I received a mysterious email last week from the Treasury, inviting me to a discussion about the Administration's policies and reactions to the economic crisis. Although the timing sucked for me - it was the Monday following the weekend of my move out of NYC - it was too rare an opportunity to pass up.
Arriving at the Treasury, I quickly bumped into AccruedInterest along with John Jansen from Across the Curve. Michael Panzner soon joined us, before we were escorted to the proper conference room, where we found Yves Smith from Naked Capitalism, Steve Waldman of Interfluidity, Tyler Cowen from Marginal Revolution, and David Merkel of Aleph Blog fame. In all, there were 8 "bloggers" and a handful of senior Treasury officials, who shall remain nameless. Henceforth, all Treasury views will be attributed to "STO" - Senior Treasury Officials.
STO began the session with a little background regarding the Administration's response to the financial crisis. The first point that caught my ear was the description of the stress tests as having been designed to restore a level of confidence in the banking system. The STO mentioned that the focus was now on reducing the footprint of economic intervention cautiously, quickly and prudently. Michael Panzner jumped right in, addressing a concept I've writted about previously - that of "extend and pretend," or "delay and pray" - the concept of attempting to avoid recognizing actual losses and or insolvencies, and growing out of them after enough time. Panzner called it "fake it 'till you make it." I mentioned that I felt like we were undergoing a "Ponzi scheme of confidence" - but that confidence mattered less than ever in the current environment where, contrary to perhaps the prior 10 years, confidence can no longer be "spent."
In other words, 5 years ago, the economy could be kept churning along if consumers were convinced that things were going to be ok - they could go and borrow more and spend more. They could take out another mortgage on their home. Today, on the other hand, that credit bubble has popped - we're broke, both as a consumer, and a nation - and we can no longer simply "spend" confidence by levering up our personal balance sheets any more. I challenged the STO that he had a poor choice of words in describing the stress tests as designed to restore a level of confidence, rather than to determine which banks were healthy and which were insolvent.
This drew a chorus of "whoa whoa's" and a murmur from a number of STO's present in the room, who quickly banded together to clarify that no one knew the results of the stress tests before they happened, and that they were designed to restore confidence by identifying the levels of capital needed by the banks, and requiring them to raise such capital. I said that if they wanted to restore confidence, they should require banks to mark assets to market, and depict the true financial situation.
The response was that banks don't mark to market because, well, that's just not what they do - since they hold assets to maturity. It was also pointed out that if banks had been required to mark to market, the system would have been insolvent multiple times in the past 50 years. I almost laughed - that was my whole point - just because you pretend that the system is not insolvent doesn't mean that it's not insolvent! Holding assets to maturity does not mean you'll receive your principal back, obviously. I also noted that I understood that my background in equities gave me a slightly different perspective, since our (equity) assets were much more liquid and had to be marked to market daily - but I took umbrage with the recent decision by the FDIC to allow banks to recognize commercial real estate loans which were clearly impaired as "performing" and avoid taking writedowns. I referenced David Einhorn, who wrote an entire book on Allied Capital - whose accounting shenanigans attempted to hide the health of their loan book in exactly this manner. Loans which were certain to default, but had not yet defaulted were still recorded on the books at full price, and as "performing."
I failed to draw an analogy to the local Washington Redskins, which I think would have been a good one: the Redskins are technically in the NFC East playoff race - they haven't been mathematically eliminated yet - but in reality, they are not a contender. Similarly, many of these CRE loans are technically "performing" - the payments are currently being made - but the values of the properties are down massively, rents are falling, and it's widely recognized as a mere matter of time before the loans default in one form or another.
David Merkel jumped in with the suggestion that even if loans are not marked to market prices, there still has to be an increase in capital requirements held against loans that have seen their market values impaired.
Steve Waldman was a harsh critic of the policy of "Prompt Corrective Action," and was credited (by me) with the quote of the day when he addressed one STO on the regulatory reform plan: "I've read your bill, and it's terrible - no offense," and followed with "too big to fail is too stupid a criteria." This led to a discussion of how capital ratios were not the problem - although I do think they are a part of the problem. The buzzword issue was really "interconnectedness," aka, "counterparty risk."
There had been suggestions as far back as a year ago, I believe, about having a central counterparty risk identifier, like the Federal Reserve, monitor the net counterparty risk of each firm, and quantify it systematically. I mentioned that the problem was that even if we had a "Counterparty Risk Czar" who somehow managed to magically quantify the exposures of each firm (which may be quite a difficult task in itself), we'd see the same problems we saw when the government went to give out the TARP funds. The government didn't want to "bail out" select firms (ie, BAC and CITI) because they feared that the stigma attached to such assistance would create panic and runs on the bank - so they asked a large pool of financial institutions to take the money to hide the truly sick cows. The Counterparty Risk Czar would have the same issue - if he were to somehow miraculously identify that Firm A had too much exposure to Firm B, the very announcement of such extreme exposure would become a self fulfilling prophecy and result in panic by investors in Firm B, which would in turn spread like wildfire to Firm A. Is the solution to move the trading of every product onto a clearing house centered exchange? Perhaps, although that would eliminate an immeasurable amount of OTC trading that the system seems to need to keep churning at its current size, and hamper the economic growth fueled by it (with "it" being financial engineering, in some sense).
I made another point that, although I was not going to presume to lecture a room full of economists and pseudo-economists (as one STO described himself) on economic theory, it was clear to me that they needed to throw away their old economic playbooks. The thing that bothers me most about economic history is that it's based on a relatively small number of samples. Furthermore, the inputs in each scenario are vastly different. Today, for example, we have record length of time the government will provide unemployment benefits, record length of time people spend receiving unemployment benefits, and yet still a record number of people exhausting unemployment benefits. I cautioned the economists in the room that there is no rule about what "usually" happens when GDP rebounds from -3% to +3% - or when unemployment goes from 5% to 10% - because it's the INPUTS that determine the rationale for the response. In other words, a +3% GDP print from government spending (which I maintain is what we just saw) is very different from a +3% GDP print from organic economic growth. The stimulus induced GDP growth will revert when the stimulus stops.
Stay tuned for Part II - where I"ll talk about some unsatisfying answers to questions asked by myself and others, and attempt to synthesize my interpretation of the Treasury's stance on policies.