Ok, so I've been reading a lot of the recent diaries by Jerome a Paris and thereisnospoon on the financial crisis. (In particular, this post is a response to the recent diary on the rec list by thereisnospoon
which is itself written in response to a recent diary by Jerome a Paris. So without having read those, this question is gonna seem rather abstract.)
Anyway, I've got a question for the economist/banker types out there that I don't know the answer to. I'm no economist, but I'm trying to just understand here.
Why don't we just have the gov't declare a CDO 'holiday,' kinda like FDR did with the banks to stop bank runs in the Great Depression, until we figure out some way to properly price these obligations?
more below . . .
According to Jerome, one possible solution to the whole financial mess right now would be to have the government simply CANCEL the liabilities inherent in all the credit default swaps (CDS) out there right now. That is, since the liabilities crippling the credit markets aren't, in a sense, 'real', why not simply have the government come in and clear the books. As Jerome said a few days ago, its not that investment banks currently have an asset problem, rather, they have a liability problem. Unless the government uses its emergency powers to cancel the massive liabilities that the CDS's racked up when the improbable happened, there's simply no end to how much they might owe as things get worse, and throwing money at it really isn't going to change things.
The one objection, according to thereisnosppon, is that without the CDS's, there's no way to know how much the whole collateralized debt obligations (CDO) market is worth, since all the CDO's were priced using their related CDS prices as a way to gauge the underlying risks being bundled in these CDO's. Which, once you understand it, is the classic bubble scenario - basing price on other prices is a classic bubble, its only a matter of time till that goes bust, and it follows the logic of all busts throughout history (ie: the original tulip speculations bust in the 1600's!).
Either way, though it seems then the reason the govt doesn't just void the CDS liabilities is because then we wouldn't know how to price the CDO's. Which is why the gov't is now buying these CDO's as 'toxic assets', without really knowing what they are worth, cause nobody does, cause they were priced based on the CDS market which has now gone to hell.
But if CDO's are bundles bonds, why can't you just put a moratorium on changing the value of these things right now? That is, set an arbitrary date in the past when things were semi-normal, and say the banks will pay monthly installments on these things based on those prices, but won't put up more collateral, try to sell them, or do anything like that, until we can, in a sense, 'dismantle' these things back into regular bonds so as to properly price them in a way that reflects real liability?
Essentially, this would freeze the CDO markets, and that's I guess what I'm suggesting - a CDO holiday, at least within this country, perhaps beyond - till we can figure out how to unravel the fake from real liabilities here. My reasoning for this is as follows: once the investment banks don't have to worry about their CDO obligations exploding and wiping out whatever real assets they have left, then they could get back to lending, and unfreeze the credit markets - right? Wouldn't that then allow normal lending to things like small businesses to resume, at least for the time being? Or something like that?
Now, I'm no finance guy, but why aren't they doing something like this?