September 25, 2008
An article in today's Washington Post suggests that in testimony yesterday, I argued that the proposed Troubled Asset Relief Act of 2008 "could actually worsen the financial crisis" by forcing institutions to recognize new losses on their balance sheets through the sale of assets to the government and by revealing some of those same institutions to be insolvent. This is not fully accurate, and some clarification is in order.
First, a technical point: A company holding an overvalued asset would have to write down the value of that asset not only if it actually sold that asset to the government at a price beneath its current book value, but also if other companies sold comparable assets to the government at a price beneath that book value. This is the essence of mark-to-market accounting. (For example, suppose Company A owns Asset X, which it holds on its books at a value of $100. Now suppose that Company B holds an asset comparable to Asset X, which it sells to the government for $50. As a result, Company A must mark down the value of Asset X to $50, because a comparable market transaction has revealed its value. In the absence of the proposed program, that comparable market transaction may not exist because of illiquidity in financial markets.) Establishing clearer market prices for currently illiquid assets could trigger similar asset write-downs and thus reveal additional institutions to be insolvent.
The second and more important point, though, is that even if this process revealed more financial institutions to be insolvent, the result would not necessarily worsen the financial crisis. As I stated in my testimony yesterday before the House Budget Committee, the current crisis is fundamentally one of collapsing confidence in the financial markets and "providing more transparency about the lack of solvency at specific institutions may be necessary to restore trust in the financial system." In other words, to restore confidence, participants in the financial markets need more clarity about which institutions are solvent and which are not. To the extent proposals like the Treasury one can accomplish this end, it would be a step toward resolving the crisis, not worsening it.
Finally, it seems worth emphasizing again a key point from yesterday's testimony -- that the financial markets face two distinct, but related, problems. One problem is that the markets for some types of assets and transactions have essentially stopped functioning. To address that problem, the government could conceivably intervene as a "market maker," by offering to purchase assets through a competitive process and thereby provide a price signal to other market participants. That type of intervention, if designed carefully to keep the government from overpaying, might not involve any significant subsidy from the government to financial institutions. The second problem involves the potential insolvency of specific financial institutions. Restoring solvency to insolvent institutions requires additional capital injections, and one possible source of such capital is the federal government. Although the problems of illiquidity and insolvency are interrelated, they are at least conceptually distinct. Indeed, some policy proposals appear to be aimed primarily at the illiquidity of particular asset markets, and others appear to be aimed primarily at the potential insolvency of specific financial institutions. The Treasury proposal appears to be motivated primarily by concerns about illiquid markets. The more the government overpays for assets purchased under that act, however, the more the proposed program would instead provide a subsidy to specific financial institutions, in a manner that seems unlikely to be an efficient approach to addressing concerns about insolvency.