If I had a trillion dollars...

Only once assets are truly marked down to levels at which liquidity providers can comfortably commit capital will the crisis end, the bailout package have an impact and will recovery begin. Then maybe, someday, we’ll be liquid...
Apologies to the Barenaked Ladies, whose song If I Had a Million Dollars ends with the line “...I’d be rich”.

Of course, a million dollars these days doesn’t let you qualify as rich--especially if you paid a million dollars for a house that wasn’t worth half that and that you couldn’t afford in the first place. What we would like to point out is that if you were the banker who wrote that mortgage--and million or so others that allowed people to buy overpriced homes that they couldn’t afford--even if you had a trillion dollars, you wouldn’t be rich. Or maybe, we should watch our tenses--even now that you will get a trillion dollars, you are not rich.

Now that Treasury has committed the first few hundred billion out of the $700 billion Congress has given it by taking equity stakes in major financial institutions, which will be followed by some kind of fiscal stimulus with details to be determined by who wins the presidential election, our thoughts have been on “what would we do if had a trillion dollars thrown at us?” If we put ourselves in the shoes of the financial system there is only one thing we can do. We have to start marking down the value of assets on our books.

We will go into more detail, but first a review of basic accounting. Brace yourself.

Assets less Liabilities = Equity

There. Now that that’s done, how does what we’ve learned apply to spending the $700 billion that Congress has given Treasury and the several hundred billion the next administration will be forced to follow up with?

Much verbiage has been spent on the role of liquidity, or the lack of liquidity, in the market crisis we’ve just experienced. Commentators rarely spend the time to delve into what exactly is this thing called liquidity, and where it comes from. Liquidity is not a natural phenomenon, like sunshine and rain, it is a business activity, like building cars (and almost as profitable recently). Holders of capital provide market liquidity by purchasing assets or selling warehoused assets in order to turn a profit. It is relatively easy to make a profit providing liquidity when there is broad consensus on the value of assets--witness the results of the major investment bank’s trading arms in the years up to 2006. When everyone is uncertain what the value of assets may be, providing liquidity because about as easy and safe as playing musical chairs in a minefield.

Which brings us back to our accounting tutorial. We learned that an entity’s equity value is equal to the value of its assets less its liabilities, or debts.

[ Business Value ] - [ Bonds, Notes, Preferred and other liabilities] = Equity

or, rearranging terms as we used to do in algebra:

Business Value = Investments

Meaning that the aggregate return on the capital structure of a company, even a bank, should tend to reflect the return on the actual business. Now, the beating that bank stocks have taken reflects the fact that the market is assigning a lower value to the business of these banks--primarily because the value of their assets (mortgages and other loans) has declined. The credit market crisis reflects the fact that nobody knows what the ultimate value of those assets will be and therefore is afraid to provide credit or liquidity until someone sweeps the minefield.

Here is where the trillion dollars comes in. As banks are recapitalized they must be forced to write down bad loans and troubled assets to as close to zero as possible. Obviously, the equity holders will bear the brunt of the pain--which is the bargain they signed up for. More junior debt holders will be hurt, too. Again this was the risk that they signed up for.

Only once assets are truly marked down to levels at which liquidity providers can comfortably commit capital will the crisis end, the bailout package have an impact and will recovery begin. Then maybe, someday, we’ll be liquid, but not rich.
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