Page 4 of 4 Health warning for a computer age
By Paul Davidson
potential purchasers of assets traded in a market without a credible market
maker: This market is not organized by an SEC certified credible market maker.
Consequently it may not be possible to sustain the liquidity of the assets
being traded. Holders must recognize that they may find that their position in
these markets can be frozen and they may be unable to liquidate their holdings
for cash.
Furthermore, the SEC should set up strictly enforced rules regarding the
minimal amount of financial resources relative to the size of the relevant
market that an entity must possess in order to be certified as a credible
market maker. The SEC should be
required to re-certify all market makers periodically, and at least once a
year.
2.Prohibition against securitization that attempts to create a public
market for assets that originated in private markets - The SEC
should prohibit any attempt to create a securitized market for any financial
instrument or a derivative backed by financial instruments that originates in a
private financial market (for example, mortgages, commercial bank loans.)
3.Congress should legislate a 21st century version of the Glass Steagall
Act. The purpose of such an act should force financial
institutions to be either an ordinary bank lender creating loans for individual
customers in a private financial market, or an underwriter broker who can only
deal with instruments created and resold in a public financial market.
Policy to create a recovery in the real economy
In October 2008, many economists are predicting a depressed housing market and
a significant recession for most of 2009 and probably 2010. There are a number
of policy actions that can be taken to shorten the recession and restore a
growing economy.
Keynes recommended the "socialization of investment" to revive an economy when
private investment spending is insufficient to maintain full employment.
Socialization of investment does not mean that the government should own
the means of production. Rather Keynes suggests that government should
encourage investment in productive activities and this need not "exclude all
manner of compromises and devices by which public authority will cooperate with
private initiative." [Keynes, 1936a, p179].
Thus when a new presidential administration takes office in January 2009 , the
government should develop investment policies for (1) repairing the
deteriorating infrastructure in the US - roads , bridges, sanitation
facilities, and so forth, (2) alternative energy research and development, (3)
tax sharing with local and state municipalities. The pre-existing condition of
a large national debt should not constrain the government from creating an
investment productive economy that creates full employment environment.
To stop the deterioration of the US housing market and to prevent any further
houses becoming vacant due to foreclosure, another Home Owners Loan Corporation
(HOLC) (similar to the one created in the Roosevelt administration) is needed.
The HOLC would buy up mortgages (at a discount) and renegotiate new mortgages
with home owner-occupiers at monthly payments they can afford possibly (a) by
lengthening the life of the mortgage perhaps to 40 years, (b) by reducing
principle, and c) by lowering interest rates.
If the homeowner-occupier still can not make monthly payment requirements on a
renegotiated mortgage, the HOLC should rent the house on a month-to-month lease
to the occupier at a rent he/she can afford until it can be sold for at least
the value of the mortgage that the taxpayers bought out. (Details for this
proposal are spelled out in P Davidson, 2008).
Finally, the new president should immediately convene an international
conference to create a new international financial architecture similar to the
IMCU plan developed in this volume. Only then can each nation pursue full
employment policies for its citizens without worrying about contagion from
foreign financial markets depressing their national economy.
Evaluating toxic assets
Beginning with decisions made almost three decades ago when the seeds were
planted and the ultimate fruition occurring in 1999 with the repeal of the
Glass Steagall Act, more and more illiquid assets were securitized, but without
a credible market maker for these securitized assets. Securitization may have
made underlying illiquid assets look like they were liquid assets, but they
were not always going to be liquid - thus they could become toxic - when some
unforeseen event occurs that induces herd behavior for a fast exit.
These securitized assets have no well organized, orderly market with a market
maker. Given the housing problem, there is no orderly market price to evaluate
the worth of these toxic assets. No one knows exactly how to evaluate the MBSs,
and other exotic financial assets on the balance sheet of holders. The SEC had
made a rule of mark-to-market for traded securities. In these days, however,
the last market price in the disorderly markets of these toxic assets
might have been "a fire sale price" , for example, at 50% to 70% discount.
Accordingly if the financial institutions holding these assets marks these
assets to market, they will be insolvent.
The original plan of Treasury Secretary Henry Paulson (only three pages long)
gave Paulson the right to buy these illiquid assets at a price not to exceed
the price the holder originally paid. If the price was at or near the original
holders' purchase price, this would improve balance sheets tremendously and
take away the fear of insolvency.
But this would mean the holders of these assets might get away scot free after
making horrible investment decisions. After all, neoclassical economists would
say that if you make a bad decision, the market should punish you - and if that
means bankruptcy so be it. It will prevent the moral hazard problem in the
future.
On September 30, 2008, the SEC suggested possible new accounting principles for
evaluating these essentially toxic [illiquid] assets using "fair value" instead
of mark to market.. The SEC news release is as follows:
SEC Office of
the Chief Accountant and FASB Staff Clarifications on Fair Value Accounting
2008-234
Washington, DC, Sept 30, 2008 - The current environment has made questions
surrounding the determination of fair value particularly challenging for
preparers, auditors, and users of financial information. The SEC's Office of
the Chief Accountant and the staff of the FASB have been engaged in extensive
consultations with participants in the capital markets, including investors,
preparers, and auditors, on the application of fair value measurements in the
current market environment.
There are a number of practice issues where there is a need for immediate
additional guidance. The SEC's Office of the Chief Accountant recognizes and
supports the productive efforts of the FASB and the IASB on these issues,
including the IASB Expert Advisory Panel's Sept 16, 2008 draft document, the
work of the FASB's Valuation Resource Group, and the IASB's upcoming meeting on
the credit crisis. To provide additional guidance on these and other issues
surrounding fair value measurements, the FASB is preparing to propose
additional interpretative guidance on fair value measurement under US GAAP
later this week.
While the FASB is preparing to provide additional interpretative guidance, SEC
staff and FASB staff are seeking to assist preparers and auditors by providing
immediate clarifications. The clarifications SEC staff and FASB staff are
jointly providing today, based on the fair value measurement guidance in FASB
Statement No. 157, Fair Value Measurements (Statement 157), are intended to
help preparers, auditors, and investors address fair value measurement
questions that have been cited as most urgent in the current environment.
How is that for determining "fair value"? What will the Secretary of the
Treasury use to decide fair market value?
Notes
1. John Maynard Keynes, Davidson P, 2007, Palgrave, London and New York.
2. If the EMT is buttressed by the assumption of rational expectations, then
expectations about the long run assure that short run market prices do not get
far out of line with their long run "fundamentals" determined price.
3. The ergodic axiom asserts that past and current probability distributions
determine the probability distribution that governs any future market price
outcome. Accordingly, the future is never uncertain, it is only
probabilistically risky but technically insurable against probabilistically
risky outcomes. The association of Keynes's concept of uncertainty with the a
nonergodic economic environment was first developed by Davidson (1982-3). For
the latest discussion see Davidson (2007, pp30-35, 102-3, 110-112).
4. The need for a revived Resolution Trust Company to help solve the financial
market crisis that was initiated with the sub prime mortgage problem was
emphasized in my earlier paper on "How to Solve the US . Housing Mess And Avoid
A Recession: A Revised HOLC and RTC", Davidson P, 2008, Schwartz Center for
Economic Policy Analysis: Policy Note, January 2008, online at:
www.newschool.edu/cepa or http//eco.bus.utk.edu/davidson.html
5. Before the day's auction begins, the investment banker will typically
provide "price talk" to their clients indicating a range of likely clearing
rates for that auction. This range is based on a number of factors including
the issuer's credit rating, the last clearance rate for this and similar
issues, general macroeconomic conditions, etc.
6. My proposed international payments system is a variant of the Keynes Plan
that was presented by Keynes at the Bretton Woods conference in 1944 and
rejected by the United States.
Paul Davidson is editor of the Journal of Post Keynesian Economics,
Visiting Scholar, the Schwartz Center For Economic Policy Analysis, The New
School.
(This article is based on a paper to be given at a conference in Rio de Janeiro
on November 6, 2008.)
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