Dear Ben and George: Time to Do Something

Includes: DIA, QQQ, SPY
by: Alan Brochstein, CFA

Dear Dr. Bernanke and President Bush,

As a long-time participant in the financial markets who has watched in dismay as the Federal Reserve and the U.S. government have failed to properly address the unfolding credit crisis, I feel compelled now that we are at the edge of a precipice that is unlike any other that we have experienced since the Great Depression to humbly offer my suggestions on what must be done.

First, there is no way to avert a recession or to prop up equity prices or home prices. You can’t magically make a bad mortgage or loan good. Risking the ire of the heads of foreign central banks by cutting rates won’t help. What is the interest rate that makes sense to a lender such that he is willing to underwrite the risk of failure of a return of principal? It is HIGHER not lower than whatever it was before. That is why the policy of cutting rates isn’t working. And as far as fiscal stimulus, why should we give everyone $800, and, in the scheme of things, is that even going to help? Both of these attempts bring in all sorts of unintended consequences without addressing the main problem: illiquidity due to the lack of a true understanding of the value of derivative securities.

Our financial system is more intertwined than ever, and much of the risk that used to reside on the balance sheets of regulated banks is now distributed broadly throughout the system. With the downgrade of Ambac (ABK) and the inevitable insolvency of the major insurance providers to the securities markets, we will now see forced selling by all sorts of entities, which, in turn, will beget even more selling and create a vicious death spiral of margin calls, capital calls, etc. Worse, this is going to scare the living daylights out of the average American who thought that his or her municipal bond was “AAA”, contributing to potential hysteria.

What can and must be done? Very simply, while it pains me as one who believes that government solutions are suboptimal at best and often disastrous, I believe that the government must resurrect a play from the S&L crisis and create an entity similar to the RTC to buy securities. By providing a floor on the value of municipal bonds, asset-backed securities or mortgages that lose their ratings, the financial calamity of a self-fulfilling prophecy of mass liquidation can be avoided. THE GOVERNMENT MUST STEP IN AND PROVIDE DIRECT LIQUIDITY TO THE HOLDERS OF THESE DISTRESSED FIXED-INCOME AND DERIVATIVE SECURITIES.

This action certainly won’t stop the inexorable slide towards recession and lower asset prices in general, but it will prevent the margin-call meltdown for which we are headed. As the new holder of default risk, the government will then be in a position to use public policy to minimize the defaults that are actually experienced. It is my understanding that many of these securities are worth more than where they might be quoted on the market, but the illiquidity that presently hangs over the market prevents a more realistic price to clear the market. Many of those that would traditionally provide liquidity are unable to do so, while those that are able to provide liquidity (and have done so to some degree) must surely question their vulnerability to an even more destabilized financial system. Over time, it is quite possible that the program could be profitable for the government if default rates come in below the very high projected levels implied by the current prices on the securities.

Dr. Bernanke, I know that you want to restore confidence, and I believe that you have come to see that lowering rates further is like pushing on a string. It unfairly penalizes those on fixed-incomes, as you are encouraging short-term interest rates below the current rate of inflation. President Bush, surely you must realize how inconsequential and inefficient the proposed fiscal stimulus will be. Most Americans will simply save that money rather than spend it. To those who are in severe financial distress, the amount is not significant. Gentlemen, the world is counting on you and your advisors to show leadership and can ill afford to continue to watch as you pursue inappropriate policy responses. Go to the root of the problem for the financial markets and provide long-term liquidity where it is needed most, thereby avoiding the death spiral of forced selling.