Dr Strangelove: Mr President, it is not only possible, it is essential. That is the whole idea of this machine, you know. Deterrence is the art of producing in the mind of the enemy . . . the FEAR to attack. And so, because of the automated and irrevocable decision-making process which rules out human meddling, the Doomsday machine is terrifying and simple to understand . . . and completely credible and convincing.
Dr Strangelove, 1964
(John Dizard in the FT) There are so many smoking, sparking, and stalled bits of machinery in the credit markets that it’s hard to decide which is the one most in need of immediate attention. The most headline-attracting stripped gears have been the monoline insurers. Who would have guessed that the insurance regulators would find a way to intervene in that mess that would make a bad situation much worse? But they have.
There may yet be a negotiated solution to the monoline capital crisis. There’s a more insidious Doomsday machine tunneling under the capital structures of the banks and major dealers: the feedback loop of mark-to-market requirements on illiquid structured securities.
To quote Dr Strangelove: the requirement that banks and dealers mark securitised assets to market is “terrifying and simple to understand . . . and completely credible and convincing”. Many now believe that like the fictional nuclear Doomsday machine, the unbending application of mark to market rules is not, in the end, a sane way to manage the world.
Here’s the problem: the mark-to-market rules assumed there would always be someone willing to buy or sell an asset at a price that bore some relation to the economic value it represented. This efficient price discovery process would provide the discipline to keep the financial institutions from being too cautious or too aggressive, relative to the economic circumstances of the time. Therefore, we wouldn’t need as intrusive a regulatory regime, with the inefficiencies of central planning and slow reaction time. The computation problems would be handled with better mathematical models, software, and data networks.
We will have lots of time on our hands over the next several years to argue why this didn’t work, since many people will not be as over-employed as they were. The reasons might include monetary policies structured to work only as long as certain governors were in office, politicians who wanted more home ownership than made economic sense, and the intrinsic greed and megalomania of speculators.
Right now, though, the problem is that the capital bases of the major banks and dealers are being reduced by losses on the mark-to-market value of securities faster than they can raise new money. That means that because nobody wants to buy a lot of the structured credit products, credit made available by the entire system could contract. That would lead to more losses, and a further contraction of credit.
We call that a depression. Yes, eventually you get to a level of prices where transactions will “clear”, because some people will have enough gold or soyabeans or yuan to buy the distressed assets.
The problem, I can assure you, is becoming acute. You know, like this quarter acute. The accountants are no longer the pliant figures of yore, ready to take the bankers’ or dealers’ word that some bond or loan, or CDO squared is worth what they say it is. Furthermore, as one board member of a very large dealer told me: “Aside from the shrinking capital (from mark to market losses), you are getting more and more assets being put in the illiquid “bucket” [by the accountants]. Those illiquid assets require a bigger capital charge, so you are getting a double whammy.”
I have made enquiries in the relevant official circles about the current state of thinking on the enforcement of mark-to-market rules. While the central banks are not inclined to suspend the rules, they are having meaningful discussions with the accountants about their application, if you get my drift. Basically, for straight corporate credits, including the merger and acquisition loans, mark to market of the tradeable securities will stay in place. However, for structured credits, such as CDOs, where valuations are being done on the basis of illiquid and arguably oversold indices, the accountants would be encouraged to find ways to value the securities that don’t result in a cycle of mark-to-illiquid-market followed by liquidation, followed by more marks, and so on.
Also, it has been suggested by some dealers, whose capital bases are getting too stretched to adequately maintain market liquidity, that they be given access to the Federal Reserve’s discount window and the generous Term Auction Facility. That would provide enough extra liquidity to keep more securities from being dumped into the capital-eating illiquid valuation “buckets”. This idea is likely to be taken seriously by the authorities.
The central banks are moving faster. We’ll see whether it’s fast enough. And if the accountants will give the banks and dealers more of a pass, they’ll need legal cover. A lot of work is needed, and needed now.