Thursday, February 12, 2009

Am I Crazy Or What

Yesterday I caught some of the House Committee hearings on Financial Services that was held with several CEOs of our major banks. To say these men, the CEOs, could think of 1,000 or more places they would have rather been yesterday than in front of this panel of questioners is to understate a fact. These men knew who they were and they knew what they did as bank CEOs. They had no doubt had some ups and downs in their lives before they got to the biggest of brass rings, the position of chief executive officer. The members of congress that asked the questions of these CEOs did not know enough about banking in the 21st century, or for that matter, any century, to be questioning these men. Yes, they are members of congress, but you would think if they are placed on a house committee of financial services that they would read a book or two about money and banking so they did not come off as so stupid. The way I saw this whole thing was a waste of time and opportunity to get some important answers, if possible.

What is the issue about “mark to market”? Mark to market means that a bank must value their assets, specifically investment securities, at their market value. If the market value drops, the bank must hold back reserves against those assets. This then reduces the amount of money that the bank can lend. When this happens to all the banks at the same time, we have a credit crunch. The problem is that when there is a market meltdown there is no market value because no one is willing to make a market in those assets/investment securities. Under normal conditions, when securities markets are up and running, and I am talking mainly about the bond market, and more specifically structured financial debt obligations such as mortgage bonds, not the U.S. Treasury market which is working just fine, there are traders at the various bond departments actively making a market in these securities. In other words, these traders will commit their firm’s capital to position several million dollars of par value of structured debt obligations. The traders will buy bonds from investors, position those bonds until they sell them to other investors. These trades, the buying and selling, establishes a market value for nearly every bond. The mark to market value or price becomes the price between the bid and asked price. The trader buys bonds on the bid side of the market and sells bonds on the ask side of the market, while the investor, the portfolio manager, sells their bonds on the bid side and buys bonds on the asked side of the market. The difference between the bid and the ask is called the spread and that is what the trader makes on the trade if interest rates don’t go up before he sells the bonds he has just bought. Each firm risks their capital every second they position an inventory of bonds. When the inventory gets into the hundreds of millions of dollars or billions of dollars, you can see how any move in interest rates can either cause more profit to be made or, if interest rates go up, the spread, or profit is wiped out. Now multiple this going on around the world 24 hours a day and you get an idea of what is going on in the world wide bond market. Now when you have a meltdown in the bond market, none of the above is taking place. No traders are buying and no investors are selling. So, the problem is: how do you value assets on the books if there is no active market? That is why the federal government is talking about buying up some of these toxic assets.

I have spoken a few times before about the role that the bond ratings play in this whole business. Yesterday, unless I missed it, not one word was mentioned about the rating agencies and the role they played in the bond market meltdown. There was fraud in the rating of structured debt obligations by the rating agencies and no one would touch this topic. Until the banking industry and the federal government deal with this problem of the conflict of interest in the rating agency business, there will be no market for structured debt obligations.

In the 21st century, banks need the investment vehicle of structured debt financing to carry on the economic recovery of the country and in turn the world. But, no firm, or bond department, is going to risk their capital on new mortgage, manufactured housing, car loan or credit card debt obligations as long as they have a rating system that is worth less than the paper it is written on.

Members of congress need to understand how the capital markets work in the 21st century before they can fix them. Because they do not know how the capital markets work, yesterday was a waste of time for the nation. Other than getting some satisfaction out of putting these CEOs down for living their life style that is common place for them, the day, in my opinion, brought no new light to the problems at hand.

I wish the right people would read my blog, or, I wish the federal government would say I am crazy and have me committed. One or the other, but let us please do something.

Stay tuned.

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