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Monday, March 02, 2009


posen on financial system resolution

via ft alphaville and particularly relevant considering the creeping restructuring on offer this week from the government (and who knows what it might be next week), this testimony by adam posen of the peterson institute for international economics are particularly salient. posen particularly addresses some of the points on bank solvency and regulatory forbearance raised by william isaac last week.

In brief, I would urge the Congress to have the US government:

Recognize that the money is gone from the banking system, and banks already are in a dangerous public-private hybrid state;

• Immediately evaluate the solvency and future viability of individual banks;

• Rapidly sort the banks into those that can survive with limited additional capital and those that should be closed, merged, or nationalized;

• Use government ownership and control of some banks to prepare for rapid resale to the private sector, while limiting any distortions from such temporary ownership;

• Buy illiquid assets on the Resolution Trust Corporation (RTC) model, and avoid getting hung up on finding the “right price” for distressed assets or trying to get private investment up front, which will only delay matters and waste money;

• When reselling and merging failed banks, do so with some limit on bank sizes;

• And do all of this before the stimulus package’s benefits run out in mid-2010

i particularly appreciate that first one, as it seems still a point of deep contention throughout the system. our shop, for example, is faced with trying to redeem from a batch of hedge funds which have been laid waste by the crisis -- most notably credit funds, unfortunately including highland capital, whom formerly constituted a flashy division of the vaunted shadow banking system. another has recently -- in spite of previously amending the fund's offering documents to gate redemptions over four quarters, the better to ensure liquidity and pricing in redemptions -- suspended all redemptions indefinitely. while this isn't surprising anymore -- indeed wasn't shocking when it began to happen last year -- it is nevertheless humorous (in the blackest sense) to hear the justifications for such refusals.

this fund and its managers have had a significant amount of time now to come to grips with the collapse of securitization, the deleveraging of banking and indeed the dysfunction of credit markets broadly which caught them out in the rain without an umbrella. while markets in the kinds of securities held by the fund are not what they were, neither is it impossible to move inventory. they've had lots of time to do so. the difficulty is primarily in the price, or rather the psychology of the fund managers.

these securities were once valued at par or better. they now can't be sold for more than, say, 30 cents on the dollar, sometimes less, sometimes much less. but the manager continues to believe in the intrinsic (though unprovable and improbable) value of the stuff, still misrepresents carries it nearer par than 30 cents, and is simply unwilling to sell for what he could get. to do so, it seems, would be much too damaging a blow to the ego -- regardless of the intentions and desires of his limited "partners".

now, such funds are not sovereigns. they don't have infinite patience and near-infinite balance sheet. their capacity to carry assets is borrowed from investors and creditors. and that has always been true.

what is coming to light is that the fund managers, in their high hubris, lost sight of that fact. they grew to believe that their balance sheet was theirs, that it could not be taken away, that they were not in fact traders -- even though their funding profile was clearly not such that would allow them to be anything but traders in the end. faced in crisis with reconciling their delusions with their reality, they chose to steal appropriate balance sheet capacity from their investors by refusing to liquidate.

now, the investors too knew the risks -- there's no pity that should be doled out for hedge fund investors, even those who succumbed to ponzi scams. that does not make such steps on the part of indolent fund managers any less a theft. the investors have made a judgment about their investment and want to exit; if this means a writeoff, then so be it. the manager, however, is abrogating that judgment, and doing so from a position of extreme potential self-interested bias. all previous professions of "valuing our investors", etc., are revealed as just so much psychopathic cant -- indeed the investors have now been deemed too ignorant to properly assess their own interests, or so goes the excuse-making, as though such an admission of contempt were much more honorable than the acknowledgement of the theft itself.

the value of the securities held in such funds is not coming back. oh, they may see a blip in market price should outright panic recede into mere nervousness, but the prospect for receiving anything like par is nil. even if held to maturity, cash flows from CDOs and various other structured finance plays are going to be severely impaired. and between now and maturity, there is zero prospect of sufficient balance sheet capacity reappearing in the structured finance world to drive prices back up even to whatever held-to-maturity valuations might be perceived to be. a long, drawn out liquidating trust arrangement serves no one well, and the end result will likely be as severe a loss as would be realized in an immediate liquidation.

so what is holding these funds back from honoring redemptions, realizing terrible losses and quietly winking out of existence? in large part, denial -- and, for those few who've got past outright denial, a desperate twilit bargaining phase.

in large part, i suspect, much of the institutional response to the crisis is characterized by similar psychological conditions. a lot of folks at or near the controls simply cannot believe that the money is really gone. and that all but assures that competent and knowledgeable voices such as posen's will continue for the time being to get hearings without exerting much influence.

UPDATE: nouriel roubini on why he (and posen) is right to advocate outright nationalization.

UPDATE: tim duy articulates the common dementia regarding asset prices, from which he does not exclude ben bernanke.

... [A]nother problem is the one to which Yves alludes to - the persistent belief that current asset prices are currently "wrong." There appears to be little thought given to the likelihood that past prices were "wrong." Instead, policymakers appear to believe that prices have intrinsic values. The trick is to get market participants to recognize those values. The belief (delusion) that the current price is simply wrong is not limited to Bernanke; it is pervasive among policymakers. James Kwak directs us to an interview with Treasury Secretary Timothy Geithner, commenting:

The idea that houses have a “basic inherent economic value” other than the prices they can fetch in the housing market is, I think, a fallacy. And so the idea that therefore houses will naturally return to some “basic inherent economic value” that is higher than current market prices is, I think, wishful thinking of the kind that has hampered responses to this crisis from the beginning. They could; but they could just as well not.

The saddest part of policymakers who cling to the notion of intrinsic housing values is that economists long ago rejected the notion that such prices existed when they rejected the labor theory of value. Is Bernanke a monetarist, neoclassicalist, or a Marxist? Value is determined by a constellation of social conventions at some point in time. If the social convention is that financing is limited by ability to repay, then cash flow (largely income), not asset appreciation, is the appropriate metric for valuing houses. "Restarting" the credit markets alone will not alter this convention; it was the willingness to disregard this convention that was the fundamental failure of credit markets. ...

Policymakers are assuming that restoring proper functioning in credit markets - and confidence in general - is equivalent to a housing price rebound. They seem incapable of envisioning a world in which this is not the case. This tunnel vision prevents policymakers of trying to devise policy which assumes that the many of the assets in the banking system are simply "bad." For Bernanke and Geithner, there are no bad assets. Only misunderstood assets.

UPDATE: via john carney, the money columnist for GQ, joel lovell, in the washington post on the ubiquity of certitude as a yardstick by which denial might be measured.

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