Other Pathways Out of the Financial Crisis

Other Pathways Out of the Financial Crisis

By David Ignatius - October 2, 2008

WASHINGTON -- Betting on the sagacity of the U.S. Congress is risky, to say the least. So let's assume the worst, and imagine that the big $700 billion bailout doesn't pass anytime soon. What happens then? Is it true that "this sucker could go down," as President Bush put it last week? Or are there other pathways out of the financial crisis?

Imagining financial life without the $700 billion rescue is a useful exercise because it helps clarify the baseline issues in this crisis.

We are beginning a painful process of deleveraging our debt-addicted economy, but that's in many ways beneficial. Martin Wolf noted in The Financial Times that U.S. household indebtedness jumped from 50 percent of GDP in 1980 to 100 percent in 2007, while financial-sector debt increased from 21 percent of GDP to 116 percent over the same period. We have all been participants in this one, I'm afraid, and the appropriate, if painful, cure is to save a bit more and consume a bit less.

The potentially crippling problem is in the short-term credit markets, where financial institutions are hoarding cash in an effort to ride out the crisis. They don't trust that borrowers will be able to repay loans.

This hoarding is creating a larger credit crisis that could begin to squeeze every business that needs money -- from department stores financing inventory to credit card companies juggling millions of purchases every day. The spike in overnight lending rates is downright scary, with the measure known as LIBOR more than doubling to 6.87 percent Tuesday from 2.57 percent Monday.

So the real question is how to unfreeze the credit markets. And here it's not clear that the $700 billion bailout is the most effective response. A better approach may be to target the specific problems that are squeezing lenders.

One step in the right direction was Tuesday's announcement by the Securities and Exchange Commission to clarify the "mark-to-market" accounting rules that have been forcing financial institutions to take huge writedowns on "illiquid" paper assets for which there's no market today.

"When an active market for a security does not exist," said the SEC clarification, companies can base their valuations on expected future cash flow. Many members of Congress have been urging the SEC to suspend the rule entirely -- and allow easier valuation standards -- thereby easing the pressure on the Treasury to buy up toxic securities. Accountants oppose the suspension, arguing that changing the rules now would further erode trust in corporate balance sheets.

A year ago, I heard warnings about the mark-to-market rules from Joe Robert, who runs a global real estate investment firm called J.E. Robert Companies. He argued that these rules were forcing financiers to sell into a declining market and assign rock-bottom valuations to assets that, if held to maturity, might be far more valuable.

Robert offers a simple example of what the mark-to-market regime has done: Imagine a street where the houses are all worth $1 million, and each has a $500,000 mortgage. But a clause specifies that if a house's value declines to less than double the loan, the mortgage will go into default. Now, suppose one homeowner is forced to sell, and has to accept a lowball offer of $600,000. Using mark-to-market rules, the lender would have to judge all the other homeowners technically in default, forcing them to raise additional cash or perhaps sell their homes. That's what has been happening in the financial world.

Another direct fix for frozen credit markets would be an FDIC program to restore bank capital that has disappeared in the downward market spiral. Former FDIC Chairman William Isaac suggested last Saturday in a Washington Post op-ed that this could take the form of "net worth certificates" issued by the FDIC to troubled banks that need time to work out of their problems. This approach worked well in the savings-and-loan crisis of the late 1980s.

"If Congress doesn't pass any bailout plan soon, that won't be the biggest problem," argues James Harmon, a former head of the Export-Import Bank. "The real issue is protecting the public, not whether markets go up or down."

The big danger now is the migration of the crisis from Wall Street to Main Street, where the pain is only beginning. Washington's focus should be on keeping money flowing in the credit system -- and thereby limiting layoffs, shutdowns and bankruptcies. And there are many ways to do that, which don't require help from feckless members of Congress.

Copyright 2008, Washington Post Writers Group

David Ignatius

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