Messages from Merrill’s Misfortunes
By Vincent R. Reinhart Tuesday, August 5, 2008
Filed under: Economic Policy
Last week’s big announcement by a Wall Street investment giant contains dark warnings about our economic future.
The business shows turned up the volume last week when investment giant Merrill Lynch announced write-downs of asset values and its intention to raise equity capital. Such a story can easily pass by the general public, as it involves the alphabet soup of high finance. Beneath the dollar signs, however, are dark warnings about our country’s economic future. Merrill’s announcement teaches lessons that are important for everyone, even those whose favorite acronym about business finance is MEGO (“my eyes glaze over”).
The U.S. financial sector is in the process of absorbing a large economic loss. As a country, America simply built too many houses. The bubble was inflated by governmental encouragement of home ownership, accommodative interest rates, and outsized expectations of capital gains on properties. When the scope of this excess became evident a year ago, house prices started falling. Capital losses and the dashed hopes of getting rich quick convinced some borrowers to walk away from their mortgages. That is the basic economic loss.
But there is more. Mortgages are the raw material of finance, serving as the collateral backing for a variety of securities. When the value of this collateral goes down as more and more mortgages slip into default, so too does the value of those securities. Indeed, the price decline exceeds the economic loss associated with elevated defaults.
We must accept the fact that our national economy is hostage to the financial system.
Merrill’s announcement indicates the scope of these losses. The firm recognized that a significant portion of securities backed by loans and other assets nominally valued at $30 billion had gone up in smoke, which is why it sold them to a private investor for 22 cents on the dollar. Acceptance is part of the grieving process. But not all firms are as far along in that process. Merrill had valued those securities at 40 cents on the dollar in its second-quarter financial statement, issued just one month ago.
How could this happen? Mortgage-related securities can be complicated, and their values are often approximated by financial models rather than measured in markets. Indeed, fear has dried up the market for many such structured obligations, increasing the reliance on approximations in pricing. And with the application of judgment comes differences in accounting, both across firms and over time.
Merrill’s travails reveal yet another key lesson about financial markets: even though a large financial institution holds complicated instruments, managers do not always control the balance sheet; sometimes it controls them.
This can be seen in the criticism now being leveled against John Thain, Merrill’s chief executive. As recently as July 17th, Thain told the investing public that “we believe that we are in a very comfortable spot in terms of our capital.” Less than two weeks later, Merrill was raising another $8.5 billion of capital. It is unlikely that Thain was intentionally misleading people, and more likely that his comfort spot turned hot in a hurry.
As the Merrill episode suggests, there are still significant mortgage-related losses that have yet to be recognized, spread across financial firms that are exposed to the U.S. real estate market. Many of those firms have had a hard time calculating the full extent of their plight. Others are using the discretion provided by accounting rules to delay recognition of the problem.
Until those financial firms admit their losses and find new capital, they will exist in a state of financial limbo. They will be suspicious of firms known to have similar problems; and those firms, in turn, will be suspicious of them. All of these companies will be tentative in supporting markets and making new commitments. Private borrowing rates will remain elevated, new loans will be hard to get, and economic expansion will be hindered.
Perhaps more firms will follow Merrill’s path and seek to raise new capital. But aggregate financial losses may wind up dwarfing private-sector resources. In that case, the health of the U.S. economy may require an injection of government funds into the financial sector. One lesson of the savings-and-loan debacle of the late 1980s—and also a lesson of banking crises worldwide—is that delaying such a government capital injection will raise the overall tab. With federal resources already stretched thin and many national priorities unfulfilled, the idea of sinking still more money into large financial firms seems distasteful. But we must accept the fact that our national economy is hostage to the financial system.
Indeed, financial bailout packages may have to take precedence over grand new spending programs and further tax cuts. Our elected officials should be considering how to engineer those bailouts at the lowest possible cost, how to avoid setting bad precedents, and how to prevent the need for such bailouts in the future.
Vincent R. Reinhart, former director of monetary affairs at the Federal Reserve Board, is a resident scholar at the American Enterprise Institute.