bad assets and rid the system of the uncertainty currently plagueing it, they individually lack the incentive to do so at such a down point in the market.  It's perfectly rational for a CEO to look at his solvency ratios, determine they're stretched but basically fine, and opt to ride his bad securities until the market recovers and he can get $0.65 on the dollar, rather than sell now and get $0.20, especially when selling at such a huge loss would seriously cut into a bank's equity.  Unfortunately it's a bit of a catch-22.  Banks won't want to sell until the market recovers, but the market won't recover until the banks start selling and we get more clarity on their exposure.

Here's the wider problem: the solvency of financial institutions, unlike that of industrial companies, doesn't depend merely on their being able to generate cash flows sufficient to service their debt.  Their solvency requires that they maintain enough confidence among lenders, depositors and counterparties that these parties don't lose faith, suddenly pull their money out all at once, and initiate a Lehman-style run.  Thus, in jittery markets where nearly everyone has bad assets, even parties whose ratios look fine on paper are at risk.  Since everyone is at risk and lenders have no way of predicting who will be the next victim of a Lehman-style run, they'll simply stop lending altogether (it's happening already).  This uncertainty can be largely eliminated if all the assets were to be removed from the system, allowing lenders to lend confidently once again.  One should view a massive government purchase of these assets a public good - like providing a military - an appropriate use of government authority, even for those of us who, in normal conditions, prefer a small government.

UPDATE, an e-mail in response:

Rich –

It’s worse than Lehman banker said; Merrill loaned the buyer 15 of the 22 cents on the dollar the buyer paid.

The eroded value of these assets is almost solely a function, we all agree, of declining home prices. Those of us who begrudgingly concede a role for our financial authorities beyond the Fed’s not insignificant power to inject liquidity into the system are finding it hard to see how the bailout addresses the fundamental problem. Indeed, it doesn’t even purport to, except to the extent that home prices will trend up with the economy. Why not have the government simply buy homes at foreclosure and raze them?  The Freddie/Fannie subsidy of bad mortgages caused an oversupply; the government will simply be eliminating that mistake.  No moral hazard, no increase in government’s authority, no subsidies to firm’s taking excessive  risks, and an idea that more effectively addresses the problem’s cause – what’s not to like?

09/30 05:24 PMShare