But please don’t forget the 1st law of financial dynamics…
Given my background as a senior investment banking professional in the credit markets, I feel somehow compelled to comment on the just proposed “market meltdown” fund (the Guardian’s moniker not mine.) On the plus side, even if substantively it achieves no more (than would otherwise be achieved by independent market forces) than increase confidence – thus improving liquidity – in these markets, that in and of itself is a good thing. (And analogous to a central bank’s ability to be a stabilizing influence in money markets…) And on this basis, as long as there is no explicit or implied taxpayer guarantee stealthily underwriting the effort – or coercion for that matter, the banks who are keen to finance this fund should obviously be allowed to get on with it.
(from the Guardian article) The US plan would see banks pooling mortgage securities and other illiquid assets in the hope it would prevent forced sales that could generate losses of billions of dollars and send shockwaves through the entire financial system.
Pooling the ailing assets into a separate warehouse may help to isolate the risk, restore confidence and even allow the fund to offload the assets at a better price than if banks individually rushed for the exits, it is believed.
At the risk of sounding patronizing, I would only suggest that the banks behind this fund don’t forget the law of conservation of risk: the underlying risks – the fundamental risk quarks – remain immutable. This does not diminish the potential value that can be created by rearranging and recombining this risk into different shapes and sizes, however the likelihood of this ultimately succeeding is in my opinion increased significantly if this ‘financial law’ is explicitly acknowledged by the financial professionals doing the engineering. Historically this has not always been the case (and has in my view been a key factor in creating some of the problems this fund now seeks to repair.) I imagine that Mr. Turner is thinking along these same lines:
(from the Guardian article) Some economists doubt, however, whether the plan will work. Graham Turner, of GFC Economics, said: “It is little more than a confidence trick that does not go to the heart of the matter – namely how to prevent the downward spiral in property prices and escalating foreclosures feeding off each other.”
I would also raise a second point which is to highlight the potential (inherent?) conflict of interest in such a fund as it would seem that it will be buying securities from its owners and is structurally engaged in a form of self-dealing. Assuming that the fund buys only securities that are misvalued by the market due to a situational (and temporary) structural imbalance of supply and demand (due to the rapid unwinding of substantial leverage in the asset class), this is probably a good thing (both for the markets and for the banks’ shareholders) however ultimately either overall leverage needs to decline (more equity injected into the asset class) and/or underlying fundamental losses need to be written off. This is true whether or not such a rescue fund exists.
Indeed the important medium term ‘$100 billion’ question is just how big are these real underlying losses and how much equity needs to be written off to clear the market. The banks in question are certainly in a good position to have a good understanding of what exactly this number is likely to be. If their management and motivation in setting up this fund is framed around accelerating the accurate repricing and acknowledgement of risk, than they can only be encouraged. If on the other hand, the real underlying driver is simply to reshuffle the deck and keep the dance going (not my metaphor!) then the credit prom might end up looking more like this:
