Deleveraging the economy

David Ignatius:

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We are beginning a painful process of deleveraging our debt-addicted economy, but that's in many ways beneficial. Martin Wolf noted in The Financial Times that U.S. household indebtedness jumped from 50 percent of GDP in 1980 to 100 percent in 2007, while financial-sector debt increased from 21 percent of GDP to 116 percent over the same period. We have all been participants in this one, I'm afraid, and the appropriate, if painful, cure is to save a bit more and consume a bit less.

The potentially crippling problem is in the short-term credit markets, where financial institutions are hoarding cash in an effort to ride out the crisis. They don't trust that borrowers will be able to repay loans.

This hoarding is creating a larger credit crisis that could begin to squeeze every business that needs money -- from department stores financing inventory to credit card companies juggling millions of purchases every day. The spike in overnight lending rates is downright scary, with the measure known as LIBOR more than doubling to 6.87 percent Tuesday from 2.57 percent Monday.

So the real question is how to unfreeze the credit markets. And here it's not clear that the $700 billion bailout is the most effective response. A better approach may be to target the specific problems that are squeezing lenders.

One step in the right direction was Tuesday's announcement by the Securities and Exchange Commission to clarify the "mark-to-market" accounting rules that have been forcing financial institutions to take huge writedowns on "illiquid" paper assets for which there's no market today.

"When an active market for a security does not exist," said the SEC clarification, companies can base their valuations on expected future cash flow. Many members of Congress have been urging the SEC to suspend the rule entirely -- and allow easier valuation standards -- thereby easing the pressure on the Treasury to buy up toxic securities. Accountants oppose the suspension, arguing that changing the rules now would further erode trust in corporate balance sheets.

A year ago, I heard warnings about the mark-to-market rules from Joe Robert, who runs a global real estate investment firm called J.E. Robert Companies. He argued that these rules were forcing financiers to sell into a declining market and assign rock-bottom valuations to assets that, if held to maturity, might be far more valuable.

Robert offers a simple example of what the mark-to-market regime has done: Imagine a street where the houses are all worth $1 million, and each has a $500,000 mortgage. But a clause specifies that if a house's value declines to less than double the loan, the mortgage will go into default. Now, suppose one homeowner is forced to sell, and has to accept a lowball offer of $600,000. Using mark-to-market rules, the lender would have to judge all the other homeowners technically in default, forcing them to raise additional cash or perhaps sell their homes. That's what has been happening in the financial world.

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Fixing the market price in and imperfect or thinly traded market is more art that science. Real Estate has always been an imperfect market where shrewd investors could buy assets that are more valuable in their hands than they were in the hands of others. For example, owning a portion of a block of land in a downtown area is probably worth less than owning the whole block on a pro rata basis because someone can build a bigger building on the whole block making it ultimately worth more.

Someone might see a house in a neighborhood as a fixer upper while another person might see it as a tear down to build a new bigger home. Someone else might see it as part of an aggregation of properties that will allow them to build multifamily housing or a high rise condo.

Real Estate is just not like a share of Microsoft which is worth the same in every holder's hands. So marking it to market can make it soar or plummet without regard to its underlying value. One of the problems with the securitization of real estate loans is they attempted to make illiquid investments be treated like other pieces of paper when they were at their heart very different.

As I have said before, there was also a failure of risk analysis in valuing these products that has had incredible cascading effects on other markets.