CONGRESS CAN DO AT LEAST ONE THING IMMEDIATELY
No where is the lack of coordination and information flow in today's financial crisis more evident than in the bruhaha over mark-to-market accounting rules, perhaps.
First, no independent body, like a regulator, has come out to say exactly which instruments aren't trading. Until you describe a problem, you cannot adequately solve it, right? We're lead to believe that it is "sub-prime" assets that are targeted, but it could be prime as well (we know that default rates have been ticking up on those) as well as commercial real-estate loans. What's more, there are a series of other securities CDOs, et. al. We should know what these are, on a system wide basis. Estimates have been put together already, by rating agencies. They just need to come full well into the public domain, via the Congress (and its regulators).
MIDDLE GROUND
If something is trading only on a very limited basis (or not at all), then there is a legitimate tension about whether to include potentially huge liquidity discounts required to induce a trade (a.k.a. "firesale") as part of the fair value of an instrument.
In the event that illiquidity is threatening the safety and soundness of the system (and does appear to be, judging by the actions and comments of some players do have full transparency into asset quality), then the Fed is right to step in to spur on the development of a pricing mechanism.
A phased approach to getting that done is possible and smart.
The SEC, rather than suspend mark-to-market wholesale, should do it only for a time and make it clear that it will accept some independent mark-to-model value, while it moves on to a longer-term solution of getting a traded market primed and running. There are enough people running models to value mortgage pools, that it would be possible for the SEC or appointed industry self-regulatory group to appoint five or six model runners to provide model marks for any pool submitted for evaluation. Firms can then mark-to-model, not using their own, but an "industry" standard. To add nuance, if one standard is too "rigid" for managements to deal with, then the firms can disclose what their valuation assumptions are for broad asset classes, when using the industry-standard models and/or independent valuation "service(s)".
DEVELOPING A MARKET - THE FED / CONGRESS CAN ACT NOW
I cannot believe that the FED, the SEC, and others cannot act using a variety of tools already at their disposal to insist that a "market" for the sludge that is out there develop.
Perhaps there is a role for a reverse auction or a way to set-up a new price-discovery mechanism that is broader than the one that is current being used, which I assume is inter-dealer pricing. The FED is not the only organization that could facilitate setting up auctions (someone just needs to get the right people into a room) or even paper auctions.
The FED itself might select a number of "benchmark" pools and set-up a special program, trading those in its own account (perhaps even to the tune of $75 billion). This could be done in a number of ways, but a repo-like market suggests itself or one in which the Fed provides an indication daily of what the collateral requirements might be, based on valuation models keyed to as many market-given or implied inputs as possible.
In the event that is too hard, the Fed could try to run a program using a yield-to-worst approach, offering up liquidity for securities using the most adverse set of assumptions. These values put a floor under those that might be used for fair-value treatment in accounting exercises. They also add liquidity, because such an approach would add the 'certainty' of a almost limitless buyer at a known price...
PRIMING THE PUMP OF INSTITUTIONAL INVESTORS
Last, the Treasury/SEC ought to find out what needs to be done to prime the pump for institutional investors to get interested in buying up the illiquid securities, again, so that risk can be spread around.
There have to be alternative approaches, some that might requires a few months to cobble together, that involve more than just putting together as big a pool as possible of capital to buy distressed assets.
Some tool has to be available to help change the character of the assets themselves, either stand-alone or in combination.
It's entirely possible that a 21st century Central Bank needs to reinvent the notion of what it means to be lender of last resort. They *may* need to do more than provide capital. They may need to get involved in the derivatives markets in ways new to them (as may Congress).
We can only speculate what those way may be, however, because we do not have the full picture of where the lion's share of the sludge is concentrated and with whom.
Wednesday, October 1, 2008
Beyond Mark to Market
