From my brother, a financial analyst and all-around brilliant guy:

In my opinion, what they should have done from the first place is force the banks to hold on to the bad assets, and instead of buying those assets, the Fed should have simply invested in the companies. Determine which banks are completely screwed, and let them fail. Take the rest of the banks, and give them capital in return for preferred equity with attractive terms (i.e. something like a 10% dividend, and the ability to convert the preferred stock into common stock).

Preferred stock is similar to common stock, except it has priority ahead of common stock. Typically, preferred stock pays a fixed dividend (unlike common stock, where the company can choose if it even wants to pay a dividend at all). In most cases, a company can defer a preferred dividend to a later period, but they still have to pay it eventually. Whatever they don’t pay accumulates over time, and no common stock dividend can be paid out until the preferred stock gets paid what is owed to them.

 

Also, in the case of a bankruptcy, the preferred stockholders have the right to claim any assets, etc. prior to the common stockholders. However, preferred stock still falls below debt on the priority chain. Debt > preferred stock > common stock in the case of a bankruptcy.

 

This works for the banks (at least the good ones that deserve to survive), the economy, and the taxpayers. With the current approach of just buying the assets, the real winners are basically all banks (they get money to get rid of their worst assets) and all of their debt/equityholders of those banks (people who willingly invested in the company, knowing the risks inherent to such a business, and who should be the ones facing the repercussions!!). Basically, the government gives them money for crap assets (and likely overpays for them), and when/if those banks recover, and the stock does better, the banks and their stockholders benefit, while taxpayers are left to hope and pray that these terrible assets end up providing a nice return… which is unlikely. Thus the taxpayers get screwed, and it’s also not even clear that this will help the economy. There are many out there saying that $700B won’t be nearly enough.

 

With the approach of recapitalizing the banks by investing in them, the good banks, the ones owning the least amount of these mortgage-backed securities, will instantly receive an inflow of capital. No waiting around for the gov. to determine how much to pay for the assets, etc. This infusion of liquidity will allow banks to immediately resume borrowing and lending, getting the credit markets moving ASAP, which is above all else the single most important problem that must be addressed. By investing in the good banks, the government stands to benefit substantially once the banks turn the corner and return to profitability. This money can be passed along to taxpayers. Once the taxpayers are paid back (of course, this assumes the gov. is competent and ethical enough to actually return the money to taxpayers), the gov. can sell down its investment in the company slowly over time–I’m not looking to nationalize our entire banking/insurance industries. Sweden took this approach in the 90s and had great success with it.

 

Fortunately, I was reading an article about the bailout bill that said that it DID grant the government the ability to recapitalize these banks in the ways I just described. However, it’s unclear just to what extent they will actually use that approach as opposed to simply buying the debt, which as of right now is still the main approach being pursued.

 

Also, to describe this situation far better than I could, and some of the key issues, check these articles out. Roubini is an NYU Professor who, although noted for being quite a pessimist, has been pretty much on point about this whole crisis. People will call him a bit of an extremist, but he is certainly looking to be the better prognosticator at the moment than those naysayers. Like I said, don’t completely buy in to his doom and gloom, but do realize that the issues he is focusing on (esp. regarding the corporate debt markets) are absolutely critical right now. The big issue is that even though companies may have GREAT long-term growth prospects, in the short-term, many of these companies literally depend upon short-term borrowing to finance their day-to-day operations. Right now, these companies simply cannot borrow that money with the way the credit markets are now. This CANNOT last for more than a very short period of time, or these companies will be screwed once their recent batch of debt expires and they need to roll it over.

 

http://www.rgemonitor.com/roubini-monitor/253853/financial_and_corporate_system_is_in_cardiac_arrest_the_risk_of_the_mother_of_all_bank_runs

http://www.rgemonitor.com/roubini-monitor/253907/the_fed_keeps_on_wasting_time_while_the_mother_of_all_bank_runs_is_underway

 

Also, I like some of his suggestions, but am not a strict adherent to any of them. I really think the sky is the limit, and I won’t pretend to know what the solution is. The government needs to think outside the box and take unprecedented steps, or I really do think the panic/irrationality that has taken hold, both in the financial markets and the credit markets, could potentially lead to a catastrophic collapse. This is exactly what happened to my company, and there is literally no reason why the same can’t happen to the national, or even global, economy. 

What is mark-to-market and what impact has it had on the current crisis? 

Mark-to-market just means that on a company’s balance sheet, the assets/liabilities are recorded at their fair market value (literally, what they would be worth if you tried to buy or sell them in the market). Thus, the values of the assets/liabilities, as they are reported on the balance sheet, are updated over time as the price they fetch in the marketplace changes. This is in contrast to recording an asset/liability at book value. Recording an asset at book value typically means that the value you attribute to it on the balance sheet is the price you paid when you bought it, adjusted for different accounting conventions that try to adjust that value for the fact that the value of most things degrades over time (cars break down, buildings need renovation, etc.) Book value is used for things like property and buildings because it is hard to determine what these things are really worth in the market. People see different value in the same piece of property, and property is rarely traded. Financial assets, on the other hand, are far more abundant and traded constantly, so you can simply just look at the last price they were bought/sold for, and there’s your market value.

 

The issue with mark-to-market is as follows. Typically, mark-to-market is touted as being much better for financial assets than book value (or any other option). This is because, in theory, the market price is the best reflection of what an asset is worth, which is basically true. However, now the prices of these mortgage backed securities are plummeting, and at least some of that is because there is no liquidity in the market (no one wants to trade in that market for them, so prices are sinking). So the question now is–is the current market price -really- what the asset is worth? Or is its price being pushed artificially lower because of the -temporary- lack of liquidity in the market. People will argue that, in fact, mark-to-market should not be used in the case of illiquid (= thinly trading) securities, because the fundamental value of the securities is higher than what they are selling for. However, not everyone buys this argument (for instance, if this were the case, then that would mean that anyone with enough money and a long enough investing time horizon would be jumping at the opportunity to buy these supposedly undervalued assets and make a killing… but this clearly is NOT happening). So basically, is the current market price an actual reflection of the fundamental value of the asset, or is it artificially low because of the lack of liquidity in the market?

 

The reason mark-to-market has been disastrous is because of the impact it has on the balance sheet. This is a bit of an oversimplification, but what is happening is this: the market value of the mortgage backed securities is plummeting, and so these companies are being forced to continually write down the value of their assets to reflect the most recent market prices. This is throwing the ratio of assets:liabilities completely out of whack. For example, suppose I have $10 billion dollars in mortgage backed securities that is being supported by $10 billion in debt (1:1 assets:liabilities). Now, all of a sudden, the market thinks (and probably rightfully so) that the mortgages backing these securities are crap and so the securities are really only worth $5 billion. Now, my balance sheet, under mark-to-market, will show that I have 2x as many liabilities as I do assets. This does two things: first, it spooks stockholders. Second, and more importantly, it leads to debt defaults. Typically, debt contracts are written so that the company who is borrowing the money must maintain certain ratios (say, assets:liabilities must be 1:1). The contracts typically state that if that ratio is not sustained, then the company can be considered to be in default of their agreement, and be forced to pay back the debt ASAP. But now, their assets are worth basically nothing, and most of these companies have little cash on their balance sheets. They can sell their assets, but they’d get pennies in return. So they can’t repay the debt are forced to default, potentially even leading to bankruptcy. 

 

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