An Answer to the Soros Policy:
How to Value Troubled Assets?

Comments by Stephan Olajide-Huesler

The buzz at the World Economic Forum was all about building good banks and bad banks, seemingly inspired by a George Soros article that had appeared in the Huffington Post.
But determining how to do this would mean distinguishing among assets and valuing them. Hence the question: How can we distinguish and ultimately value troubled assets? The short answer is we can’t—and really, we dont need to. The approach and therefore the nature of the questions asked continue to miss crucial points. We need to split banks along functional, institutional lines.
Government has become the central go-to place for sorting out any troubled situation in this crisis. Ultimately, however, the value of these assets must be and will be determined by the marketplace.
It may be possible to estimate the overall size of the problem, but it is unfeasible if not impossible to weed through the granular structure to determine which assets are in effect bankrupt or establish values appropriately. It means chasing a moving target in a deleveraging cycle.
It is true that carving out bad assets has generally worked in the mini-crises that occurred before the leveraged boom of the past 60 years. The difference today is that throughout the boom, the leverage accelerator found traction every time monetary authorities opened the liquidity valves and thus swiftly reaccelerated the economy. But today it is the centre that is sick, too sick to lift itself. And the periphery of our global monetary system has relied on export driven policies, leaving it at its mercy. It must have been clear to at least some people that this could not go on forever, yet today authorities continue to search for the next big thing to inflate in an effort to reignite economic growth.
Instead, the question that must be answered first is, how much leverage is prudent. Is debt in the amount of 350% of GDP sustainable, even expandable? Before the Great Depression the level of debt was barely at 160% of GDP. Any debt level of more than 200% of GDP is extremely rare. It seems many feel today that the “sophistication” of the world’s largest economy, fully furnished with the tools of Modern Finance can bear much higher debt levels than was historically the case.
This is however a great misconception. It isn’t simply a case of lack of regulation and missing capital reserves. The all-pervasive application of Modern Finance in investment and risk management has dissociated markets from real economic risks. This dissociation not only created a false sense of – mathematically calculated – security in the marketplace but also greatly affected the choices that were made. Financial markets were corrupted from their core function: the allocation of risk and capital.
Hence, the system’s efficiency has in fact deteriorated drastically from the times before Modern Finance. Not only is the current debt level unsustainable, most of this debt was created with false assumptions and misleading models.
Therefore, it is not so far-fetched to assume that the market-place will eventually, one way or another, force an adjustment to sustainable debt levels. To bring U.S. debt back to pre Depression debt levels we have to anticipate a reduction of more than $25 trillion.
This brings us back to the attempt to value distressed assets today, in fact how should we value any asset, any cash flow? What will happen to all those asset prices that were carried by that debt that will have to be reduced by more than half?
How in the world can we even speculate on values when we are riding down a deleveraging cycle of this magnitude and have merely started the process?
Ultimately, the solution lies in being tough and realistic, especially with our bankers, who so far have only shown us contempt (by continuing to pay or collect extraordinary bonuses) and displayed a great measure of ignorance, seeming to be primarily interested in extricating themselves from responsibility and saving their hides.
It is important that we secure the commercial banking assets of our large banks that have gorged themselves on leveraged assets. The fate of these leveraged assets can only be some sort of market liquidation via some sort of bidding mechanism. We have seen it done quite successfully in recent Asian crises, but it entailed the worst of those assets going for no more than 20 cents on the dollar. Governments have to realize that outside of the commercial banking assets they cannot bail out anyone without running the danger of ruining the finances of their country.
Commercial banking is the backbone of our economies, and once the government safely has its hands on these businesses, it can become more relaxed about the prospect that the markets will likely significantly deflate asset prices, even those of healthy businesses.. The main obstacle to swift and bold action by government today is the fear that the economy will implode if we allow assets to deflate. It is believed that allowing assets to deflate will bankrupt and incapacitate the financial system, which will bring economic activity to a standstill.
That is unjustified fear-mongery by those affected (bankers and asset owners) that has no base, in particular if governments were to carve out and own the crucial commercial banking businesses. On the other hand, it is sheer lunacy to risk financial ruin of the country by trying to keep up appearances of a bubble gone by.
Monetary policy is, in my humble opinion equally misguided. The strategy of quantitative easing (QE) will not work, not this time. It is true that in past crisis quantitative easing, i.e. competitive currency devaluation has always worked. In fact, QE is just another name for the global currency system that we have been running for decades with the US as the reserve currency and the Fed pumping liquidity. Of course it lifted everyone quickly from any slowdown in growth. Furthermore, these financial crisis were to a large extent isolated to certain areas or industries with in the global economy. Today, the entire planet is in the same boat. QE is a competitive devaluation race to the bottom. Ben Bernanke still feels that he knows what he is doing and trusts that he will be able to mop up all this liquidity when the engines are jump-started again. That may be possible to a large extent, although we will have to see how financial regulation will be able to restitute the Fed’s control over liquidity generation. To make sure that the system is provided with ample liquidity is a good thing but it would be naïve to assume that this provision of liquidity will have any significant real effect. Monetary policy has lost its grip a long time ago. In the current situation it should be facilitatory and get out of the way, trying not to do make embarrassing decisions. The current policy direction clearly signals the persistance of the message that this is a crisis of liquidity. The facts speak against this notion, clearly. In fact, setting interest rates to zero is more harmful that helpful. Zero interest rates indicate that things are bad, and interest rates near zero prompt market participants to assume a negative future and lead to increased risk aversion.