U.S. Government Launches Another Round of Salvos to Defuse the Financial Crisis

Most of the measures have been tactical in nature, dealing with specific short-term stresses in the financial markets. On the tactical side, the Treasury also plans to step up purchases of mortgage-backed securities beyond the $5 billion that was already committed. Fannie Mae and Freddie Mac will increase their purchases of mortgage-backed securities. The SEC has reinstituted restrictions on short-selling of financial stocks. In addition, the Treasury said it will tap into a Depression-era fund to provide temporary guarantees for the money market mutual funds. Finally, the Federal Reserve said it will expand its emergency lending efforts to allow commercial banks to finance purchases of asset-backed paper from money market funds, in a move that should help the funds meet the demand for redemptions.

But the big news in the past 12 hours was the joint announcement by the Treasury, the Federal Reserve, and the Congress of a more comprehensive strategic initiative to address the fundamental problems that have been ailing the financial system. This primarily relates to roughly $2.5 trillion in subprime and Alt-A mortgage debt that was originated in the 2005 to early 2007 period. A significant portion of the subprime/Alt-A debt was securitized, perhaps as much as 60%. Thus, what is lurking in the balance sheets of commercial and investment banks and insurance companies—no matter how we try to reshuffle the deck—is about $1.25 trillion of illiquid mortgage assets. With write-offs to date of about $500 billion, the book value of these assets is closer to about $800 billion. Not all of these assets are held on the books of U.S. banks, and of course there are still roughly $1.25 trillion of "whole" subprime and Alt-A mortgage loans on the books of banks worldwide.

Given very thin trading in subprime/Alt-A mortgage assets, it is difficult, if not impossible, to assign a fair market value. Mark-to-market losses on average could be in the neighborhood of about 60% or even higher, depending on the credit rating. Compounding this problem, write-offs on prime mortgage-backed securities—although low as a percent of the total asset value—are running higher than what had been projected. That implies significant additional unexpected losses on prime mortgage-backed securities.

When you stack all of these losses up, and then add in the additional pressures from a cyclical economic downturn, it is not hard to arrive at the conclusion that this represents an insurmountable strain on financial system capital. The apparent chaos in the markets that we have witnessed in the past week is a symptom of this reality. We estimate that the losses in the U.S. commercial and investment banks from write-downs on residential mortgage assets alone would represent a hit of about 40% of bank capital. The de-leveraging of credit flows connected with these write-offs has already caused total credit growth in the economy to slow to recessionary rates.

While the strategic plan of the Treasury is sketchy at this juncture, we believe that it will be modeled after the Resolution Trust Corporation of the 1980s. The U.S. government will have to provide a significant amount of funding to an agency that would purchase distressed and illiquid assets, presumably at "fair value." It is not clear yet whether the new agency would be responsible for taking over insolvent institutions (as was the case with the Resolution Trust Corporation).

The initial cost will be in the hundreds of billions of dollars, to be funded by the U.S. Treasury. However, the ultimate cost to the taxpayer should be much lower, presuming that the economy and the housing market recover, perhaps in the second half of 2009 and 2010, and that the assets would therefore have some intrinsic long-term value to maturity. The advantage of moving the assets to a federal agency is that it would remove the month-to-month instability connected with mark-to-market valuations that apply to the private financial sector.

There are plenty of questions on how this new agency would work, especially the tricky task of assigning valuations to the assets that they intend to buy. The private U.S. financial system still will have to bear a share of the losses on these assets in the months ahead, but the success of the plan is to establish an end-game for this long drawn-out crisis so that the banks can take a final set of lumps and move on. But the plan is not a magic wand, as this final round of write-offs to be borne by the financial system will exact further short-term deflationary pressure on an economy that is still battling recessionary forces.

If the new strategic initiative accomplishes the broad goals of allowing the financial sector to take a final set of lumps and move on from the crisis, thereby restoring more normal credit conditions, while at the same time minimizing the long-term costs to the taxpayer, then it will be deemed a success. That being said, significant short-term upward pressure on the deficit is an inevitable result of moving forward on this type of strategic gambit.