By Arnold Kling
Many assets are highly illiquid and the institutions that hold them, such as banks, are in the business of providing liquidity to the economy and holding such assets as collateral. Making those assets “mark to market” meant that reserves were drawn down and converted into ever more loans during the upswing, and now must be built back up at a time when asset prices are plummeting and capital is scarce. Instead, a more stable capital adequacy rule — such as a leverage ratio that was based on the original asset values — would limit this pro-cyclical behavior. This means that the complex approach taken in the Basel II discussions for international capital rules need to be scrapped, and the process restarted.
Whatever you do, don’t go back to book-value accounting. That is what made the S&L crisis of the early 1980’s so bad.
Speaking of the S&L crisis, Nicholas F. Brady, Eugene A. Ludwig, and Paul A. Volcker suggest that we need to resurrect the agency, called the RTC, that unwound the S&L’s. With all due respect to the authors, I would subject that proposal to more careful scrutiny before trying it.
The RTC was bounded. It only had to deal with failed depository institutions. The problem today is not limited to any particular type of institution.
The RTC was passive. It received the assets after the S&L’s failed. What Brady-Ludwig-Volcker are proposing is an active agency, that would “buy paper.” Buy at what price? Using what guidelines?
Finally, Robert J. Samuelson writes,
What’s really happened is that Wall Street’s business model has collapsed.
Read the whole thing. While everyone is talking about tighter regulation for Wall Street, the reality is that the market has killed the business model before the regulators could get to it.
Part of the business model involved investment banks holding securities. I would suggest that this was not so much that they said, “Hey, let’s hold securities for fun and profit.” The private securitization business involves slicing and dicing cash flows. The low-risk cash flows are attractive, and the investment banks sell them. They keep the remainder (“toxic residuals,” as they are known) almost as a loss-leader, while they collect fees from trading the good stuff. The problem is that, in Talebian fashion, the losses from the toxic residuals are wiping out years of fees.