Thursday, December 16, 2010

Mervyn King Gets a Second Chance to Save the Global Financial System

Thanks to WikiLeaks, we now know that by March 17, 2008, Mervyn King and the Bank of England realized that they were dealing with a solvency and not a liquidity crisis.

The cable, which was published in the Guardian, follows [emphasis added]:
1. (C/NF) Since last summer, the nature of the crisis in financial markets has changed. The problem is now not liquidity in the system but rather a question of systemic solvency, Bank of England (BOE) Governor Mervyn King said at a lunch meeting with Treasury Deputy Secretary Robert Kimmitt and Ambassador Tuttle. King said there are two imperatives. First to find ways for banks to avoid the stigma of selling unwanted paper at distressed prices or going to a central bank for assistance. Second to ensure there's a coordinated effort to possibly recapitalize the global banking system. 
For the first imperative, King suggested developing a pooling and auction process to unblock the large volume of financial investments for which there is currently no market. 
For the second imperative, King suggested that the U.S., UK, Switzerland, and perhaps Japan might form a temporary new group to jointly develop an effort to bring together sources of capital to recapitalize all major banks. END SUMMARY
Systemic Insolvency Is Now The Problem
2. (C/NF) King said that liquidity is necessary but not sufficient in the current market crisis because the global banking system is undercapitalized due to being over leveraged. 
He said it is hard to look at the big four UK banks (Royal Bank of Scotland, Barclays, HSBC, and Lloyds TSB) and not think they need more capital. A coordinated effort among central banks and finance ministers may be needed to develop a plan to recapitalize the banking system.
Unblocking Illiquid Mortgage-Backed Securities
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3. (C/NF) King said it is also imperative to find a way for banks to sell off unwanted illiquid securities, including mortgage backed securities, without resorting to sales at distressed valuations. He said sales at distressed values only serve to lower the floor to which banks must mark down their assets (mark to market), thereby forcing unwarranted additional write downs. 
He said we need to find an auction system where banks could move paper they want to sell without fear of stigma that the market views selling at a low price as a sign that a bank is in trouble. King said, however, he did not yet know how to structure such an auction and that further dialogue was needed. Kimmitt acknowledged the need to find ways to unblock these markets and said we should remain in touch bilaterally as well as in the G-7, the Financial Stability Forum, and the central banks.
A Possible Approach To Recapitalization
4. (C/NF) The G-7 is almost dysfunctional on an economic level, said King. Key economies are not included, especially those that have large and growing pools of capital. King said that a new international group was needed to address the issue. It could be a temporary group, and he suggested that perhaps the central banks and finance ministers of the U.S., the UK, and Switzerland could coordinate discussions with other countries that have large pools of capital, including sovereign wealth funds, about recycling dollars to recapitalize banks. King said Japan might not be included because it has little to offer. King noted, though that including the Japanese might force their hand in finally marking to market impaired assets. Kimmitt said that he was cautious about starting new groups in the international financial community because of the inevitable debate around whom to include.
5. (C) The King proposals were not casual ideas developed in the course of luncheon conversation. It was clear that his principal objective in the meeting was to outline his outside-the-box thinking for Kimmitt. King included very few details about his proposals and was content to present broad concepts, thereby planting the seeds for future discussion.
As this humble blogger was reading the cable for the fifth time, it served to re-emphasize the fact that Europe and the US have not yet addressed the systemic solvency issue nor have they managed to find a solution for making a market for the illiquid securities.

It is now three years into the credit crisis and, like Japan, banks in Europe and the US are not marking impaired assets to market.

The problem of solvency has not gone away.  Nor has the problem of valuing illiquid securities or impaired assets.  

The question is how to create a market for the illiquid securities and impaired assets!

Mr. King highlights every regulator's concern when it comes to selling illiquid securities and impaired assets for which there is no liquid market.  As discussed in the Looting of the Irish, the problem of not having a liquid market is that Wall Street will be happy to buy the assets for less than they are worth.  This in turn increases the amount of capital the banking system needs from the government and ultimately its taxpayers.

Mr. King suggests the Wall Street auction model which is designed to loot and pillage the banking system and through the recapitalization mechanism, the national treasury. 

Wall Street's basic approach is to share loan-level performance detail on the collateral underlying the illiquid securities and impaired assets with a limited group of prospective buyers.  After the prospective buyers have had a chance to do their due diligence, Wall Street then conducts an "auction" of the illiquid securities and impaired assets complete with competitive bidding to realize the 'best' price.

The aspect that gives rise to looting and pillaging is the absence of an independent "fair" value determined by the credit markets.  Without this value, how do the sellers, which is ultimately the government when banks need to be recapitalized, know if:

  • The highest price from Wall Street's "auction" is below, equal to or above fair value?
  • They got a good deal or were ripped off?
Fortunately, governments did not pursue this auction strategy.

If not an auction, then what?

Since the beginning of the crisis in 2007, your humble blogger has been advocating a different method for creating a market.  This method is based on the idea that sunlight is both the fundamental building block of the global financial system and the best disinfectant for the opaque auction process.  

Governments should first require the disclosure of current loan-level performance information on the collateral underlying the illiquid securities and impaired assets to all credit market participants.  To insure the information disclosed is always current it should be updated on an observable event basis (observable events include a payment, delinquency, default, or borrower insolvency filing).

This lets the credit market analysts and third party pricing services value these illiquid securities and impaired assets and independently determine what their fair value is.  

Then, and only then, let Wall Street auction the loans to all prospective buyers.

Armed with the fair value of the illiquid securities and impaired assets, governments could see how well Wall Street performed in maximizing the value of the illiquid securities and impaired assets.  Was Wall Street able to justify it fees by auctioning off the illiquid securities and impaired assets for more than the credit market analysts and third party pricing services believed was fair value?

By maximizing the value of the illiquid securities and impaired assets on the banks' balance sheets, governments minimize the amount of capital required to recapitalize the banks.

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