Thursday, November 11, 2010

Solving the Toxic Securities Problem Keeps Getting Kicked Down the Road

The failure by the US government to fundamentally resolve the problem of the toxic structured finance securities continues to inflict significant damages to government and central bank balance sheets and the global economy.

On August 9, 2007, BNP Paribas froze three funds because they were unable to value the structured finance assets they contained.

Shortly thereafter, TYI, LLC published a white paper which both described the problem in valuing these securities and how to fix the problem.  It described how existing structured finance disclosure practices do not provide the investor with the information the investors needs 'when' the investor needs it to make a fully informed buy, hold or sell decision for individual securities.  It noted that the result of these disclosure practices would be a security devaluation cycle with no logical stopping point.

The conclusion was inescapable:  the inability to value these securities would effect every part of the financial system until the disclosure practices were corrected.

The inability to value these securities meant that financial institutions that owned these securities could no longer be valued.  In particular, it was impossible for their peers to tell which, if any, financial institutions they dealt with were financially solvent.  In 2008, this doubt about solvency led directly to liquidity problems as global financial firms became reluctant to lend money to each other.

The Bush Administration was faced with the choice of curing the problem with the toxic assets or treating the symptoms.  Unfortunately, it chose to treat the symptoms using a broad range of responses including issuing government guarantees and making TARP funded preferred stock investments.

This left the fundamental problem of valuing the toxic securities and their underlying assets unresolved.  It was kicked down the road to be handled at some future time.

The choice to kick the problem down the road was very unfortunate as it fed the crisis.  It undermined confidence.  It is really hard to have confidence in the prospects for the economy when the government is running around implementing what it describes as heroic and unconventional measures to head off Great Depression II.  As the government scrambled to contain the crisis, it sent the unmistakable message that it did not know what it was doing.

There was a simple, better alternative to kicking the problem down the road.  The alternative was to solve the problem.

The government would have had to acknowledge that the securities could not currently be valued because of the lack of loan-level performance information and announce that the government would cover the cost of making the information available to the market.  This simple tactic would have transformed the issue from being fueled by fear, as in oh my god how bad a problem are the toxic securities, to an issue driven by rational analysis, we will know what the facts are in a fixed period of time.

In 2009, the Obama Administration arrived promising change you can believe in.  The administration promptly adopted the treat the symptoms solution of the Bush Administration.  This was not surprising given that President Obama appointed as the leaders of his economic team individuals who were responsible for developing and implementing the treat the symptoms solution.

Again, the fundamental problem of valuing the toxic securities and their underlying assets was not resolved, but rather was kicked down the road to be handled at some future time.

By late 2009, against a backdrop of significant fiscal stimulus, the Obama Administration declared that the policy of treating the symptoms was successful as a second Great Depression had been avoided and the US economy was recovering.

There was only one small problem with this claim.  The toxic assets still exist, they are still impossible to value and the issue of financial institution solvency has not been ended.  Temporary relieve from the acuteness of the symptoms does not mean that the cause has been cured.

Is there any support for the idea that the issue of solvency has not been ended given the heroic claims by the Treasury Secretary Geithner after the bank stress tests?  Unfortunately, yes.

Before the credit crisis, financial accounting required the banks to mark their investments to market prices.  When the prices of these assets started plunging, the government and the banks urged the financial accounting industry to suspend mark-to-market accounting as the decrease in the market value of the toxic securities was wiping out the capital at these institutions (note: this is a treatment for a symtom of the valuation problem).  Mark-to-market accounting still has not been reinstated.

There could be a number of reasons why mark-to-market accounting has not been reinstated.

One reason is that everyone knows the toxic securities still do not provide the current loan-level information needed to value them.  Without this data, as demonstrated by the Brown Paper Bag Challenge, investors would be blindly betting when it comes to valuing and buying individual securities.

Given the hundreds of billions of dollars of losses they incurred as a result of the inability to value these securities, without the necessary disclosure, investors have been reluctant to return to the structured finance market despite explicit bribes, like PPIP, and forceable coercion, under zero interest rate policies.  This lack of investor activity suggests that the 'market' price for these toxic securities will not be high enough and that reinstating mark-to-market accounting will once again show that the financial institutions have a need for additional capital.

Over the last several months, Yves Smith has been documenting on Naked Capitalism several other reasons that investors might be reluctant to purchase the toxic securities.  Prominent on her list is the possibility that the loans were never properly conveyed to the trusts that were suppose to hold them for the benefit of the structured finance security investors.

The inability to value the toxic securities and their underlying assets continues to weigh down the global economy.

The impact is felt everywhere, but most importantly in the confidence of businesses and individuals to look forward to and act on the idea of a better economy in the future.  It is hard to think the economy is going to improve when the toxic securities are still out there making a return to normal capital market functioning impossible.  At the same time, the programs to treat the symptoms of the toxic securities are themselves becoming toxic (see QE 2 and the rise of commodity prices).

The time to solve the toxic securities problem has come.  Solving the toxic securities program also allows the government to unwind all the programs it put in place to treat the symptoms.

No comments: