One of the objectives of this crisis is for the “Mark to Market” rules to be replaced by Mark to Shitpile rules, where banks and others can use their own “internal estimates” of what an asset is worth. The reason for this is that many of the derivative bets were, just that, bets. The instrument has no future payments attached to it, but instead, the company that sold the Credit Default Swap or other derivative took a one time payment, and then essentially bet that there would never be a default. The “value” of the derivative is, no more and no less, the chance that the person writing it will never have to pay.
It’s time to get real about this. The solution is not to suspend mark to market, but to provide an alternative market mechanism to mark to, one that is not in the hands of the people who created the instruments. If it can be marked to market, it should be. However, if there is no market, then we can create one.
Thus there are two hearts of restructuring, one is a replacement for “market value” as the value of a security, because market value is too volatile, and other rules are too prone to abuse. The other is to essentially admit that private entities were collecting taxes, and then walking away. In effect, they were taking money for a situation that they knew was the “eat babies” case, where the government would be bailing them out any way. If IBM defaults, then chances are, everyone else is too. More over these bets were then layered on top of each other, an entity selling swaps, would then cover it’s own risk of default more cheaply than it’s outstanding bets, and the entity owning that swap did… nothing. It would be like a company writing an insurance policy for your car without having any money, and then turning around and selling the risk of having to pay for less than you paid them, and then that company doing the same, and so on.
Market of Last Resort, or Fool of Last Resort
The solution to the first is to use the government as the “market maker of last resort.” This concept explained by economist Paul Davidson is to add to the arsenal of other last resort market functions of the government, to act when on one else well. The idea I am proposing is called “mark to money.”
Mark to money takes the total capitalization of the derivative issuer, the revenue collected or scheduled to be collected as an income stream and computes an implied rate of interest. It then prices this at the risk/return of the comparable market based security. The game with derivatives that are called “Credit Default Swaps” was to try and sell off all reasonable risks and keep the last bit of what economists call “liquidity preference.” That is, what having money in your hand is worth to you.
Now ordinary risk is generally priced in the market well, but that last little bit of risk, is something people are willing to pay a great deal more to get rid of. People don’t like to die, they don’t want to be thrown out on the street. Getting that last incremental bit of stability is, from empirical data, expensive. Chasing the next sigma of uptime is as expensive as all the ones before it. This last bit of risk aversion and liquidity preference is the difference between, for example, the best corporate bond, and the best government bond.
The theory of the market fundamentalists was that it should be possible to arbitrage that last bit. Arbitrage, remember, is when the same thing is being sold in two places for different prices, and it is possible to buy it in one place and sell it in another without the costs of buying and selling eating up the profits. LTCM made a big bet on being able to do this, and failed. The Credit Default Swap market was trying to do the same thing, in reverse. If there is a spread between the cost that people are willing to pay for that last bit of security, and what a bit of security would ordinarily cost, why charge less than it really costs to remove the last bit of risk, act as if you have just bought ordinary easy to manage risk, and pocket the difference? Since, if it ever comes to pass that everyone defaults, “well, we will all be eating babies if that happens, so there is no need to even worry about it.”
Let me put this in computer terms. You can reduce the number of crashes in your home computer very cheaply by using a simple disk utility one a month, keeping dust away from the computer, and not allowing it to be cluttered with downloaded bloatware. By doing this you can reduce the number of crashes considerably, at almost no cost. Let’s say it has reduced 75% your risk. But to go from a computer that locks up once a week to a computer that locks up once a month, is very different from going from a computer that is down one minute a year, to one that is down less an 1 second a year. What the CDS market did was pretend that if you pay to have someone run their disk doctor utility every day, that was the same thing as quartering the risk to a large data center filled with complex databases, web servers, applications and having millions of users. It other words, it pretended that there was no diminishing curve of risk avoidance.
The CDS market assumed that the public would be the “fool of last resort.”
The reason that government is often more expensive than the free market, is that people demand that government get rid of this last bit of risk. Therefore, we can offer a principle: the last bit of risk cannot be sold in the market. Regardless of the excuse, regardless of the instrument, the public liquidity preference may not be bought, sold, borrowed against, or loaned except under terms that the public specifies. Thus Social Security, Universal Health Coverage, the cost of protecting the financial system, and other functions, are part of the public risk aversion and public liquidity preference. Since the public must, ultimately, step in when these risks go bad, the public has the right to collect the natural cost of protecting against them as fees, insurance, regulations, or public monopolies.
So the first step to the problem is to insure the wider market, and to charge the natural cost of insuring.
George Soros, Paul Krugman, James K. Galbraith and others have proposed different variations on recapitalization of the banking system. Recapitalization and recollateralization mean that the public makes an assurance of being the insurer of last resort in the cast of everything else going wrong. It can do this because it is also the borrower, and in the models being proposed, the market maker of last resort.
This would mean that instead of buying up toxic assets, that is assets that have no upside value really, but only might not have downside value, that in effect the government is stepping in and backing the Credit Default Swap, For this to work the government has to cancel out arbitraged straddles and the leverage based on them. These leveraged bets were then moved into the financial system, because they were equal only by the fiction that it is as easy to go from one crash a month to less than one slowdown a year, as it is to go from one crash a month to one crash a week. If you are selling something at much less than it costs to make, there are always plenty of people ready to buy.
Robert Rubin, former US Treasury secretary and currently a senior adviser to Citigroup, said fair value accounting worsened the financial sector’s problems. He told a Financial Times conference that fair value ”œis not serving our system well” and urged regulators to change the rules.
But regulators and investor groups have so far supported fair value and the transparency it brings.
Many regulators impose stricter standards when assessing banks’ capital requirements.
Auditors have also defended the accounting. Sam DiPiazza, head of PwC, the accounting firm, said in an interview with the Financial Times on Tuesday: ”œTo suggest you don’t track and report fair values means you end up in a world where management still knows the real prices, as do market counterparties, but not the investors.”
This is crucial. Mark to market was a replacement for the previously abused standard, “Historical value,” which was used to pretend well into the crash that assets were worth what they had been during the run up. Mark to market basically forced everyone to take their medicine as soon as it became clear that the losses were there. Derivatives offered a way around this, by throwing the day of reckoning out into the future. One can do this with options as well.
The crucial part was to create heavily leveraged securities, which were above market risk return ratios, because of their illiquidity. Losers in these would not be able to sell easily, and when they began getting claims on them, were forced to take those losses, or double up on bets. A similar unravelling of reinsurance took down the previous incarnation of Lloyds of London where new members did not realize, or it is alleged were specifically recruited to bear, the costs of “Incurred but Unreported” claims.
The core of Lloyds, in small scale, is the core of the problem now. Each security was, in effect, a company without reserves. Thus the creators of these instruments had no reason to have reserves to cover the risks, once the profits had been extracted. But even this would only have led to a bath on the part of a few people, if it were not for the crucial next step: Leverage Laundering.
Leverage laundering is the process by which profits based on borrowing are made to look as if they have an underlying revenue stream. For example, a company manufactures something, they lend money to another company to buy it, and then book the “profit” of the sale right then. The company then issues shares, those shares seem to be backed by “earnings” which are then used to value the shares. Leverage has been laundered, mutual funds by the shares, ordinary people borrow money thinking they have assets and so on. This example of leverage laundering becomes unravelled when the original borrower defaults, and the lending manufacturer takes back the, much less valuable, equipment.
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