Devil lies in the details - the importance of financial sector resuscitation

Despite the House passing the Recovery and Reinvestment act over the past week, there's been a persistent sense of doom and gloom in the US and global markets. Though it is a fallacy to predict the effectiveness of such an initiative using a short-term stock market reaction, we cannot ignore the natue of the stick market reaction and the sector which bore all the brunt - financials. Let's take a quick look at the numbers.

The recovery and reinvestment act, in terms of size, looks quite dwarfed in context of overall macro economic numbers (all numbers as of end Q3 2008):
Domestic financial sector debt: USD 16.9 trillion
Domestic home mortgage debt: USD 10.5 trillion
Domestic consumer credit: USD 2.6 trillion
Domestic Federal debt: USD 5.8 trillion
In comparison, the act would add to budgetary deficits by USD 185 billion in 2009, USD 399 billion in 2010 and USD 787 billion cumulatively over the next few years. So, despite all the hoopla over the size of the package and the fiscal profligacy tag imposed by fiscal conservatives (if there is such a class at all!), the size of the package is quite moderate! Let's look at it another way: Federal debt increased by over USD 770 billion over Q3 2007 to Q3 2008 (15.2% increase). In comparison, the stimulus act would add over USD 584 billion (9.9% increase) over 2009-'10.

From the above, its clear that the stimulus act by itself does not pose a fatal threat to the fiscal state of the US economy. As long as there's a foundation of fiscal discipline (read avoidance of unfettered tax cuts and freebies), the economy will be able to absorb the fiscal bump to reach a mangeable steady state.

However, as can be easily seen from the above macro-economic numbers, there's little that the stimulus act can achieve unless there is a very focused and directed effort to 'unfreeze' the money flow in the financial sector, with special emphasis on 'directed' mortgage lending.

TARP Phase 1 obviously didn't achieve it, neither did any efforts from the Federal Reserve for driving additional liquidity. During the past few months, while Federal Reserve lending to banks increased by over USD 800 billion, deposits from banks with the Fed increased by almost the same amount - what a sheer fallacy! The basic problem with the above efforts was the same - as long as the mortgage freeze persists and banks continue to face the risk of further write-offs on newer assets, no amount of additional money in the system wil help ensure free flow of credit!

Phase 2 of the financial and mortgage sector revitalization act has to do all of the below to be effective (as highlighted in some of my write-ups earlier too):

1) Until the credit market freeze is significantly overcome, its difficult to ensure free credit flow without altering the rules of the game. In some form or fashion, there need to be a dilution of the mark-to-market rule - i hate to advocate a core principle behind conservative/realistic accounting, but a temporary 2-year moratorium on mark-to-market provisions related to assets in high-priority sectors would not be too bad. For the sake of argument, lets say we enforce a 2-year moratorium on mark-to-market provisions for new mortgage-related assets, including mortgage loans, MBS, CDOs and CMOs with residential and commercial real estate assets as collateral for the base reference credit. Considering the potential danger associated with rule-interpretation, derivatives (CDS) should be kept out of this moratorium and continue to be subject to mark-to-market norms. This has to be complimented by a mechanism to rid the bank balance sheets of existing written down/troubled assets, through some federal participation, as has been already discussed.

2) Even if the above is done, money flow to sectors deserving the highest priority cannot be ensured without a new dose of targeted/priority lending norms. This can be either through carved out priority lending funds or clear provisions to channel a specified percentage of government funding to new loans in targeted sectors (including obviously residential and commercial mortgage)!

3) A thorough revamp of the regulatory and compliance scenario. Tim Geithner already referred to mandatory stress testing for banks receiving (above a certain threshold limit of) TARP funds, but we probably need to go much deeper and broader beyond that. The US has been unfortunately lagging in implementation of Basel II as compared to Europe and Asia - some would question the efficacy of these norms by pointing out the failure of several banks in Europe, but as in many other cases, the mode and manner of implementing such norms/guidelines is even more important that the risk/regulatory oversight that it mandates. Even if banks compute capital norms per Basel II norms and practice market disclosure, true risk assessment often lies in some areas where rules are not as explicit - risk aggregation, stress testing and scenario analysis. Also, goal alignment between business groups and risk management groups through risk-aligned performance measurements and the like is equally critical.

More over, central and regulatory oversight would not be complete without a fresh complementary dose of self-regulatory guidelines, principles and institutions focusing on oversight of equity and credit rating agencies, enhanced market disclosures and fostering market discipline.

A lot depends of the finer print of the financial sector package that Tim Geithner would hopefully announce over this week and next - what it addresses and how! I am personally sure there would be enough meat in the proposal, given how the current administration has conducted itself so far.

Stimulus package - ensuring efficiency and sustainability

The Senate is closer to signing of the stimulus bill, after a short hiatus of introspection and wrangling. Though one does feel that the package is spread out a bit too thin - in terms of areas it tries to cover - it never the less provides a much-need lever for trying to stem the current economic decline. Sceptics would question the relevance of another 850-odd billion 'stimulus package' when the earlier 700 billion kitty (TARP) did little to either ease money supply or contain fincnail sector turmoil! This could very well be true unless administration and execution of the package is done in a business-like fashion. Adding the money remaining from the TARP package, the government has a ~USD 1 trillion pool now to spark economic activity.

Despite all the goodwill and long term benefits that green energy spending and healthcare spending would bring, we probably cannot pull ourselves out of the rut unless there is targeted efforts at improving money supply. Government spending in infrastructure would drive some downstream activity in construction and ancilliary sectors; but this cannot result in sustainable business acticity unless the core issue of liquidity and money supply is addressed. We need to address the root problem for this - ongoing mark-to-market impairment on the balance sheets of fincancial services firms and resulting squeeze for meeting regulatory and economic capital norms. This cannot be achieved without both of the following:
1) I would absolutely hate to advocate scrapping of the mark-to-market rule, but a temporary 2-year moratorium on mark-to-market provisions related to assets in high-priority sectors would not be too bad. For the sake of argument, lets say we enforce a 2-year moratorium on mark-to-market provisions for new mortgage-related assets, including mortgage loans, MBS, CDOs and CMOs with residential and commercial real estate assets as collateral for the base reference credit. Considering the potential danger associated with rule-interpretation, derivatives (CDS) should be kept out of this moratorium and continue to be subject to mark-to-market norms.
2) There should be explicit provisions for emergency priority lending provisions targeted at residential/commercial mortgage and commercial lending. This can be either through carved out priority lending funds or clear provisions to channel a specified percentage of government funding to new loans in targeted sectors.
With steps like the above, banks can continue to build core-sector assets without undue downside risk, and also beef up interest income since base treasury funding rates would be low enough to provide decent margins even at low lending rates.

None of the above would ensure sutainability unless backed by strong regulatory changes as advocated in some of my earlier notes - oversight on credit rating agencies, enhancement of supervisory oversight on risk management, stronger corporate governance norms...among other things.