The financial system in the Unites States (and globally, really) is a complex ball-under-the-shell game, with about a couple thousand shells involved. This allows any given official to say, “We’re fixing the problem,” when in reality they’ve simply moved it out of sight once again. By the time you catch up (or think you’ve caught up) they’ve moved it three times more. The public, and most of the financial press, takes the official’s word for it. They’re too confused to do much else.
The switch-a-roo continues with the latest revealing of a plan to remove “toxic assets” from bank books. Obama’s Treasury Secretary Timothy Geithner laid out details that would effect a transfer of as much as $1 trillion in assets, using a combination of public and private investing along with FDIC insurance. The stock markets jolted upwards, signaling what some see as a reversal of the economic crisis. But what is really happening here? While not confident that I understand every detail in this melee (does anyone?), I have a some firm suspicions about the big picture.
Perhaps the greatest immediate woe hanging over the heads of the publically traded big banks and financial institutions is that the laws require them to publically report their earnings at the end of each quarter. Reports of huge losses move investors to sell their stocks in these institutions, tanking values even further, and beginning a deadly downward tailspin. The end of the current quarter approaches rapidly—a few days away—and it promises to be the bloodiest loss yet for banks holding “toxic” debts on their books. Without some kind of deus ex machina the immediate future looks very dim.
Last month talk had already begun about how to help these banks improve their balance sheets. While the honest thing to have done all along would have been simply to enforce the contracts—and thus allow the banks to fail for making ultra-risky loans to begin with—serious talk ensued about how to change the accounting laws that require reporting the bad earnings. At issue here was Federal Accounting Standards Board Rule 157 (FAS 157) popularly known as the “Mark-to-Market” or “Fair Value” rule. This rule requires institutions that hold “illiquid” (and thus, mortgage-backed) assets to report the value of those assets according to current market values—in other words, according to what they could be sold for today (as opposed to what the houses sold for back when the banks loaned the money). Since real-estate markets have slumped and millions of homes have fallen into foreclosure, prices have fallen drastically, and thus “market value” today sits far below what the banks have loaned out. This has already forced banks to show massive losses when reporting earnings because these “toxic” debts have so significantly weighed down their books. In light of the looming problem, many experts and non-experts have called for the rule-makers to temporarily suspend FAS 157 (which had only taken effect early last year anyway).
I cannot tell why the bureaucrats did not take this route. I suppose that it would have been too openly dishonest to just change the rules so abruptly (the public would have seen the ball under the shell here!), or perhaps such a drastic about-face remains in the works but (like all things bureaucratic) will take quite some time to bring to pass. And yet, balances must be reported at the end of March. What do the big banks do? After all, foreclosures have not slowed, but rather increased; many who avoided foreclosure by renegotiating with their lenders have nevertheless failed on their payments within the year, and now face foreclosure again. Worst of all, commercial real estate foreclosures have barely begun, and many experts predict the round of commercial failures to eclipse the residential mortgage problem in both size and effects. So what do they do? What for the end of March, and what for the next year or two of earnings reports?
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I think this is primarily, if not all, that Geithner’s plan is designed to do: give these failing institutions a “legal” way to transfer that debt off of their books so that they can then turn to the public with “positive” balance sheets, “positive” earnings and say “We’ve recovered. We’re solvent, sound, strong. Invest in us!” Instead of trying to change or suspend FAS 157, Geithner has simply given the banks a way to bypass it. Instead of not reporting bad assets, the banks hope to not have bad assets to report. They hope some other investor—backed by the government—will come and purchase the toxic loans.
Of course, the question remains, “Where will the toxic debts go”? Who picks up the bill? The plan outlines that the U.S. Treasury will match private investments 50/50, and the FDIC (the same government agency that insures your local bank accounts) will essentially loan up to 84% of the money. So private investors who wish to participate will only have to put up a tiny fraction of the money, yet stand to reap half of the profits. Yet the real problem remains, as I see it. The assets up for bid are exactly what they’ve been labeled: toxic. Unless foreclosures stop soon and property values rise steeply—and these are BIG ifs—these assets are still about the riskiest bet in the financial world. What investor will dare buy these things?
This last question rings particularly loudly as I write because news just hit of the Treasury’s latest auction of debt. Demand was markedly low, which means that investors do not care even to buy these particularly safe (though low-return) investments. (Further, this means that the government is having trouble raising money for its trillion dollar deficit-funded projects.) If investors are wary of buying the safest of government-backed investments, what can we presume about the market for buying toxic assets even with government insurance?
I have to say, I am certainly skeptical about whether Geithner’s plan will even prop up the banks. I am very skeptical it will turn the economy upward in the long run. I am, however, certain that the plan is merely moving the ball under one more shell. The question is, how long until that shell turns out to be the final bombshell?