A Possibly Dangerously Naive Question About the Financial Crisis

Like a lot of folks, I’ve spent about a week trying to give myself a crash course into what, exactly, is going wrong with the financial sector so the best policy course of action can be pursued. This has mostly left me agreeing with just about every economist in the universe that the Treasury Department’s request for a blank check is a bad idea. Also, it has left me wondering where exactly Wall Street folks learned how to add and subtract, but that’s a another issue entirely.

One thing that does appear to be clear, though, is that one of the major issues in the financial sector appears to be that nobody knows how to properly price mortgage-related debt/securities/etc. Consequently, nobody knows which banks are solvent and which aren’t, which threatens to put a credit freeze over large swathes of the industry. So the bailout plan is, as I understand it, an attempt to prevent a credit freeze by buying up all the debt that nobody knows the value of.

So here’s my naive question: why is it better to write a $700 billion blank check for financial instrustments that nobody knows the value of rather than having the Fed or the Treasury spend $15 million to hire an independent accounting/auditing company to go through all of the mortgage related assets and figure out how to assign a value to them in a way that allows banks to know the price of their debt and, therefore, level of solvency?

This is an honest question that I don’t know the answer to. Why can’t we come up with a way to price these things quickly and avoid saddling taxpayers with this liability? Feel free to enlighten me on my economic ignorance in the comments.

FILED UNDER: Economics and Business, US Politics, , ,
Alex Knapp
About Alex Knapp
Alex Knapp is Associate Editor at Forbes for science and games. He was a longtime blogger elsewhere before joining the OTB team in June 2005 and contributed some 700 posts through January 2013. Follow him on Twitter @TheAlexKnapp.

Comments

  1. @jimgeraghty Could also do a little thinking out loud and asking questions. Alex Knapp doing that: http://is.gd/31dT

  2. DC Loser says:

    Of course we can’t have that! Why, it’s a crisis that needs to have an immediate solution. We can’t have the taxpayers pay a fair price for these worthless assets. How else is Paulson going to pay off his Wall Street cronies?

  3. Person of Choler says:

    1) 15 million wouldn’t come anywhere near covering the cost of doing what you suggest.

    2) The process would take too long to be of any use in keeping the credit system liquid.

  4. Michael says:

    So here’s my naive question: why is it better to write a $700 billion blank check for financial instrustments that nobody knows the value of rather than having the Fed or the Treasury spend $15 million to hire an independent accounting/auditing company to go through all of the mortgage related assets and figure out how to assign a value to them in a way that allows banks to know the price of their debt and, therefore, level of solvency?

    Time, I would imagine. By the time that independent accounting company decides that company X is solvent, they could have already been run into bankruptcy.

    Also, it’s probably not simply a matter of adding up all the numbers and seeing if they’re in the red or black. We’re venturing into uncharted economic theory here, and figuring out what it all means, and how it all works with everything else, will take a lot of time and brain power. It’s not just that we don’t know the value of these assets, it’s that we don’t know how to determine the value these assets.

  5. just me says:

    I would vote time is the reason your idea wouldn’t work.

    I do think a blank check would be a very dumb move to make though.

    I can buy that there needs to be some kind of bailout, because the alternative may be worse than the bailout itself, but I think figuring out how to correct the mistakes, and correcting them should be tied to the money.

  6. Michael says:

    I can buy that there needs to be some kind of bailout

    There doesn’t have to be a bailout, it’s just that a bailout is the only option that’s been presented thus far that can be implemented fast enough to be effective.

    I’d much prefer a stop-gap measure that will hold the markets up long enough for a better foundation to be laid, but I’m not sure what such a measure would be. Also, now that the market is all hyped about a bailout, anything less will likely spark a panic that will hurry the collapse we’re trying to avoid.

  7. Michael says:

    I’d also add that with the price tag of the proposed bailout, and the fact that we’re going to bail out foreign banks now too, maybe we should start revisiting the idea that it’s better than the alternative, because at some point that will stop being true.

  8. Dave Schuler says:

    The credit crisis isn’t just hypothetical. On Tuesday and Wednesday short term Treasuries actually went negative for a while.

    Michael is right. Timing is the issue. Putting a decision off until values could be put on everything (or until after the inauguration of the next president as some have suggested) would effectively be saying that whatever your preferred outcome is is worth the very serious risk of an economic collapse.

    The rule in emergency medicine is first try to stabilize the patient’s condition. Punishing the patient for stupidity or even identifying the underlying issue can wait until that’s accomplished and it’s pretty much the same in an financial crisis.

  9. JKB says:

    Because this isn’t a matter of buying the assets at a true market value. They know or have an idea what that is because the crisis is that no one wants to sell the junk a the low prices offered. Enter the bailout, which will purchase the junk at a price above market to cover the deadbeats on Wallstreet.

    The crisis is that even the public is starting to see that most of this stuff is worthless MBA magic dust and that no one knows who was snorting (owns) the magic dust.

    If they let his junk get marked to market, then mortgage money would dry up in an instant and house prices would comedown to the historical reality. That would mean a lot more foreclosures and the loss off all the nice property tax money based on inflated prices.

  10. Triumph says:

    Listen, all you naysayers don’t realize that if we don’t give Bush full authority to do whatever the hell he wants, the terrorists will win.

    It is likely that Al-Qaeda could use sneaky means to own all of our assets through revenues gained from poppy growing in Afghanistan. If Bush doesn’t have a clean bill we risk another 9/11.

    This must be rectified ASAP.

  11. Alex Knapp says:

    The rule in emergency medicine is first try to stabilize the patient’s condition.

    Yes, but before you can stabilize the condition, you need to at least recognize the immediate problem. If the patient’s lungs are shutting down, you might give him steroids, but if his lungs are shutting down because of an infection, you’ve made the problem worse because steroids inhibit the immune system. It’s worth taking the extra minute to check his temperatue and make sure he’s not running a fever first.

  12. Person of Choler hit on the two most obvious problems with your solution Alex. I would add that the value of these securities is not absolutely definable in any accounting system we know of, as the value of the underlying assets will continue to fluctuate, perhaps wildly, depending on among other things the availability of credit and even the assets themselves depending on how they are measured and potentially liquidated. There are some complicated interactions at work here. Anything is really only worth what someone else is willing to pay for it and that can be fiendishly hard to figure out in this environment.

    Also, a better medical analogy of the problem right now is that the patient has gone into shock due to massive blood loss. That must be addressed first, regardless of whatever else may seem to be wrong, though without question these are more systemic problems that must be addressed before the patient can be released. To torture this analogy a little more, the last thing anybody typically wants to be concerned with at a time like this is how it will be paid for.

    Maybe we just need a way to short the housing market to further mitigate the risk.

  13. Alex Knapp says:

    Charles,

    I agree that timing is obviously an issue, but an attempt to value mortgage based debt would have to relieve the stronger banks and prevent a widescale credit freeze, right? And a strong and fast triage of valuations through the worst banks would assist in liquidations, where the Fed could be the purchaser of last resort but the debt sold out on the open market, like a fast paced Chapter 11.

    I really do think that more information is needed before we cut what is now a 1.8 trillion dollar check. To torture the medical analogy further, yes, we know the patient has blood loss, but we need to make sure that we have the right blood type before we transfuse!

  14. Patrick T. McGuire says:

    Besides the timing issue, you might have a hard time finding an outside audit firm that would be willing to take on a task like this, the liability risk would be tremendous.

    An outside firm would take the heat off of the gov’t and place it on themselves. They would be tasked with finding an accurate value in a hurry which is a contradiction in terms for an auditor. For fear of getting the wrong value, they will want to drag their feet as long as possible, which gets back to the timing issue. But if they get the value wrong, they become the new scapegoats, allowing those acutally repsonsible for this mess off the hook. Even if they get the value right, there will be an unending argument by the various sides that it’s wrong, that we need to do something more drastic because so much time has been lost, and inevitably that it was a mistake to hire an outside firm.

    The only outsiders that would take this on would have to be incompetent to begin with otherwise they would see the trap they would fall into. That doesn’t help anyone either.

  15. Alex Knapp says:

    Patrick,

    Good points there. Best I could offer to counter is to hire accountants from several different firms? Charge them with finding a consensus?

    Like I said, this was a proposal looking for flaws, so I appreciate the comments.

  16. FWIW, I don’t much care for the bailout, though it may now be the best of a number of bad alternatives. All in all, this is yet another argument for smaller and fiscally responsible government since government social engineering played a significant role in creating the conditions that led to this fiasco.

    I figure my share of the debt to be incurred for this bailout to be around $40,000 given the latest estimates. Almost makes me wish I had gone out and bought way too much house with too little down a few years ago, except I still have to live with myself.

  17. Oh, and as for the medical analogy and transfusions, start with type O blood until you have time to learn more, since everyone can accept that.

  18. Michael says:

    Instead of simply buying the bad debts, which lets the companies cut their losses and go about business as usual, by don’t we loan them the same amount of money using the debt as collateral? That way they get an infusion until the value of the debt can be determined, then they either pay off the loan or go into a somewhat more controlled bankruptcy to unload it.

    Worse case scenario then, the government still gets the same assets for the same price as they’re proposing now. More likely some of those companies will simply pay off the loan, taking a slight loss on their end but avoiding bankruptcy. The strong institutions survive, and the weak ones don’t drag down the strong ones.

  19. Michael says:

    FWIW, I don’t much care for the bailout, though it may now be the best of a number of bad alternatives.

    Like I said earlier, now that everybody is banking (pun intended) on a bailout to save Wall Street, anything else, even if it’s a better solution, will probably spark a panic that will make things worse.

  20. Michael says:

    Oh, and as for the medical analogy and transfusions, start with type O blood until you have time to learn more, since everyone can accept that.

    But you’ve got 5 dying patients and only enough type O for 3.

  21. Triage is a bitch.

    However, when all the patients are stabilized, there should be some hell to pay on how it got this bad this fast. Unfortunately, so few people understand how it got to this point that it will devolve quickly into the usual demogoguery and know-nothing populism.

  22. Michael says:

    Unfortunately, so few people understand how it got to this point that it will devolve quickly into the usual demogoguery and know-nothing populism.

    If we’re lucky a 20-something blond American chick will go missing somewhere in the world, and we can forget all about who’s fault this was and let them get back to business as usual.

  23. Dave Schuler says:

    Yes, but before you can stabilize the condition, you need to at least recognize the immediate problem. If the patient’s lungs are shutting down, you might give him steroids, but if his lungs are shutting down because of an infection, you’ve made the problem worse because steroids inhibit the immune system. It’s worth taking the extra minute to check his temperatue and make sure he’s not running a fever first.

    I can see you’ve never watched House. If you give the patient steroids and he gets better, it isn’t an infection.

    Alex, you’re not asking to take the patient’s temperature. It would take years to untangle the web of financial transactions.

  24. If we’re lucky a 20-something blond American chick will go missing somewhere in the world, and we can forget all about who’s fault this was and let them get back to business as usual.

    A friend of mine has been noting these episodes for years and has labelled it the “White Woman in Danger” syndrome.