Bailing Out the Beaten-Down Financials: The Devil's in the Details

Despite the House passing the Recovery and Reinvestment act over the past week, there's been a persistent sense of doom and gloom in US and global markets. Though it is a fallacy to predict the effectiveness of such an initiative using a short-term stock market reaction, we cannot ignore the natue of the stock market reaction and the sector which bore all the brunt - financials. Let's take a quick look at the numbers.

The recovery and reinvestment act, in terms of size, looks quite dwarfed in context of overall macro economic numbers (all numbers as of the end of Q3 2008):

• Domestic financial sector debt: USD16.9 trillion
• Domestic home mortgage debt: USD10.5 trillion
• Domestic consumer credit: USD2.6 trillion
• Domestic Federal debt: USD5.8 trillion

In comparison, the act would add to budgetary deficits by USD185 billion in 2009, USD399 billion in 2010 and US 787 billion cumulatively over the next few years. So, despite all the hoopla over the size of the package and the fiscal profligacy tag imposed by fiscal conservatives (if there is such a class at all), the size of the package is quite moderate! Let's look at it another way: Federal debt increased by over USD770 billion in Q3 2007 vs. Q3 2008 (15.2% increase). In comparison, the stimulus act would add over USD584 billion (9.9% increase) over 2009-2010.

From the above, it's clear that the stimulus act by itself does not pose a fatal threat to the fiscal state of the US economy. As long as there's a foundation of fiscal discipline (read avoidance of unfettered tax cuts and freebies), the economy will be able to absorb the fiscal bump to reach a manageable steady state.

However, as can be easily seen from the above macro-economic numbers, there's little that the stimulus act can achieve unless there is a very focused and directed effort to 'unfreeze' the money flow in the financial sector, with special emphasis on 'directed' mortgage lending.

TARP Phase 1 obviously didn't achieve it, and neither did any efforts from the Federal Reserve for driving additional liquidity. During the past few months, while Federal Reserve lending to banks increased by over USD800 billion, deposits from banks with the Fed increased by almost the same amount. The basic problem with the above efforts was the same: as long as the mortgage freeze persists and banks continue to face the risk of further write-offs on newer assets, no amount of additional money in the system will help ensure free flow of credit.

Phase 2 of the financial and mortgage sector revitalization act has to do all of what's described below to be effective (as highlighted in some of my write-ups earlier too):

1) Until the credit market freeze is significantly overcome, it's difficult to ensure free credit flow without altering the rules of the game. In some form or fashion, there needs to be a dilution of the mark-to-market rules. I hate to advocate a core principle behind conservative/realistic accounting, but a temporary 2-year moratorium on mark-to-market provisions related to assets in high-priority sectors would not be too bad. For the sake of argument, let's say we enforce a 2-year moratorium on mark-to-market provisions for new mortgage-related assets, including mortgage loans, MBS, CDOs and CMOs with residential and commercial real estate assets as collateral for the base reference credit.

Considering the potential danger associated with rule-interpretation, derivatives (CDS) should be kept out of this moratorium and continue to be subject to mark-to-market norms. This has to be complimented by a mechanism to rid the bank balance sheets of existing written down/troubled assets, through some federal participation, as has already been discussed.

2) Even if the above is done, money flow to sectors deserving the highest priority cannot be ensured without a new dose of targeted/priority lending norms. This can be either through carved out priority lending funds or clear provisions to channel a specified percentage of government funding to new loans in targeted sectors (including residential and commercial mortgage).

3) A thorough revamp of the regulatory and compliance scenario. Tim Geithner already referred to mandatory stress testing for banks receiving (above a certain threshold limit) TARP funds, but we probably need to go much deeper and broader than that. The US has been unfortunately lagging in implementation of Basel II as compared to Europe and Asia - some would question the efficacy of these norms by pointing out the failure of several banks in Europe, but as in many other cases, the mode and manner of implementing such norms/guidelines is even more important than the risk/regulatory oversight that it mandates. Even if banks compute capital norms per Basel II norms and practice market disclosure, true risk assessment often lies in some areas where rules are not as explicit - risk aggregation, stress testing and scenario analysis. Also, goal alignment between business groups and risk management groups through risk-aligned performance measurements and the like is equally critical.

Furthermore, central and regulatory oversight would not be complete without a fresh complementary dose of self-regulatory guidelines, principles and institutions focusing on oversight of equity and credit rating agencies, enhanced market disclosures and fostering market discipline.

A lot depends on the finer print of the financial sector's package that Tim Geithner will hopefully announce over this week and next - both what it addresses and how. I am personally sure there will be enough meat in the proposal, given how the current administration has conducted itself so far.

Disclosure: None

Comments

[Speedspirit:]

The crisis in the financial sector has sparked much debate on the process of reconstucting the rules in which to play by and to save a dead process. It would be better for the big banks to collapse. The system "THEY" created has never run well and has become so complicated that they cant predict the outcomes of their expert advise. As seen over they last decade they havent gotten anything right. And now we should trust "THEM"

Now "THEY" want to create a banking monoply. We are seeing the process move us into a government controled state that is just like communism. A free country exists to let the smaller fish eat the bigger fish. Yes the adjustment would be painful but anyway out of this mess is going to hurt, PERIOD.

We can see that the American spirit is alive and well. But remember for 8 years the ex-president created this mess under these guidelines and they are no good. Time to rewrite a brand new set and move on.

Feb 23 09:35 AM

[Margaret Opine:]

WHILE I WANT TO BY CYNICAL...Self-preserv... does not allow me that luxury. I have lost too much money on Wall Street (because I made my fair share on Wall Street) and I want to make some of it back and then quit WS and retire into my good night. I say honestly, so you need to pay attention: I can't honestly say that the loss of money has grinded me to an end...because it has not. I say honestly that the misbehavior of the "gatekeepers" has taken me under. I am just stunned even though I knew and could predict the human behavior that was underfoot. Even so, I did not want it to be really happening. I wanted the "boys" to not be boys but men, our American heros. I wanted the men to shoulder the huge responsibility:TPT, the public's trust and feel dam good about it as their American legacy. Very few Americans hate the idea of the people on Wall Street making ooodles of money; most Americans just want their families and their 401K, unmolested. That's their American Dream, which also includes a house of some sort.

I am sickened by the guys who would take advantage of the people's trust and run it into the ground. I am awaiting the use of the word "treason" for such behavior.

Feb 23 11:40 AM