For the last few days, I've been listening/reading rather than talking/writing. Reflecting on what I have read and heard, there is one thing that stands out.
Everybody's got their own idea of how they would fix the financial markets.
Some are actually pretty good and might even work better than what we'll probably get. Others sound good but probably wouldn't work in practice. Others are downright nonsense.
But the purpose of this post is not to list and categorize all of the proposals floating through the blogosphere. Nor will I offer a complete proposal of my own. Rather, I just want to offer a few general observations.
I'm generally in favor of getting this toxic paper off of the balance sheets of the banks in the interest of unclogging the system and restoring a sense of normalcy in the markets. I am genuinely concerned about what could happen if the banks continue to hold this paper for a long period of time. The crisis of confidence and the inability to lend would lead to a stagnation not unlike Japan in the 1990s.
So if we agree to take this paper off the books of the banks, the next step is to agree on a way of valuing that paper. Given that the market for this paper is not functioning very well, price discovery is a challenge. The government would be making the market, and being the only buyer of any consequence, you'd think that they would be able to buy the paper at a pretty good discount.
But...
If the government buys the paper at fire sale prices, you still have the solvency problem and many financial firms could go under. While many folks may not lose a lot of sleep over this, there still is the matter of making sure that the market participants are on sufficient footing to move forward in the aftermath. With lots of insolvent firms out there, credit will still be constrained.
Since fire sale prices will not cure the insolvency problem and since paying more than market prices means taxpayers are more likely to lose, there is a reason to look for another way. It would not be out of line to require troubled institutions to give up some equity in return for the above market price on the assets. That way, the shareholders will bear some of the cost--as they should.
It is also not out of line to demand management changes and a reduction of the "golden parachutes". I am not against multi-million dollar salaries for CEOs whose leadership is valued by the market. But I do believe that some of the cases we have seen recently are evidence of a collective action problem in which the shareholders have been unable to exert the optimal level of control over compensation issues. In the long run, that's a problem that deserves more study. In the short run, in the case of insolvent firms dumping their toxic paper, a more direct approach may be in order.
I'm not against having the firms being "bailed out" suffer a little pain in the process. But for the sake of the system, that pain cannot be so severe that it threatens the ability of the firms to function in the future. If you're looking for my bottom line, there it is.
There will have to be regulatory changes going forward. However, it is impractical, and I believe folly, to require those changes as a condition to passing this "bailout" package as some in Congress would like.
The world markets are watching. At the moment, the world markets are extending their forbearance to us as they wait to see how we are going to handle the solvency crisis that now looms large even as the liquidity crisis enters its end game. They have been very patient with their forbearance. But if inaction means a significant risk of catastrophic failure of these institutions, then the world's patience will wear thin. And that's a scary thought.
So I am fairly confident that a "workable" solution will be reached before the markets open on Monday. I do not look for an "optimal" solution. If an optimal solution exists, it is undoubtedly too complicated to be "workable". But I believe that a number of ideas on the table have the potential to avert a complete meltdown. I think that when all the parties (including both McCain and Obama) meet behind closed doors and really come to grips with the magnitude of the problem and the fact that a workable solution exists, we'll get one.
I sure hope I'm right.
By the way, today's award for the best job of explaining the consequences of inaction and the issues inherent in the different approaches to a solution goes to Peter Orszag of the CBO for his testimony to the House Budget Committee. His complete statement is on the CBO Director's blog. Excellent explanation.
Everybody's got their own idea of how they would fix the financial markets.
Some are actually pretty good and might even work better than what we'll probably get. Others sound good but probably wouldn't work in practice. Others are downright nonsense.
But the purpose of this post is not to list and categorize all of the proposals floating through the blogosphere. Nor will I offer a complete proposal of my own. Rather, I just want to offer a few general observations.
I'm generally in favor of getting this toxic paper off of the balance sheets of the banks in the interest of unclogging the system and restoring a sense of normalcy in the markets. I am genuinely concerned about what could happen if the banks continue to hold this paper for a long period of time. The crisis of confidence and the inability to lend would lead to a stagnation not unlike Japan in the 1990s.
So if we agree to take this paper off the books of the banks, the next step is to agree on a way of valuing that paper. Given that the market for this paper is not functioning very well, price discovery is a challenge. The government would be making the market, and being the only buyer of any consequence, you'd think that they would be able to buy the paper at a pretty good discount.
But...
If the government buys the paper at fire sale prices, you still have the solvency problem and many financial firms could go under. While many folks may not lose a lot of sleep over this, there still is the matter of making sure that the market participants are on sufficient footing to move forward in the aftermath. With lots of insolvent firms out there, credit will still be constrained.
Since fire sale prices will not cure the insolvency problem and since paying more than market prices means taxpayers are more likely to lose, there is a reason to look for another way. It would not be out of line to require troubled institutions to give up some equity in return for the above market price on the assets. That way, the shareholders will bear some of the cost--as they should.
It is also not out of line to demand management changes and a reduction of the "golden parachutes". I am not against multi-million dollar salaries for CEOs whose leadership is valued by the market. But I do believe that some of the cases we have seen recently are evidence of a collective action problem in which the shareholders have been unable to exert the optimal level of control over compensation issues. In the long run, that's a problem that deserves more study. In the short run, in the case of insolvent firms dumping their toxic paper, a more direct approach may be in order.
I'm not against having the firms being "bailed out" suffer a little pain in the process. But for the sake of the system, that pain cannot be so severe that it threatens the ability of the firms to function in the future. If you're looking for my bottom line, there it is.
There will have to be regulatory changes going forward. However, it is impractical, and I believe folly, to require those changes as a condition to passing this "bailout" package as some in Congress would like.
The world markets are watching. At the moment, the world markets are extending their forbearance to us as they wait to see how we are going to handle the solvency crisis that now looms large even as the liquidity crisis enters its end game. They have been very patient with their forbearance. But if inaction means a significant risk of catastrophic failure of these institutions, then the world's patience will wear thin. And that's a scary thought.
So I am fairly confident that a "workable" solution will be reached before the markets open on Monday. I do not look for an "optimal" solution. If an optimal solution exists, it is undoubtedly too complicated to be "workable". But I believe that a number of ideas on the table have the potential to avert a complete meltdown. I think that when all the parties (including both McCain and Obama) meet behind closed doors and really come to grips with the magnitude of the problem and the fact that a workable solution exists, we'll get one.
I sure hope I'm right.
By the way, today's award for the best job of explaining the consequences of inaction and the issues inherent in the different approaches to a solution goes to Peter Orszag of the CBO for his testimony to the House Budget Committee. His complete statement is on the CBO Director's blog. Excellent explanation.
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