Markets are always correct... except when they're totally wrong

For several decades, banks have successfully begged Washington, DC to eliminate regulation after regulation (and neuter regulatory agency after regulatory agency) by arguing free markets know best and are self-monitoring and self-correcting.

So it’s deeply ironic that — many trillions of dollars in losses later — those same banks and bankers have successfully begged Washington, DC for multi-trillion-dollar bailouts by claiming their “losses” aren’t really losses. They claim their “toxic assets” are really quite valuable. It’s just that the mean old market is systematically under-valuing them, so they need a few trillion dollars to get themselves through this rough patch. It’s not a bailout. It’s a bridge loan. In exchange for our warehouses full of fresh $100 dollar bills, banks are oh-so-reluctantly giving the Federal Reserve their really valuable mortgage debt that the suddenly insane financial marketplace is systematically undervaluing.

The report of the Congressional Oversight panel headed by Harvard Law Professor Elizabeth Warren highlights that Treasury Secretary Geithner (a long-time banking industry insider) is playing along with the megabanks' charade by avoiding the obvious and time-tested solutions — liquidation and government reorganization — advocated by virtually all sensible unbiased economists. Geithner has instead chosen the most industry-friendly approach: massive direct and indirect subsidies, which, the report warns, carries three risks: 1) “obscuring true valuations”; 2) “distorting both specific markets and the larger economy”; and, 3) “that it will be open-ended, propping up insolvent banks for an extended period and delaying economic recovery.”

One key assumption that underlies Treasury’s approach is its belief that the system-wide deleveraging resulting from the decline in asset values, leading to an accompanying drop in net wealth across the country, is in large part the product of temporary liquidity constraints resulting from nonfunctioning markets for troubled assets. The debate turns on whether current prices, particularly for mortgage-related assets, reflect fundamental values or whether prices are artificially depressed by a liquidity discount due to frozen markets – or some combination of the two.

If its assumptions are correct, Treasury’s current approach may prove a reasonable response to the current crisis. Current prices may, in fact, prove not to be explainable without the liquidity factor….

On the other hand, it is possible that Treasury’s approach fails to acknowledge the depth of the current downturn and the degree to which the low valuation of troubled assets accurately reflects their worth.

So, instead of reorganizing bankrupt banks — as capitalist economies are supposed to — taxpayers are paying failed banks trillions in subsidies on Geithner’s hunch that current market prices are absurdly low and poised to bounce back strongly, a hunch completely at odds with decades of banking industry deregulation propaganda.

Posted by James on Monday, April 13, 2009