The economic turmoil that the whole world is facing started with the bursting of the asset bubble in the U.S.
The bursting of the asset bubble caused 2 things. First, banks experienced a diminution in value of security since the value of the property that secured the housing loan dropped. This led to a default in the housing loan. The immediate action banks had to take was a foreclosure action to recover the loan.
Second, CDOs and CDS derivative instruments that included such loans or mortgages in their basket of securities, had to be downgraded. This damaged the capital market in Wall Street and other financial capitals throughout the Western world.
The ripple effect tore through the real economy as bank liquidity began drying up. The ripple also pervaded the stock markets causing a collapse in share prices. Wealth began to shrink. More liquidity dried up.
Go back to the source. The root of the problem is the value of the assets or properties that formed the securitisation for banks.
This is the subject matter that the Troubled Asset Relief Program or TARP was supposed to address.
The problem is that the value of the so-called toxic assets cannot be pinned down.
Any econometric or mathematical model depends upon certain fixed assumptions and certain variables. The valuation of assets is currently a major variable. This led Stephen Roach of Morgan Stanley to observe that the key thing is to find a way to value and dispose of the bad debts from the books of banks. He said, correctly, that the issue is how to develop a pricing mechanism for toxic assets.
In other words, how do we convert the valuation of toxic assets from a variable that keeps changing minute by minute and hour by hour and day by day into a fixed valuation?
Fix that and TARP has a chance of working. And, if TARP works, the financial markets and capital markets will find the bottom earlier and economic recovery can be more easily mapped out. Not just for the U.S. but, for the rest of the world.
My suggestion, crazy as it sounds is, that the U.S. Congress should legislate the value of the toxic assets.
The free market pricing mechanism has failed in the sense that it is in an irrational free-fall mode with the bottom being nowhere in sight.
Times are so dire that even in the bastion of capitalism, meaning the U.S. there is now a widespread resignation that banks may need to be nationalised.
So, why shouldn't the U.S. legislators consider a piece of legislation to fix the value of the toxic assets based on say, the values as at 1st January 2007?
Forget about the mark-to-market rule for the next 3 years. FRS 139 or it's U.S. equivalent IAS 39, should be kept in deep-freeze for 3 years. That should be enough time for the U.S. and the whole world to pick up the pieces.
For good measure, the legislation should have a sunset provision that the free market pricing mechanism will kick in for the toxic assets 3 years from the date of enactment of the legislation.
How about it, world?