Seeking Rational Exuberance

How we’ll know when things are returning to normal.

“Trust will eventually re-emerge as investors dip hesitantly back into the marketplace,” predicts Alan Greenspan, whose Federal Reserve legacy depends on it. “Financial markets freeze up as an excess of fear displaces a protracted period of what some might call irrational exuberance. Eventually the market freeze will thaw as frightened investors take tentative steps towards re-engagement with risk.” Mr. Greenspan’s forecast last week on when markets will recover was only as precise as “sooner rather than later.”

The credit crisis is a crisis of information — or rather the lack of information — so perhaps the focus of this column can help identify when “sooner” might be. At the risk of irrational exuberance at the thought that an end can ever be in sight, here are signs for knowing when we’re past the worst of the credit crisis and at the start of a recovery:

– When prices are discovered. For all the complexities of the credit crisis, a basic rule applies: Prices require the interplay of supply and demand. Why don’t mortgage-backed securities have prices? There’s plenty of supply but no demand. Potential buyers of bad debt don’t have the information they need. Acquisitions of troubled financial institutions by less troubled ones have been propped up by taxpayers, delaying the establishment of market-clearing prices. The end will be in sight when transactions happen without subsidies.

Friday’s offer by Wells Fargo to buy Wachovia without government support is encouraging. Wells Fargo told investors that it calculates Wachovia’s losses at some $75 billion out of $500 billion in loans. This is a fraction of the $300 billion in bad assets that Citigroup estimated when it agreed to buy Wachovia with government backing. If Wells Fargo is right, there could be less need for government capital to keep banks afloat.

– When messengers are no longer being shot. Investors don’t trust markets that suppress accurate information, so look for recovery when short selling is decriminalized. The number of companies whose shares can’t be sold short started at 19 in July, went to 799 and now is just under 1,000. A list that began with the too-big-to-fail financial firms now includes 20% of regularly traded stocks, including IBM and CVS Caremark.

Short sellers were the first to alert the market and regulators to troubles in financial services firms. Shooting the messenger didn’t undo the message, but has delayed the day of reckoning. In the meantime, trading volume in the “protected” stocks has fallen by 50%, with an expanded spread in the bid-ask, forcing investors to pay more to trade them.

– When accounting approximates reality. One of the more arcane debates has been between those who defend the mark-to-market accounting rule even in an illiquid market where there are few transactions to establish market values, versus those who want financial firms to have flexibility to estimate the value of troubled securities. Marking to a nonexistent market communicates little information, but likewise a guestimate of ultimate value also conveys little. This debate mattered chiefly because bank capital requirements are based on accounting, but this is circular illogic: The federal regulators who review the accounts of banks know they can’t trust either method of accounting. Accounting needs to fulfill its basic mission of being informative.

– When lawyers draft clear terms and conditions. More than a year into the crisis, banks still don’t have a sound view of their assets and liabilities. One overlooked reason the problems seem so bottomless is that law firms representing banks failed to draft adequate disclosure about investments in mortgage-backed securities. Lawyers didn’t fully explain the terms and conditions underlying securities, hiding their real risks.

Adequate disclosure would have made clear the payment and investment flows through each level of securities and where the risks lie, including when they are swapped to counterparties. Offering documents should be crisp on where and on whom investors take credit exposure at each step of the payment and investment flow. Disclosure for complex financial instruments via detailed diagrams would be progress. Meanwhile, the role of not-very-careful lawyers will be Exhibit A in inevitable lawsuits against banks.

When moral hazard becomes political hazard. The toxin in the system was inserted by Washington. For over a decade, the government mandated mortgages to unqualified home buyers through Fannie Mae and Freddie Mac and through laws telling banks to make their own bad mortgage loans. Even after financial services firms are stable and investors return to the market, consumer confidence depends on Washington accepting its responsibility and backing off. Markets are complex enough, we are now reminded, without the poison of government-mandated bad loans.

Alas, it’s one thing to demand that banks mark their mistakes to market. It may take our political system much longer to do so.

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