Why TARP Has Failed

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.

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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.

Comments

[1worldcurrency:]

Failed banks must fail. Save the welfare program for those in need.

2008 Nov 04 03:56 AM

[Steven Hansen:]

sorry roger, the poison needs to remain on the books of the poisoned. i have no argument with the painstaking analysis your recommend. once we understand the damage, then take the next step.

do nothing until the problem can be defined - any decision made on incomplete information has no chance of success.

2008 Nov 04 05:16 AM

[mcrem51:]

This makes way too much sense to be the public policy we adopt.

2008 Nov 04 08:37 AM

[danflan:]

Well put Roger.

And by allowing the bad companies to hide their losses, which makes it difficult to tell good from bad, we undercut the good companies' ability to raise and then deploy capital to those who need it, can use it effectively, and will contribute to growth.

The ridiculous thing is that many folks seem to think the answer to our problems is REDUCING mark to market, to prevent "paper losses." To them I say why not just go a step further and suspend financial reporting altogether in the affected industries? If a little less transparency is good, why isn't no transparency better?

2008 Nov 04 11:22 AM

[kebu77:]

" '....Assessing the value of mortgage-backed securities [MBSs] requires scrutinizing mortgages down to the level of individual ZIP Codes.....' As both Markowitz and I have argued, we need good information on these portfolios.... [S]ecurities 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...."

Take out the trash.

An intermediary needs to be introduced and rules imposed to get a much quicker MBSs valuations than "months or longer" and to do loan mods on targeted mortgages of primary residences in reliance on results. If this involves legislation or regulation to modify MBS contracts, so be it. (Though, based purely on financial considerations, selected non-primary residential mortages might be included if a security holder notice-and-approval mechanism could be efficiently implemented.)

The goal is to get marketable valuations quickly and re-liquidify the MBS market.


Sheila Bair's current "class action" loan-mod exercise re IndyMac is being rendered ineffective because only mortgages not bundled into MBSs are included and her model is unable to drill down to outcome comparisons based on probable losses arising from foreclosure (thus no meaningful compromise of principal as a part of work-outs and too high an income threshold for participation).

If a minimum baseline, separate from any given delinquent or at-risk mortgage, can be set, then the Bair approach can be expanded and made more efficient.

The $700B bailout bill was originally advertised as being mainly for buying MBSs to improve bank liquidity, help homebuyers, and establish a real-value bottom to house prices (rather than an "undershoot" based on excess foreclosures and real, measureable harm to neighborhoods).

But Bait and Switch happened. If nothing meaningful happens on relief for homebuyers/house prices, the Hill will move on bankruptcy reform. I think bankruptcy reform is needed anyway, but it will surely occur if there is no alternative option out there.

2008 Nov 04 01:08 PM

[Kinabalu:]

"Others, such as myself, see proper valuation - be it mark-to-market or otherwise - as the linchpin to addressing today's problems"

I don't think Dr. Markowitz (he does have a Ph.D. in economics) was thinking about accounting when he referred to valuation as the critical step, I think he was talking about the economics of investing. An investment in a 30 year mortgage that a bank intends to hold to maturity is a different investment than one that you may sell tomorrow. There is no question that runs on banks have been caused by made up values for hard-to-value assets.

Dr. Markowitz is an interesting subject because the "Father of Modern Portfolio Theory" is also the "Father of Financial Engineering". You can trace the antecedents of many of the sophisticated mortgage products created in recent years back to him. I prefer Warren Buffets admonition: "Beware of geeks bearing formulas".

2008 Nov 04 02:43 PM