Dear DK and Colleagues

Re: The Question of Trust: Beyond Paulson's Bold Plan

In the past year, the US Treasury, the Federal Reserve and the central banks of a number of major countries have engaged in a series of efforts to put out one fire after another in the highly distressed credit markets. It has become increasingly evident that the credit contagion which has engulfed the banking and brokerage sectors is now spreading far beyond to the wider economy. The crisis at the world's largest insurer -- AIG -- represented a breach of the firewall that traditionally separates financial intermediaries from the real economy. Now the contagion is threatening to spread to other insurers as well as to industrial loan and credit card stalwarts. The result is widening credit contraction which threatens to cripple economic growth and bring about recession and rising unemployment -- not only in the US, but throughout much of the world.

Treasury Secretary Paulson has now proposed that the US Treasury "buy" up to USD 700 billion of mortgage-related securities as a means of shoring up confidence in financial markets. Although Paulson's plan is unprecedented, the crisis now being faced is unlike any other economic crisis we have experienced. There has been a pervasive collapse of trust in the entire structure of financial intermediation which underpins market economies. Banks no longer trust each other. Investors no longer trust banks and other large-cap financial institutions. Lenders no longer trust borrowers. Without trust, financial intermediation cannot function. Confidence in the markets has been so shaken that there is no real choice but to embrace Paulson's plan to enhance substantially the role of government to rescue and to stabilize the credit markets. However, it must be recognized that throwing money at financial institutions cannot by itself restore trust. We believe there are additional steps which are needed to bolster Paulson's plan to address risks which could potentially undermine this effort to stabilize financial markets.

Paulson is right in focusing initial attention on the mortgage market. While deterioration of credit markets has spread far beyond the mortgage market, it is the continuous decline in valuations of residential and commercial properties that is opening catastrophic fault lines under the foundations of the credit markets. Issuers of mortgage-related securities for more than a decade have been repackaging them and selling them off to institutional investors like pension funds. By passing on the associated risks, issuers were provided unprecedented opportunity for leveraging their lending activities. This leveraging in turn gave rise to a vast market for an endless variety of asset backed securities, and a market for credit default swaps (CDS) which were a form of insurance against potential defaults. In September, 2008 the global CDS market is estimated at around USD 70 trillion, a significant multiple of the actual underlying value of all mortgage-related securities and other forms of securitised debt. The CDS market thus became yet another source of extreme leverage during a period when risks were thought to be so widely dispersed that insurance against default of any debt security seemed to warrant little more than a narrow spread over prevailing bond rates.

From 2007 onwards the credit market have experienced a sustained earthquake, as property markets began collapsing -- not only in the US but in the UK, the Euro zone and Eastern Europe. The fault lines under the asset backed securities market opened up, threatening to swallow up much of the capitalization underlying property markets. Because of "mark-to-market" accounting rules adopted in recent years, the leveraged positions of issuers of securitised debt forced them to write down the valuations of their inventory alongside falling property prices. The negative consequences were in turn greatly amplified by the extreme leverage generated by the widening of spreads in the credit default swap (CDS) market, as investors' perception of risk grew hour by hour. As CDS spreads widened, calls were being made for increased collateral at the very time when financial institutions were already under severe pressure to write down the value of their inventories of securities backed by mortgages and other forms of debt.

Institutional investors like pension funds, insurers and hedge funds have been shocked to find that valuations of their vast holdings of mortgage-related securities and other types of securitised debt have been falling dramatically. Having lost confidence in the entire securitised debt market, buyers have gone on strike. Moreover, holders of any form of asset backed securities have attempted to dump their contaminated debt securities but have found almost no potential buyers. Virtually any form of asset backed security has become illiquid as demand has dried up. Yes, some scavenger buyers have appeared here and there, but they are only ready to buy at a few cents on the dollar -- which is establishing fire sale valuations on all assets of the same class throughout the markets.

Since the late summer of 2008 the deterioration of global credit markets has been spiralling out of control. The entire securitised debt market, including not only mortgage-related securities but securities based on credit card debt, automotive credit, and loans for consummation of LBOs and mergers, has looked to be collapsing. The CDS spreads have been exploding. Not only the US financial market, but the global financial market has been looking to be coming closer and closer to financial Armageddon.

To halt the downslide towards financial market collapse, Paulson proposes that the US government acquire USD 700 billion of mortgage-related securities (including both residential and commercial mortgage-related securities) which have become illiquid in the absence of willing private market buyers. However, because US elections are only weeks away, there is insufficient time for Congress to devise a formal new agency which could buy distressed assets and then sort them out, clean them up, and sell them off to a supposedly revitalized market.

The Paulson plan envisages a series of USD 50 billion tranches for "buying" outstanding mortgage-related securities. This would ease pressures on some segments of the market for mortgage-related securities, but it would also entail new risks. When Treasury would "buy" a package of asset backed securities, the acquisition price would automatically establish a market valuation, which then every private holder of similar illiquid securities would have to accept as fair market value. Under Financial Accounting Standard 157, adopted less than a year ago, this would require accountants to treat the Treasury-established price as an appropriate market "input" for valuation, even if there was no active market in such assets. This would set in motion severe mark downs, followed by cascading downgrades by rating agencies. There would be risk that each new tranche of Treasury relief capital would kick the debt markets further down the steps towards the bottom basement.

Moreover, at a time when the US economy is headed into a recession, boosted by credit contraction and rising unemployment, it can be expected that rising business and household defaults will combine with accelerated write downs and even more downgrades to blow out the spreads in the global USD 70 trillion CDS market. As debt valuations fall, the highly leveraged CDS market would tend to grow exponentially and eventually explode and disintegrate. By then, the US Treasury's USD 700 billion debt relief package might have been found to be little more than a temporary painkiller.

Thus, throwing money at the problems could potentially even accelerate the downslide without the support of other actions. Paulson's plan therefore needs to be bolstered by measures to slow down the pace of deterioration, so that viable enterprises have time to work out their distressed asset positions and potential investors, especially institutional investors, can take time to re-evaluate underlying asset quality. The recent decision to halt short trading in the equities of a wide variety of financial institutions is a necessary emergency action to halt a spiralling decline. Other brakes also need to be applied. In particular, the current FASB Section 157 requirements for contemporaneous mark-to-market write downs should be suspended. If necessary, the suspension could be limited to the rule's applicability to illiquid but performing loans in cases where firms' solvency standards are otherwise acceptable. This might at first sound like an attempt to cover up the extent of trouble in the credit markets, but mark-to-market at moments when markets are illiquid and there are no credible buyers makes no sense. Such mark-to-market requirements should be suspended and new time intervals set for periodic revisions in valuations. During the suspension period, efforts should be made to revise accounting standards to reflect the reality of possible periods of market illiquidity, particularly at turning points in the business cycle. Basel II, which also imposes unrealistic standards during periods of illiquidity, should also be revisited.

Rating agencies must also be addressed. For a long time their ratings have seemed to be inept and not reflective of underlying risks. In response to growing criticism from market participants, regulators, and politicians, the rating agencies have speeded up their responses to changing credit market conditions. The tardiness in downgrades at the beginning of the down cycle was damaging, but the recent acceleration of downgrades is like throwing gasoline on a fire. The recent cascading downgrades of publicly listed companies and financial institutions results in widening CDS spreads and demands for increased collateral, converting viable businesses into what credit markets deem to be toxic waste. There is real need for the government to apply brakes to the rating agencies' overeager downgrade efforts. The rating agencies should be required to interact with the Treasury's newly enhanced financial market rescue team, and to take into account a more slow and methodical process of mark-to-market revisions in valuations.

Read the article at mi2g.net.

Ultimately, concerted action by governments and financial enterprises will be needed in an unprecedented effort to put right what has gone so far wrong that financial market Armageddon can no longer be considered a highly improbable, or "black swan" event. The concatenation of collapsing financial market confidence and forced deleveraging of the entire structure of financial intermediation has set in motion The Great Unwind. Only a bold and unprecedented collective effort by governments, with willing cooperation of the private sectors, can hope to limit the extent and duration of the damage likely to be wrought by The Great Unwind.

Treasury Secretary Paulson's initiative must be applauded, but additional actions are needed, along with additional participation by major governments around the world.

Best wishes


Harald Malmgren and The ATCA Research & Analysis Wing (ATCA RAW)

Dr Harald Malmgren is Chief Executive of Malmgren Global and also currently the Chairman of the Cordell Hull Institute in Washington, DC, a private, not-for-profit "think tank" which he co-founded with Lawrence Eagleburger, former US Secretary of State. He is an internationally recognised expert on world trade and investment flows who has worked for four US Presidents. His extensive personal global network among governments, central banks, financial institutions, and corporations provides a highly informed basis for his assessments of global markets. At Yale University, he was a Scholar of the House and Research Assistant to Nobel Laureate Thomas Schelling, graduating BA summa cum laude in 1957. At Oxford University, he studied under Nobel Laureate Sir John Hicks, and wrote several widely referenced scholarly articles while earning a DPhil in Economics in 1961. His theoretical works on information theory and business organization have continued to be cited by academics over the last 45 years. After Oxford, he began his academic career in the Galen Stone Chair in Mathematical Economics at Cornell University.

Dr Malmgren commenced his career in government service under President John F Kennedy, working with the Pentagon in revamping the Defense Department's military and procurement strategies. When President Lyndon B Johnson took office, Dr Malmgren was asked to join the newly organised office of the US Trade Representative in the President's staff, where he had broad negotiating responsibility as the first Assistant US Trade Representative. He left government service in 1969, to direct research at the Overseas Development Council, and to act as trade adviser to the US Senate Finance Committee. At that time, he authored International Economic Peacekeeping, which many trade experts believe provided the blueprint for global trade liberalisation in the Tokyo Round of the 1970s and the Uruguay Round of the 1980s. In 1971-72 he also served as principal adviser to the OECD Wise Men's Group on opening world markets, under the chairmanship of Jean Rey, and he served as a senior adviser to President Richard M Nixon on foreign economic policies. President Nixon then appointed him to be the principal Deputy US Trade Representative, with the rank of Ambassador. In this role he served Presidents Nixon and Ford as the American government's chief trade negotiator in dealing with all nations. While in USTR, he became known in Congress as the father of "fast track" trade negotiating authority, which he first introduced into the historically innovative Trade Act of 1974. He was the first official of any government to call for global negotiations on liberalisation of financial services, and he was the first US official to call for the establishment of an Asian-Pacific Economic Cooperation arrangement, known in more recent years as APEC.

In 1975 Dr Malmgren left government service, and was appointed Woodrow Wilson Fellow at the Smithsonian Institution. From the late 1970s he managed an international consulting business, providing advice to many corporations, banks, investment banks, and asset management institutions, as well as to Finance Ministers and Prime Ministers of many governments on financial markets, trade, and currencies. He has also been an adviser to subsequent US Presidents, as well as to a number of prominent American politicians of both parties. Over the years, he has continued writing many publications both in economic theory and in public policy and markets.

[ENDS]

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Best wishes


DK Matai

Chairman
Asymmetric Threats Contingency Alliance (ATCA) & The Philanthropia
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ATCA: The Asymmetric Threats Contingency Alliance is a philanthropic expert initiative founded in 2001 to resolve complex global challenges through collective Socratic dialogue and joint executive action to build a wisdom based global economy. Adhering to the doctrine of non-violence, ATCA addresses asymmetric threats and social opportunities arising from climate chaos and the environment; radical poverty and microfinance; geo-politics and energy; organised crime & extremism; advanced technologies -- bio, info, nano, robo & AI; demographic skews and resource shortages; pandemics; financial systems and systemic risk; as well as transhumanism and ethics. Present membership of ATCA is by invitation only and has over 5,000 distinguished members from over 120 countries: including 1,000 Parliamentarians; 1,500 Chairmen and CEOs of corporations; 1,000 Heads of NGOs; 750 Directors at Academic Centres of Excellence; 500 Inventors and Original thinkers; as well as 250 Editors-in-Chief of major media.

The Philanthropia, founded in 2005, brings together over 1,000 leading individual and private philanthropists, family offices, foundations, private banks, non-governmental organisations and specialist advisors to address complex global challenges such as countering climate chaos, reducing radical poverty and developing global leadership for the younger generation through the appliance of science and technology, leveraging acumen and finance, as well as encouraging collaboration with a strong commitment to ethics. Philanthropia emphasises multi-faith spiritual values: introspection, healthy living and ecology. Philanthropia Targets: Countering climate chaos and carbon neutrality; Eliminating radical poverty -- through micro-credit schemes, empowerment of women and more responsible capitalism; Leadership for the Younger Generation; and Corporate and social responsibility.
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