Yesterday, the stock market tanked as Treasury Secretary Geithner outlined his financial stability plan. Blogger Felix Salmon noticed the mirror image:
“I like the symmetry here. On November 21, when Barack Obama announced that he was nominating Tim Geithner to be his Treasury secretary, the Dow rose 494 points and broke through the 8,000 barrier. On February 10, when Geithner gave his first major speech as Treasury secretary, the Dow fell 273 points and broke through the 8,000 barrier.”
I once wrote that “the market is a lot like a fun house mirror.” New data affects prices indirectly. And sometimes the reflection comes out warped. Ben Graham said it best:
“...the influence of... analytical factors over the market price is both partial and indirect – partial, because it frequently competes with purely speculative factors which influence the price in the opposite direction; and indirect, because it acts through the intermediary of people’s sentiments and decisions.”
I’m not sure if the market decline had more to do with the substance of Geithner’s speech or the sentiments of traders. I certainly didn't think it justified marking American businesses down a couple percentage points.
Personally, I didn’t find the plan especially bad. I thought it would have a lot more detail. I’m glad it didn’t. How could anyone come up with a detailed plan at this point?
Some banks – some very big banks – are going to have to be recapitalized. The only way to start that process is to look at the economic reality under the accounting fictions that are bank balance sheets.
It doesn’t matter if you use mark-to-market or mark-to-model, you’re still going to end up with some very inaccurate balance sheet numbers in times like these.
Markets – be they liquid or illiquid – value assets oddly from time to time. And models are as flawed as their makers.
At least Geithner is talking about a stress test. That sounds like the first step toward recapitalizations.
Unfortunately, he’s also talking about private money coming in to buy toxic assets. Unless there are ironclad government guarantees involved, I’m not sure that will fly.
Some of these assets weren’t just overpriced the way houses were – they were inherently flawed.
Accountants record. They don’t analyze.
There isn’t a right number and a wrong number. There are just useful numbers and useless numbers.
For example, it makes not one iota of difference to me – as an investor – what dollar value public Company A assigns its 23% stake in public Company B, because public Company B files with the SEC. All I need to know is the number Company A put on its books and where I can read all about Company B. The rest is up to me.
Unfortunately, you can’t do this with “toxic assets”.
In her book Dear Mr. Buffett, Janet Tavakoli quotes an email from Warren Buffett:
“I’ve looked at the prospectuses, and they are not easy to read. If you want to understand the deal you’d have to read around 750,000 pages of documents.”
If you want to understand how CDOs and other toxic assets are built, read Janet's book.
A lot of people make the argument that these assets are not toxic at some prices.
Theoretically, that’s true. If there’s value in an asset – at some deep discount to par – a high-risk asset can become a low-risk investment.
But, as I wrote in my review of Janet’s book, these toxic assets are “meta-bets”. A low price is little help if there is inadequate cash flow or collateral built into the asset.
A low price can’t fix an inherent flaw in an asset. If the cash flow generating potential of the asset is almost non-existent, the asset is essentially worthless.
Warren Buffett gave a great example of this kind of inherently worthless asset in his 1990 letter to shareholders:
“At the height of the debt mania, capital structures were concocted that guaranteed failure: In some cases, so much debt was issued that even highly favorable business results could not produce the funds to service it. One particularly egregious "kill- 'em-at-birth" case a few years back involved the purchase of a mature television station in Tampa, bought with so much debt that the interest on it exceeded the station's gross revenues. Even if you assume that all labor, programs and services were donated rather than purchased, this capital structure required revenues to explode - or else the station was doomed to go broke.”
A lot of these toxic assets were similarly structured. They were built to fail.
A bad house is a good value at some price. A risky mortgage is a good value at some price. But “meta-bets” are trickier. They can suffer from the same sort of problem Buffett described with the very worst junk bonds – you can actually take a good asset, with good cash flows and then put so much debt on top of it that the only way you can fix the problem is by restructuring the debt.
In such cases, a low price is no longer enough. The terms are the problem.
Nationalizing the biggest banks – a surprisingly popular view among bloggers if not investors – doesn’t address the underlying issue of payment obligations that can’t be met.
Recapitalizations would help banks lend, but problems would still linger. And unless nationalized much smaller banks – and some clearly don’t need it – I’m not sure you could ever get the kind of clean purge investors and lenders so desperately want.
John Hussman has written about a different approach:
“The heart of this problem continues to be the need to restructure the payment obligations of borrowers. For the better part of a year now, I have repeatedly (and increasingly urgently) advocated the restructuring of mortgage obligations by a variety of methods (collecting the pieces of securitized mortgages through “all or nothing” auctions, writing down principal in return for “property appreciation rights”, etc).”
I agree. We could use a little innovation here. Economists, politicians, and pundits seem to be drawn to the same stale ideas.
We need to fix the balance sheets of both banks and homeowners. The way to do that is to admit that mortgage debt is improperly structured. We need to apply some bankruptcy court like thinking to our approach to insolvent banks and borrowers.
Their current capital is as unsustainable as the TV station Buffett wrote about in 1990. Just as you can’t keep corporations – even good corporations – under a mountain of high-yield debt greater than their cash flows, you can’t keep homeowners in a state of insolvency.
We wouldn’t allow it in individual cases. And yet we’re basically encouraging borrowers to keep trying to meet terms that are unsustainable.
In both cases, we need to admit the insolvency and then move to remedy it through debt restructuring.
That won’t eliminate the need to recapitalize some of America’s biggest banks. But without debt restructuring, I’m not sure recapitalizing those banks that are too big to fail will be sufficient to avoid a long-term credit freeze.
Just think how long it would take borrowers to get out from under their current debt burden. We’re talking about a process of balance sheet rebuilding that would go on for years and years – long after the official end to this recession. I’m not sure you could resume anything like normal economic growth under those conditions.