Comments on: The Liquidation Trap

By: Club Troppo » How to fix the financial crisis

Club Troppo » How to fix the financial crisis — Sat, 01 Nov 2008 04:23:49 +0000

[...] not really. I’m buggered if I know. But this post from Thomas Palley seemed as ‘on the money’ as any I’ve seen lately. [...]

By: The Progressive Economics Forum » The Liquidation Trap

The Progressive Economics Forum » The Liquidation Trap — Wed, 24 Sep 2008 18:52:17 +0000

[...] http://www.thomaspalley.com/?p=130 [...]

By: JHecht

JHecht — Sat, 20 Sep 2008 00:54:06 +0000

For many years the investment community wanted commercial banks to adopt mark-to-market accounting rules (Citibank currently uses MTM accounting). This was because investors generally did not believe that book-value bank assets bore any relation to their economic (i.e., discounted present) values. Now while it is true that bank managers must pay attention to their duration gap, they fought against FASB who wanted to impose MTM accounting on the commercial banking sector. So while the investment community seeks to blame mark-to-market accounting for the current crisis, it was they who wanted to use it to “discipline” commercial bank managers. I should also point out that “statutory accounting principles” (that state insurance regulators apply to property-casualty insurance companies), require insurers to adjust their “surplus” (i.e., net worth) each quarter by the amount of realized and unrealized capital gains or losses. While this introduces some volatility into an insurer’s capital base, it generally forces insurance managers to pursue a relatively conservative asset mix (say 70% bonds, 30%). So MTM accounting can have some “disciplinary” effects on financial managers. However, as Tom correctly points out, you cannot use mark-to-market accounting to value thinly/infrequently traded assets of possibly questionable asset quality (e.g., a commercial bank loan to an auto repair shop).

By: Jim

Jim — Fri, 19 Sep 2008 03:31:20 +0000

Thank you for a lucid, pragmatic description of where we are at.

I too am struck by the reaction of the right and left for moral consequences. I would suggest that the complexities of the system itself invites manipulation for personal gain at the expense of the system. The call for consequences to this behavior is a reaction to those in power acting in self interests, rather than the best interests of the system. Therein lies the paradox we currently face.

The belief that the pursuit of individual gain is of benefit to the system overall is the test we now face.

By: VoiceFromTheWilderness

VoiceFromTheWilderness — Fri, 19 Sep 2008 01:23:39 +0000

What I don’t understand about your prescription of relaxing mark to market rules, is that for more than a year now we have been hearing about investment banks holding lots of assets in level 3, which is precisely not mark to market. And though I don’t have references on hand, my impression from what I’ve been watching for the last year is that companies have been moving assets into level 3 over the last year. I may not be correct about this, but my impression is that the Lehman situation comes about *despite* having assets in level 3. That is that even though they were marking to model their capital reserves became inadequate. Plenty of people have been calling for and end to mark to model for a long time (mish for example) but we haven’t seen Paulson or anybody else coming out and doing it. If there exist assets valued based on a model at this time, then your thesis that mark to market is causing the problem seems less clearly the primary cause. What if the models are showing that in an environment of falling house prices, and rising defaults, tranches of mortgage back securities are likely not to perform well, and if the poor performance indicated, also then implies poorly capitalized companies altogether.

Just exactly how long do these institutions get to assert what amounts to made up values for these assets under your proposal? A week? A month? A year?

Lets go with a year. Okay, so you get to pretend you have assets that you don’t for a year, are you going to start paying the mortgage payments to the MBS holders when the owners of the houses whose mortgages you control stop doing so? Well, okay, how much is that going to cost? And where are you going to get the money? borrow it? hmmm.

Okay, now what if it isn’t a year? What if it’s two years? Three years? What if when you revert to real accounting the problem starts all over again? the idea that people haven’t been rigging up the accounting to put a pretty face on things (lipstick on a pig I believe this situation has been called by some - calculated risk - for quite a while) simply flies in the face of truth. Your argument would be a lot stronger if there was a countervaling benefit to the people who are being asked to extend benefits to those who have been lying and cheating. You want to change the accounting rules? Ok, well, then we also ought to nationalize the institutiions requiring this little benefit, and begin an active and thorough investigation into the question of whether they knowingly violated the law. You want to change the accounting rules now, but it was entirely obvious that letting Fannie and Freddie run 80:1 capital ratios was going to turn into a disaster. Which is the real cause of the problem, and we all know it. It’s all well and good (sort of) to allow changes to manage a problem, but if those changes don’t address the problem, don’t actually do anything to fix the problem…

That thar’d be con-artists working for thieves

By: The Glittering Eye » Blog Archive » Two Three Posts on the Financial Crisis (Updated)

Thu, 18 Sep 2008 17:55:54 +0000

[...] Thomas Palley has a fine post on the situation and some advice that goes against the prevailing wisdom: Bad debts will have to be written down, but it is better to write them down in orderly fashion rather than through panicked deleveraging that pulls down good assets too. [...]

By: self

self — Thu, 18 Sep 2008 15:46:40 +0000

Unless serious discourse on non-bank regulation and the future tax burden distribution accompanies a publicly funded bailout, only the naive would expect political leverage not to be exercised.

Systemic risk should not be a trump card used to quell a discussion for which the public has now paid a fair price. Not looking behind the curtain with regulation and oversight is what got us here. So it seems disingenuous to dismiss what are effectively negotiation postures (by left and right) for a seat at the table so to speak. It is not imprudent, it is both just and necessary given the present regulatory environment.

By: LBoord

LBoord — Thu, 18 Sep 2008 13:22:15 +0000

We need to change the Mark to Market rule, to return control of the balance sheet to the managers and not to fire sale liquidators.

By: Real Time Economics : Secondary Sources: Mishkin, Liquidation Trap, Trillion Dollar Bailout

Thu, 18 Sep 2008 13:02:44 +0000

[...] Liquidation Trap On his blog, Thomas Palley warned of a liquidation trap that has falling asset prices causing financial distress, in turn compelling further asset sales and price declines. “The Fed must lower interest rates, and not just for standard reasons of stimulating spending. Lower short term rates are needed to make longer term assets (including houses) relatively more attractive, thereby shifting demand to them and putting a bottom to asset price destruction? The great irony is central banks can produce liquidity costlessly. Usually the problem is restraining over-production: today, it is over-coming political concerns about ‘bail-outs.’ Those concerns are legitimate, but they also risk inappropriately restricting liquidity provision and unintentionally imposing huge costs of deep recession.” [...]

By: Mark

Mark — Thu, 18 Sep 2008 12:02:35 +0000

If one of the causes of the trouble is that financial institutions do not trust each other, relaxing the mark-to-market rules will only increase the distrust.

Rather than relaxing these rules, we need to get all derivatives traded on open exchanges with public pricing.