ON THE HOLE IN OUR BUCKET

CIRCULAR PROBLEMS

The cover story in Barron's this weekend is titled "Let it flow", referring to the getting credit flowing again to jump-start an increasingly stalled economy here and abroad.  It starts of course by re-capping the Herculean game of chicken played between Congress and the financial markets this week:

"NECESSARY, BUT NOT SUFFICIENT. That best describes the $700 billion financial-markets rescue package that made its tortured way through Congress last week, finally earning the House of Representatives' OK Friday, along with $152 billion of ancillary goodies for Main Street thrown in to attract the necessary votes."

It then goes to offer a sobering assessment of the week:

"It is doubtful that passage of legislation establishing the Troubled Asset Relief Program, or TARP, will cure the key ill crippling the capital markets and the U.S. economy: the inability of borrowers to obtain credit from lenders unwilling to extend it.

The stock market indicated as much in Friday's session, with the Dow Jones Industrial Average surrendering an earlier gain of 300 points even as President Bush signed the bill in mid-afternoon. Stocks ended the day with a 157-point loss."

The week wasn't easier for overseas investors, as the article highlights:

"In the past few weeks, however, both the economic and financial risks have morphed into a deepening crisis, which has jumped borders and begun to grip Europe. Fortis, the giant Dutch-Belgian bank, was partially nationalized last week; Hypo Real Estate in Germany received a 35-billion-euro ($49 billion) bailout, and U.K. lender Bradford & Bingley was taken over by the British government. The Irish government said it would insure all liabilities to shore up confidence in its financial institutions.

Meanwhile, the Fed has been furiously pumping liquidity into the global banking system, extending massive amounts of credit to U.S. institutions and sharply increasing the so-called swap lines with foreign central banks to $630 billion. These provide dollars to foreign banks that desperately need them."

A lot of the short-term hope for relief by markets around the world, was in the passage of the so-called bailout plan in Washington.

But the crux of the longer-term problem though is a chicken or egg dilemma with the bail-out plan, originally named TARP (Troubled Asset Relief Program), as the piece highlights:

"The idea behind the TARP is that sellers of impaired assets would use the cash received from the program to make new loans or investments, thus reliquefying the financial system. But there is no assurance either that holders of such assets could be induced to sell at a loss, or that they'd lend out their newfound cash instead of sitting on it. Depression, after all, is a state of mind as well as a state of the economy."

The article then goes on to explain another key aspect of the legislation:

"ONE FEATURE OF THE Emergency Economic Stabilization Act, the official name for the legislation signed Friday, requires the Securities and Exchange Commission, in consultation with the Fed and the Treasury, to study the impact of so-called mark-to-market accounting, and report back to Congress in 90 days.

Mark-to-market accounting, which stipulates that assets be carried on balance sheets at their current market price, has been blamed for exacerbating the credit crisis. By requiring writedowns on loans and securities that have declined in price, institutions have to make a corresponding reduction on the other side of the balance sheet, to capital. That only worsens the credit crunch.

"Ending the credit crisis will be highly unlikely without some type of accounting accommodation," according to Bridgewater Associates, the highly respected institutional money manager. "Because mark-to-market accounting on existing assets threatens bank capital today, it increases solvency concerns today, which raises funding costs and accelerates the need to sell assets today, which depresses the prices of those assets, which threatens capital and raises funding costs."

"This cycle can be broken if banks communicated an accurate or conservative assessment of the fair value of their assets in the footnotes of their financial statements, thereby telling equity and bond investors what they need to know to value the company. But if these losses were accrued over the remaining life of the assets, thereby avoiding the immediate hit to the book value of capital, the selling pressure would be reduced, which might even allow prices to rise and reverse the cycle and improve sentiment. This seems pretty obvious without any knowledge of history, but history overwhelmingly confirms the need for such a change."

Bridgewater's proposal isn't the same as more radical suggestions to suspend so-called fair-value accounting. Indeed, ignoring current market values of assets would only heighten the lack of faith investors display for current book values."

The Bridgwater proposal needs to be considered thoughtfully if we're to break this vicious downward spiral in the way this whole thing is currently playing out.

In fact, both the "mark-to-market" discussion, and the discussion of the Stabilization Act's hoped for role in stopping the downward spiral in stablizing credit in our economy, brings to mind the famous children's song "There's a hole in my bucket", which this Wikipedia entry explains as follows:

"The song incorporates an infinite-loop motif. In order to fix the leaky bucket, one needs straw. To cut straw, one needs an axe. To sharpen the axe, one needs a stone. In order to wet the stone, one needs water. But when asked how one would get the water, the answer is "in a bucket" (implied to mean the only one available – the leaky bucket which, if it could carry water, wouldn't be in need of repair in the first place)."

The song is much more fun to listen to, especially in this YouTube version by Harry Belafonte and Odetta:

Hopefully, the song will bring a smile to your face as it did mine, even as we ponder how we fix the hole in our economic bucket in the weeks and months to come.