Friday, 17 October 2008

Financial Meltdown Hysteria

I see that EVERYONE is simply hysterical about the "Global Financial Meltdown", and even MORE hysterical about the US government "bailout".


From what I have seen and read, it can all be summarised fairly concisely:

1. The 1968 CRA (Community Re-investment Act) forced banks and other lenders to lend money to people who (in the eyes of the banks involved) could not be relied upon to repay the debt.
NOTE: This DOES NOT mean that ALL of the debt is bad, simply that the RISK associated was higher than the banks would have been prepared to accept, absent the threat of government sanctions for non-compliance.

2. The provisions of the above law were strengthened in 1995 so that even MORE people could force the banks to lend them money against the banks' better judgement. There is much truth in the old saying "The banks only lend money to you if you can prove that you don't need it." We only need to add - "unless the government forces them to."

3. The US govt recognised that the risks were higher and established a GSE (Government Sponsored Entity) or two to buy these loans from the banks and thus move the risk and reinforce the CRA provisions. (Think Fannie Mae and Freddie Mac - who named those things anyway?)

4. Sarbanes-Oxley came along in response to other corporate malfeance and established that corporate balance sheet assets had to be valued at "mark to market" rules. There was no real impact of this provision for a while.

5. There came a time when the market for these "sub-prime" loans evaporated (for many and various reasons), and those holding the assets had to value them at ZERO because nobody wanted to buy them - there was no market to use for "mark to market". The majority of these loans are in large part perfectly healthy, and will be repaid in full as per the terms of the contract. Others are not so healthy and will be defaulted, but they are STILL not worth NOTHING.

6. Balance sheets of companies looked TERRIBLE, with both real and imaginary losses - share prices tumbled. Margin borrowers started to hurt, credit ratings went south.

7. Can you spell "CREDIT CRUNCH"? Right - I thought you could.

Where exactly is the problem?

While the creation of the "sub-prime" market was stupid, and the actions of some of the key players were reprehensible and no doubt in some cases illegal, the market and the government quite rightly recognised that there were enhanced risks associated with these loans, and managed them appropriately - by shifting the problem to someone else if not actually resolving the issues. (Fighting the might of government can be hard on ANYONE.)
So we have a whole heap of loans, that collectively have a value, but nobody knows which ones are "good" and which are "bad" so they don't want to buy ANY of them. Thus these loans are forced to be valued at ZERO because of the provisions of some other law.

I am not belittling the other problems that exist, but it seems in large part that simply redefining the way these instruments were valued (along with prosecuting the illegalities) would have gone a long way to softening the blow.

Now comes the "bailout".

The US government is buying these loans via a hugely expensive pork-filled legislative bill.

(One interesting aside is that the bill is not specific and targetted (and thus becomes open to pork-barrelling) because it originated in the Senate, and the Senate cannot originate money bills, so the senators had to find an existing bill to which they could add these provisions - the ultimate earmark).

Please note this carefully: the bill authorises the purchase of risky debt-based assets. IT DOES NOT GIVE MONEY AWAY FOR NOTHING. The US government becomes the owner of the debt-based asset, and in the process establishes a market for these securities. Since a market now exists, Sarbanes-Oxley "mark to market" rules can be met, or alternatlively the asset can be sold and removed from the balance sheet entirely.

What happens next?

Corporations will recover as their balance sheets now more accurately reflect reality. True, they have been the recipients of tax-payer largesse in buying stuff that nobody else wants at the moment, but they do NOT get money for nothing.

If the government paid a reasonable price, it will eventually make a profit as most of the loans are paid out, and the others default and the security asset is sold for recovery.

What's not to like?

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