Step into the Bar Car – It’s Friday Afternoon

How gauche. Heathens!

Part 2.

Still with me?  Okay.  The next issue revolves around clarity versus opacity.  The fundamental problem with the financial system is that no one trusts what the banks say their assets and liabilities are worth, especially their assets.  There are three ways they have of determining value:

  1. They can use the cost they paid (or received) for something;
  2. They can use a model, like a spreadsheet, that uses forecasts and various other assumptions to determine a value; or
  3. They can use a market price.

The problem with the cost method is that not much is worth today what you paid for it last year.  In some cases things are worth more and in many cases they are worth less.

The second methodology, using a model, is the methodology used by banks, investors and rating agencies to value many of the exotic instruments that are at the core of the problem. No one trusts those models any more.

The latter methodology is the much-debated “mark to market” convention whereby institutions mark the value of their assets and liabilities to the value placed on them by the current market.  I own 5 oranges.  I paid $1 for each of them a week ago.  If I went to buy them today, they would cost me $0.50.  Even though I am not selling them or doing anything else with them, they are now worth only $2.50, rather than the $5 they were worth when I bought them.

If we don’t like either of the first two methodologies, that leaves us with looking at the market price.  The problem is that there is no price for many of these things because there are no buyers.  What is your house worth if no one will buy it?  And when there are buyers, the prices are all over the place – volatility is high.  The best method of determining value, and hence solvency, is broken.  Is Citigroup worth a fraction of what it was last year?  Maybe.  Maybe not.  When you are in the trust business, and nobody is trusting, you’re in trouble.

Let’s keep following this meandering track and see where it heads (Ack! What’s with the trains!)  In order for the government to rescue the financial system, it needs to create trust.  One way to do that is to buy all of the “bad” assets and put them into a “bad bank”.  (Okay, this is crying out for a joke, but I need to wrap this thing up.  Another post perhaps.)  That seems logical, setting aside all of the grumbling about taxpayers bailing out banks.  The problem, is, what price do you pay?  How might you determine the price?  Didn’t we already pass that stop?  (I give up – I can’t fight this train thing any longer).

If you set the price too high, they’ll sell you everything, the taxpayer gets really screwed, and the shareholders of these financial insitutions get rich.  Not only that, but all of their friends and neighbors will come knocking at your door to get in on the action.  If you set the price too low, they won’t sell you enough, figuring that opacity is better than clarity at a really low value.  Better the evil you don’t know than the evil you do.  The mess won’t get cleaned up and the problems will continue.

Thesis 2: The crux of the problem is price.

Have a drink.  I’ll get it and you can pay me later, when I figure out a price.  I’m going to step into the Gents for a moment. I’ll be back in the next post.

(to be continued)

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Published in: on February 27, 2009 at 23:01  Comments Off on Step into the Bar Car – It’s Friday Afternoon  
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