Settling debts

The biggest problem for those most closely affected by the economic crisis is pricing assets. Prices give signals to markets and regulators, and without a reliable pricing mechanism, making policy or transactions is virtually impossible. Figuring out what all the bad stuff is worth has been vexing for government authorities and investors. The Federal Reserve and Treasury, having recently reconsidered purchasing the toxic assets which have crippled credit markets instead of straight transfer payments to banking institutions, cannot accurately determine what the value is of the underlying assets which comprise the subprime-backed securities. Investors, also ignorant of what the stuff is worth, cannot restructure existing deals as well as make new ones without knowing how much capital must go towards taking the loss of holding securities no one wants. 

An idea, though possibly mooted before, would be to aggregate the values of each sub-prime mortgage when it was underwritten. Next, exclude the value of the loans which have gone bad. Divide the dud loans by the total, and that would give a base line risk premium. In any security containing a tranche of subprime backed debt, the weighted average of the interest rates of the underlying components would give an interest rate for that security. Though this might be imperfect and slightly less sophisticated than what analysts and quants expect out of pricing securities, it presents a least bad option. With a sound, mathematical fundamental logic, priced securities can give some signals to the stalled markets for these products. Moreover, Fed and Treasury will not have to continue this bastard version of 'helicopter monetarism.'

Such a move has its benefits. Existing CDOs and CDSs, which no one wants to touch, might generate some interest if spreads between high rated and junk debt is rationalized a little better. At this juncture, perhaps the price of inaccuracy might be a reasonable trade-off when balanced against the pervasive uncertainty which has ground structured finance to a halt. The reluctance to 'man up' and cope with bad decisions has resulted in widespread nationalization. New monitoring of ratings agencies must doubtless accompany any bailout program.

The big question is what to do with the borrowers responsible for paying back loans they ought not to have received. Does such a program amount to paying the mortgages for anyone who does not deserve that sort of relief? This concept is not a federal buyback of dud house loans. It would provide a valuation basis for things that are quite difficult to price. If proliferation of subprime mortgage underwriting was at the root of the problem, tracing back to the origin will clarify some things. As far as quelling concerns on the demand end, lenders and regulators should use whatever measures exist to keep even a meager flow of partial interest payments coming through a strict custodial system. This plan does come with its own opportunity costs: bank officers cannot allocate time to more productive endeavors if they are to spend time as glorified collection agents. However, necessity wins out in the current scenario, especially since the credit industry cannot focus on more profitable projects in a climate of uncertainty largely a product of its own machinations. Perhaps the shame of losing prestige might be enough to curb moral hazard in the future. 

It is perplexing that a simple solution to a complex problem did not receive more consideration. Then again, the haste with which the Fed and Treasury have pushed through a somewhat random number warrants questioning. Though thousands of citizens petitioned their representatives and senators to block the bailout, lawmakers acquiesced to the requests of Bernanke and Paulson (Paulanke). Questions naturally arise: Is the true scale of the financial market calamity too frightening to unleash on an already nervous public? Was the decision seen as a sop to bankers who provide a consistent donation stream into politicians' war chests? Is the price of inaction worth doubling the debt ceiling? Have the last eight years ingrained an anti-intellectual culture which discourages clash and debate? 

 

Largely, this financial crisis represents a spiral in the breaching of taboos. Lenders used to never loan money to anyone who could not provide proof of income or assets. One used to have to earn access to a lot of credit, and that process encouraged an ethos of productive behavior such as saving and investment. Greater inclusion in the market benefits consumers and producers, but bad money does drive out good. Ratings agencies once had unimpeachable, neutral reputations. Instead, they broke through the firewall between raters and the firms they rate much like the close relationships accountants and the firms they audited precipitated in a previous period of corporate failure through criminality. Blind faith in free market orthodoxy resulted in budget cuts for agencies such as the SEC and DOJ Antitrust division, and the unintended consequence of which was an inability to probe market anomalies in real time. Investment banks had leverage exposure many order of magnitude higher than their market capitalization. Este nihil sanctum? 

With luck, the borrowing binge on the micro and macro levels will end. However, no politician has posited a plausible way of accelerating debt service. Failing to commit to deep austerity measures sends a damaging cultural signal with far deeper consequences than the inability of the markets to receive a signal at all.