There have been many who have suggested that FAS 157 (or 159) is to blame for the current crisis. Sorry, but that doesn’t fly. The trouble does not stem from the accounting, but from the rotten investments. High-quality liquid investments do not have problems getting priced for reporting purposes. If you can’t get a liquid price, there is a reason for that. Prices in illiquid markets jump around — that is a rule.
AIG (AIG) might survive if banks that face a lot of counterparty exposure decide to lend to them to minimize their own losses. At this point, it looks unlikely, but it is possible that banks that would have large credit exposures to AIG would make a loan to AIG. One other note, the $20 billion loan from their subsidiaries appears to be contingent on AIG getting significant help from other sources of financing. No link, but from Bloomberg — “AIG hadn’t gotten access to the New York lifeline as of about 10:30 a.m., said David Neustadt, a spokesman for state Insurance Superintendent Eric Dinallo. “It would be part of a broader deal,” Neustadt said. “If there’s no broader deal, then it doesn’t happen.” The regulators didn’t say yesterday that access to the cash would require such conditions.“
So what does the FOMC do today? My guess is that they loosen 25 basis points, or do something that gives an expectation of expanding the monetary base. I suggested that this might have to happen last month, when I saw credit stress continuing to build in the banking system.
That said, the FOMC could stand pat, and offer to take in lower grade collateral via tri-party repos in order to help keep marginal instituions afloatt, while leaving the monetary base flat. That’s been their default policy for the past year, and it may have delayed some of the credit stress, but it has not solved the basic problem of too much bad lending. Not that the FOMC can solve it without buying all the bad debt, and extinguishing it in a burst of inflation.
We ask too much of the Fed in bad times, and in good times, we don’t ask them to restrain the banks as much as we ought. The problems we face today stem from the monetary and banking laxity from the mid-90s to 2007. There’s a lot of bad debt out there, and no easy way to change it. We are witnessing history now, as leverage collapses in big complex institutions, and in small places too (home mortgages), and we realize that even the government is too small to deal with the problems that they let grow for over a decade, and we didn’t care while the good times rolled on. At present, the main open question is whether the defaults are big enough to trigger another wave of defaults. As for that question, I don’t know the answer, but will try to gauge the risks as time moves on.