Although President Obama and millions of his fellow citizens are pinning their hopes for economic recovery on his $819 billion stimulus package, the impact of this plan may turn out to be severely limited unless the president quickly resolves another daunting problem bequeathed to him by his predecessor: the $1.3 trillion of illiquid subprime mortgage-related securities lingering on the books of the nation's financial institutions because market values have not yet been established for them.
More than three months after the so-called Troubled Asset Relief Program was authorized by Congress, these securities, which include collateralized debt obligations, still represent an albatross over the financial system that impedes the restoration of trust and confidence and thereby the flow of money and credit.
The major reason for this predicament is that the government has been stymied by its fixation on establishing prices, rather than values, for these instruments. Trouble is, in a market ruled by fear and uncertainty, as this one is, there's a vast difference between the two. One early proposal — a reverse Treasury auction — was apparently scrapped because the prices that would have been established would surely have been deeply discounted. This short-lived proposal called for the Treasury to purchase mortgage-related assets at the lowest prices offered by the banks and other financial institutions that held them. Under mark-to-market accounting rules, financial institutions would have been forced to take additional writeoffs and raise more capital, measures that would have further undermined confidence in the banking system.
So what we really face is a valuation crisis first and a liquidity crisis second. As things now stand, the failure to establish fair and verifiable market values is preventing the orderly unwinding of credit-default swaps, the derivative insurance contracts that various counterparties use to leverage their bets on mortgage securities and other instruments. The remaining CDS contracts, which still amount to trillions of dollars in notional value, must be settled before market uncertainty can be removed and confidence restored.
Fortunately, there is a way out of this mess. But it would require the Treasury and market participants to acknowledge that the intrinsic value of a security, as determined by empirical mortgage market data, may be substantially greater than what a buyer is willing to pay for it in a panic-driven marketplace.
To end the credit crisis and forestall further damage to our deteriorating economy, the Obama administration must confront the valuation crisis head-on. Here's how:
First, suspend all further Treasury loans to banks and Wall Street firms until all problematic mortgage assets can be valued intrinsically. The hundreds of billions of dollars that have been injected so far have failed to stabilize the markets, and injecting more will only exacerbate the crisis.
Second, immediately impose a temporary moratorium on mark-to-market accounting in its current form. Then redefine "fair value" to mean the amount derived from empirical mortgage data, which takes into account any likely devaluation resulting from delinquencies, prepayments, defaults, and foreclosures. This data is available from reports produced by all mortgage servicers.
Third, hire one or more firms to value all financial assets using this data. That calculation is performed by discounting risky cash flows and determining the conditional probability of default using the servicer data. The most efficient way to undertake this valuation is to start with securities backed by Countrywide Financial mortgages, because they are benchmark issues that make up about 20% of the MBS market.
These valuations would be posted on the Treasury Department Web site and recalculated monthly, using fresh servicer data, for every security until maturity. Under this plan, intrinsic valuation would become the basis both for fair-value accounting under generally accepted accounting principles, and for the resolution of outstanding and future credit-default swaps contracts.
Once rational, intrinsic values are assigned to each security, outstanding CDS contracts could be resolved in an orderly manner. Market forces would cause the system to relax without the need for additional government cash infusions, since CDS-related liabilities would be converted into cash at a predictable pace and in predictable amounts.
The mere announcement of this valuation plan and the initial results would go a long way toward ending the credit crisis, largely because it would remove the fear of bankruptcy that now hangs over many CDS players. Additionally, the values given to the securities would filter down to the level of the underlying residences, helping to stabilize home prices and forestall additional foreclosures. After the immediate crisis is resolved, which would likely take about six months to a year, these procedures would be incorporated into a comprehensive plan for re-regulation of the nation's financial services industry.
