The devastating credit squeeze that has been gumming up the interbank and commercial paper loan markets for months shows few signs of letting up. The underlying problem remains firmly in the market for subprime mortgages.
During the savings and loan crisis of the late 1980s, dud mortgages were held by the banks that issued them. This made identification of the infected institutions simple and the solution obvious: shut them and sell their assets at a steep discount. The bill to the US taxpayer was considerable, about $125bn, but the damage to the wider economy was minimal because the crisis was well contained.
The subprime virus is far more difficult to quarantine. Securitisation of mortgages has spread the financial risks around the economy in such a way that banks are no longer likely to go bust from holding the bad loans they originated. But the repackaging of those mortgages in complex collateralised debt obligations and structured investment vehicles has made it difficult to identify who is holding what. This has led to fears of credit risk among banks when dealing in the interbank lending market, exacerbated by the fact that the instruments in which the mortgages have become intertwined cannot be reasonably valued once they stop trading.
There are some mildly encouraging signs that basement valuations for these mortgages are emerging as desperate fund-seekers and well-heeled risk-takers find each other. Citadel, for example, has purchased $3bn in debt held by troubled E-Trade Financial, valuing those assets at 27 cents on the dollar. The question is whether other such deals will begin emerging imminently, establishing some semblance of a market and real prices for these assets.
Once banks can start marking to market rather than meaningless models, more is likely to come on balance sheet. This will have two positive effects. First, banks will regain confidence to lend once they know that their regulatory reserves are sufficient. Second, they will regain confidence in counterparties who are able to do the same. The interbank lending market will start functioning again, opening the way for businesses to retap commercial paper and other debt facilities. The problem is that there is as yet no evidence that the Citadel deal heralds good things to come. Citadel, as a holder of E-Trade stock and debt, had unique incentives to act.
We believe that what is needed is a new Resolution Trust Corporation based on the 1989 model that cleaned up the S&L mess. Congress would establish this new RTC to buy up subprime mortgages at deep discounts. The RTC would establish, say, five tiers of mortgage, offering, say, 70 cents in the dollar for tier A, 60 cents for tier B, 50 cents for tier C, and so on. Sellers would have to pay the RTC a fee for evaluating and classifying any mortgages they wished to sell.
How much would such a scheme cost the US taxpayer? In the worst case, in which house prices continued to fall steeply, and in which these free options to sell were very widely exercised, the bill would be some fraction, say up to a quarter, of the total subprime write-off—about $75bn. The silver lining—nay, platinum—would be the relatively rapid revival of the global credit system, the oxygen of the world economy.
But the bill is likely to be much lower. Financial institutions could use these put options to mark their mortgage debt in a way that would be legally waterproof and credible to the market. In addition, the existence of such put options will almost certainly encourage all sorts of institutions to bid higher prices for such debt, knowing that their downside risk would be limited. Thus the RTC may wind up buying very little, if anything.
The RTC is not an alternative to regulatory reforms to address abuses and skewed incentives in the appalling subprime Ponzi scheme that has ballooned this decade. Lenders, brokers, ratings agencies, market makers and borrowers have all contributed to the mess and each group must suffer some share of the market fallout. Each must face an incentive structure consistent with market integrity and stability. But failure to enact an RTC to fish out the bad debt that is rotting our credit markets only makes it more likely that Congress and the administration will adopt an election-year gimmick agenda with Sarbox-type haste and results.
Mark Fisch is managing partner at Continental Properties. Benn Steil is director of international economics at the Council on Foreign Relations and co-author of Financial Statecraft
This article appears in full on CFR.org by permission of its original publisher. It was originally available here.