The fact that the global financial system is in crisis is not longer up for debate. But how we solve the problems both here in the U.S. and abroad is still very much in question. The Treasury plan to make direct injections into ailing firms, and to offer participation to firms that are not currently unhealthy but want additional liquidity, is akin to offering strong medicine to a sick patient whom you have not yet diagnosed.
How much capital do damaged firms really need? This requires understanding the extent of the damage. But by providing capital in the absence of such an accounting, the Treasury is deferring the day of reckoning, the time when the damage becomes apparent and the true magnitude of the capital required is known. Such a deferral, without the need to face into problems today, will set us - the U.S. taxpayer - up for yet another Social Security-style crisis. And this we do not need, and certainly cannot afford.
Much time has been spent debating the issue of security valuation. Some see harsh mark-to-market rules as a root cause of the problems. Others, such as myself, see proper valuation - be it mark-to-market or otherwise - as the linchpin to addressing today's problems and establishing a firm base off which to build a healthier, more stable, more honest and transparent financial system. Harry Markowitz, the "Father of Modern Portfolio Theory," sees valuation and transparency as two essential ingredients for a healthy financial system:
Now 81 and still teaching and advising funds, Mr. Markowitz has good news and bad news. The bad news is that bailouts to restore liquidity aren't addressing the real problem. The good news is that once we have the information to measure the losses of bad risk-taking, markets will recover.
In an essay recently posted on the Web site of Index Funds Advisors titled "What to Do About the Financial Transparency Crisis," Mr. Markowitz calls for urgency in addressing the underlying problem of mismatched securities. So long as there is continued "obscurity of billions of dollars of financial instruments," we run the risk of Japan-style stagnation. Banks there, with the support of the Ministry of Finance, refused to mark bad debts to market for a decade.
"Just as with all securities, the fundamental exercise of the analysis and understanding of the trade-off between risk and return has no shortcuts," Mr. Markowitz says. "Arbitrarily assigning expected returns absent an understanding of the risks of the securities is precisely how the economy arrived at this point."
Mr. Markowitz reckons it could take a year before we have the transparency we need. Assessing the value of mortgage-backed securities requires scrutinizing mortgages down to the level of individual ZIP Codes. "The valuation process will take as long as it takes, but it is the primary step toward effectively utilizing the very controversial bailout and avoiding the structural problem of a stagnant economy.
So how does this relate to TARP and the Treasury's efforts to stabilize the financial system? As both Markowitz and I have argued, we need good information on these portfolios, and legacy mark-to-model values just won't do. Either values have to be marked-to-market, even if the number of trades is relatively small, or securities have to be painstakingly analyzed by valuing each of their components, a process that could take months or longer.
The market, however, may not wait for such analysis to be performed. First and foremost, we have a crisis of confidence, on the part of banks towards banks, customers towards banks and the U.S. Government towards banks. We cannot have banks hoarding taxpayer funds without delivering any benefits to the taxpayer, but this is exactly what has happened because the crisis of confidence has not yet been addressed. Banks are acting rationally, but because they have been given a set of rules that don't make a lot of sense, their actions have drained public coffers while doing little to help us emerge from a credit holiday.
The answer, I believe, is to go back to the tried-and-true approach of creating a centralized mechanism for taking on broken portfolios that need years to recover, recapitalizing damaged institutions after their balance sheets have been cleaned up and enabling confidence to be restored in our financial system. Because as long as possible portfolio blow-ups lurk around every corner, few will be attracted to investing in troubled institutions and even fewer of these institutions will be willing to play their part in the money creation process.
And without banks extending credit and letting the multiplier effect take hold, we will continue to face stagnation with poor prospects for recovery. Further, the act of pushing short rates towards zero will have little impact on the outcome, except to the extent that it provides additional fodder for a possible inflationary spiral once we come out of our economic malaise.
As I have uttered many times to my children at a time of frustration when working on a hard task, "Let's have a redo." I think Messrs. Paulson and Bernanke are in need of a redo. Right now.