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Bailing Upward

As Congress debates the staggering sums proposed by the Troubled Asset Relief Program (TARP), there is naturally concern among both liberals and conservatives that the program is ill-conceived. Much of this anxiety, however, stems from a series of misconceptions about the origins of the crisis. Cutting through these misconceptions helps illustrate the importance of TARP: why it will provide a modicum of stability to the financial system, allowing us to avoid the worst of a prolonged downturn--and why, in the long run, it is insufficient.

One dangerous misconception is that the crisis "begins and ends with government," to quote a column by Kimberly A. Strassel in The Wall Street Journal. In her narrative, easy money "inspired banks and mortgage firms to borrow more and take riskier bets.” While the combined effect of monetary policy, capital requirements, accounting rules, and government-sponsored mortgage subsidies certainly created the context for the crisis, blaming Washington gets it precisely backwards. It was the decisions of the investment and commercial banks that generated the shocks now reverberating in the Capitol and throughout the economy.

The huge growth in mortgage indebtedness between 2002 and 2006 was fueled largely by the expansion of the securitization markets--banks could now sell mortgages to investors, a hand off that increased the banks’ incentive to make ever riskier loans while collecting handsome fees. Alas, that perverse incentive troubled very few on Wall Street. These mortgage-backed securities were enormously popular. They yielded high returns at a time when interest rates were low around the world. And mathematical models supported this trend. They suggested that, while owning one subprime mortgage was risky, buying a security that bundled many mortgages wasn't, given the low probability that all the homeowners in any given bundle would default simultaneously. The banks didn't just package and sell these securities to hedge funds, pension funds, and other institutional investors. They retained significant quantities of them in their own portfolios.

This leads to a second misconception: That the decline in housing values, especially in the subprime sector, was the main culprit--"the root cause of all this," as former Federal Reserve vice chairman Alan S. Blinder told The New York Times. In fact, the trigger of the crisis was the leverage put against mortgage asset values by leading global financial institutions. These banks were able to borrow money (mostly on a short-term basis) at rates in the interbank market and then pocket the spread between the cost of their short-term funding and the yield on the mortgage-backed securities they retained.

This might have worked nicely in moderation. Certainly any major bank should be able to withstand a temporary 10-to-20 percent decline in housing prices from the lofty heights of recent years. But instead, as the real estate market started to crack in 2007, most of the large commercial banks and Wall Street investment banks were absurdly over-levered. For every dollar of assets on their balance sheets, they often had 96 to 97 cents of debt. With that type of leverage, their balance sheets were exposed to any slight change in the market value of their assets.

To insure against that risk, the banks and investment banks bought credit default or "wrap" insurance from a small number of insurers and from one another. Under the accounting rules, as long as they had a guarantee from a AAA-rated insurer, changes in the market values of the mortgage-backed securities they held on their books did not have to be recognized. So credit insurance enabled them to run their leverage up to record levels, and the relaxation by the Securities and Exchange Commission of the net capital rules in 2004 gave them the regulatory leeway to reduce the capital required as a cushion against that risk.

The increase in leverage facilitated by the availability of credit default insurance was truly remarkable. Once upon a time, a debt to capital ratio of 12:1 was considered dangerous. In this new era, firms regularly maintained a 30:1 ratio.


This leverage game worked until the summer of 2007, when the ratings agencies belatedly began to downgrade the ratings of various classes of mortgage-backed securities (to account for burgeoning payment delinquencies and defaults). Then, they put the insurers under review to account for the fact that those defaults made a call on their guarantees much more likely and the adequacy of their capital uncertain. It soon became clear that banks and investment banks could lose the benefit of all or a portion of their credit default insurance. At the end of the third quarter of 2007, firms had to start setting aside reserves to absorb losses from their portfolio of mortgage-backed securities--losses they never imagined having to pay themselves.

With so much leverage against now impaired assets, "solvency" began to be called into question. And as each player tried to reduce its leverage by selling off the same class of assets simultaneously, prices eroded further, causing further crushing mark-to-market writedowns. By early 2008, the mortgage-backed securities market “fundamentals” were bad (as housing prices continued to fall and default rates rose), but the realities of the market were even worse, with a paucity of buyers and a huge overhang of paper needing to be sold.

This is why we need to resort to the TARP stopgap measure, even at such a great cost. Banks and investment banks have recognized approximately $500 billion of losses over the past year while raising about $400 billion to try to restore their capital base. But they still have a long way to go to bring down their leverage ratios. They need to reduce the holdings of mortgage-backed securities on their books, and there remains only a thin market for these assets outside of a few "vulture" funds. At the same time, prospective investors are skittish about pouring new cash into financial institutions.

TARP can help restore liquidity to the banking system while facilitating the necessary consolidation and restructuring of the industry. In the absence of a purchaser of last resort for these securities, the banks will continue to remain capital-constrained and withdraw liquidity from the system, ratcheting up the cost of credit not just for housing, but also for car loans, business loans, student loans, and so on. Consider where we stand relative to recent history: Since the end of the Vietnam War, credit has grown year over year by two to eight percent, with only three declines. As The New York Times reported late last year, bank credit and commercial paper were actually down nine percent during 2007--a pace not seen in decades. This is a clear sign that credit is contracting in a manner bound to provoke a severe economic downturn.

By removing toxic assets off the banks' books, TARP will help replace them with readily marketable assets that can unfreeze lending activity, and help drive economic growth. The manner in which the money is spent, however, will be crucial to determining TARP’s ultimate success. It may be necessary for the government not only to buy the derivative securities, but also to buy delinquent mortgages directly from the structured finance trusts.

Direct control of troubled mortgages underlying the structured finance trusts would give the government the flexibility to work with homeowners to keep them in their homes--perhaps by renegotiating new mortgage terms--and avoid yet another wave of foreclosures that would put further pressure on real estate values. In turn, direct purchases of troubled mortgages from the trusts would enhance the cash flows and market prices of the derivative securities the banks hold. Absent this flexibility, there is no certainty for either the taxpayers or the financial institutions that real estate values will not continue to deteriorate, or that mortgage-backed securities' values can be stabilized and the health of leveraged banks restored.

It is a misconception to think, as some have, that the taxpayer outlays will ultimately be a negligible cost to the Treasury, or even a boon. The only way the TARP program can help to rebuild the banks’ capital base is to take assets off their hands at a level above current market clearing prices. While Treasury's ability to hold these assets over a longer time horizon than the banks may afford it the opportunity to recover whatever premium over market it may pay to the banks, we should not sugarcoat the fact that the taxpayers will be putting hundreds of billions at risk and incurring the opportunity cost of committing that capital to the bailout. There’s a compelling case to be made that, to compensate the taxpayers, the government should acquire equity stakes (or the option to buy a stake down the road) in the selling institutions.

Acquiring a stake in the firms, of course, poses its own substantial risks. We cannot transform the banking system into a huge collection of government-sponsored entities with the potential for ongoing political intervention, not to mention confusion about the nature of government "guarantees," whether implicit or explicit. As such, these stakes should be passive--perhaps in the form of preferred shares that provide a measure of downside protection together with warrants that offer participation in the upside of the common stock--and there will need to be transparent and equitable criteria about which banks gain access and on what terms.

It is important to dispel the misconception that these high-risk activities were confined to real estate. The market for leveraged loans that financed the recent buyout boom has also been a casualty of similar behavior. The same handful of large private equity firms chased the same handful of large public companies--with cheap financing provided by the same handful of banks. Although the numbers are smaller than the mortgage mess, most banks exacerbated their problems through their exposure to these loans as well.

The irony is that an industry, whose raison d’etre is efficient capital allocation, allocated capital so inefficiently. The liquidity crisis provoked by debt-laden balance sheets will take years to correct. TARP is a solution to the liquidity issues, but it will also make it clear how little capital banks have at their disposal--and how badly they need capital to survive. Thus the need to raise capital will not likely go away, though TARP can facilitate the money-raising process by putting a protective floor under the balance sheets of most of our financial intermediaries.

This is why the Treasury bailout, however necessary, should merely be a prelude to systemic reform. Consider the three very fragile links in a chain of risk that many observers recognized years ago: high financial leverage; accounting-rule arbitrage, inducing the purchase of credit insurance; and a reliance on a relatively narrow array of counterparties to underwrite those credit guarantees. (It strained credulity to suppose these insurers could make good on all their insurance contracts in the predictable event that a class of assets simultaneously deteriorated. One insurer alone wrote more than $400 billion on mortgage securities.) TARP addresses none of these issues.

There is no question that one immediate factor exacerbating the solvency crisis for banks has been the application of fair value or "mark-to-market" accounting rules to the balance sheets of the troubled institutions. These rules, put into effect over the past 15 years by the Financial Accounting Standards Board and the SEC, have pegged the valuing of assets to wild (often panicked) fluctuations in the market, rather than at a value justified by the assets’ fundamentals. Heavy markdowns coupled with extreme leverage have proved a lethal combination, making it difficult to survive the possibly temporary impairment of asset values in the absence of further accounting flexibility. At the same time, the fair value rules themselves would not have sparked anywhere near the financial damage were the relevant institutions not so heavily indebted.

Similarly, we cannot expect that TARP will provide a long-term solution unless we urgently address and sensibly regulate the opaque realm of credit default swaps. Late last week, the SEC said it would investigate the manipulation of this market. But ultimately, that is beside the point, since we are absurdly ignoring a long-term solution to the ripple effect of defaulting counterparties that could impose hundreds of billions of cascading losses in a matter of days. This was, after all, the government's stated rationale for stepping in to preserve AIG.

The cruelest irony is that none of this needed to happen. Many of these structural flaws were self-evident. But neither the risk managers on Wall Street nor their overseers in Washington wanted to face reality. So now, to stanch the bleeding they unleashed, we need TARP. And to justify TARP’s risk for taxpayers and to preclude a sequel to this calamity, the Congress and the next administration will need to address the root causes of our current predicament. Wall Street could not handle the risk itself. Regrettably others will now have to do so.

Larry Grafstein and Jim Millstein work on Wall Street. These are their personal views.

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By Larry Grafstein and Jim Millstein