Unfreezing the credit marks at no charge to us

Flore Roger Guillot
December 2, 2008
Dec. 4
December 4, 2008

As we all know by now, America’s credit markets are frozen.

Banks either can’t or won’t loan money to consumers or each other in sufficient quantities to keep our economy on track.

Part of the reason – but only part – is that so many banks invested in mortgage-backed securities (MBS) and other derivatives that have declined in value as the national housing market has tanked. With less capital, banks must make fewer loans.

Typically, and because it was an election year, Congress’ response was to throw taxpayer money at the problem.

Treasury Secretary Paulson was given over $700 billion to buy these troubled securities from banks and make direct capital infusions into the banks.

The hope is that more capital will translate into more loans.

I hope it works. So far it hasn’t. Below are three additional actions Congress can take to unfreeze the credit markets without spending taxpayer money.

1. Change a Federal Rule.

It’s called Financial Accounting Standard 157, better known as the “mark-to-market” accounting rule. This regulation requires banks to carry investments like MBS on their books at the value the banks could sell them for in the free market.

There is no market for MBS – no one will buy them – so banks have to value them at fire sale prices, which means banks’ capital reserves are diminished and they can’t make loans.

But many MBS are not worthless. An MBS is basically a bond backed by a pool of mortgages. Certainly, most MBS are worth less than they once were because of mortgage defaults, but not every American has defaulted on his mortgage.

Only about 17 percent of subprime mortgages are in default, and the percentages are much lower for better quality mortgages.

Most homeowners are still paying, which means that the typical MBS is worth less but still worth something.

The mark-to-market accounting rule is beneficial under normal circumstances. It requires transparency and prevents banks from “cooking their books” by artificially inflating the value of their assets and therefore their net worth.

But the rule doesn’t work when markets break down. Congress should temporarily suspend the rule and allow banks to value their MBS on a discounted cash flow basis, which will give a more accurate picture of most banks’ capital base.

First Trust Portfolios of Chicago contends that doing so will solve roughly 70 percent of the financial crisis without spending a penny of taxpayer money.

2. Trade Stock for Troubled Securities.

Instead of buying MBS with taxpayer money, Congress can set up a new government-owned corporation to buy the troubled securities from banks. The corporation would pay for the MBS with preferred shares of stock in the new corporation, which would pay a government-guaranteed dividend.

These shares of stock, backed by the full faith and credit of the federal government, would have instant value, could be freely bought and sold, and would augment banks’ capital base, allowing them to loan again. Virtually no taxpayer money would be required.

3. Allow Private Equity Funds to Invest in Banks.

Private equity funds have as much as $450 billion they could invest in banks, but they are reluctant to do so because of a rule that requires a fund to sell all its nonfinancial investments if it buys a majority interest in a bank. Changing the rule would mean more capital for banks and therefore more loans, once again without having to spend taxpayer money.

Not every solution to America’s problems requires the expenditure of taxpayer money.