by Simon Johnson and James Kwak

The government plans to bail out the banking sector by buying up to $700bn (for now) of “impaired assets” … but at what price? Pay too little, and the banks will not have sufficient capital to remain solvent; pay too much, and the wealth of the American taxpayer will be unilaterally handed to the banks and their shareholders. Last week Hank Paulson, Treasury secretary, said the government would pay “fair market value”, which, many pointed out, would do little to help the banks. On Tuesday, Fed chairman Ben Bernanke equated the current market with a “fire sale” and proposed paying “hold-to-maturity” prices. But what does this mean? Read more

by Gilad Livne and Alistair Milne

The credit crisis has had a seismic impact on the global financial landscape. A central reason is an unforeseen interaction of fair value accounting rules and the illiquidity of structured credit products. Firms are required to mark to market their large portfolios of structured credit products, but for most of these products there is no longer any functioning market. Instead, as has happened on several occasions, we observe cumulative death spirals, in which the only prices that can be used for valuation are based on the fear that a Lehman or similar large firm will implode, and thus forced to sell a large structured credit portfolio. Mounting fears bring about large mark to market losses, increase counterparty margins, and bring about the very implosion that is feared in the first place.

Clearly recapitalisation of the banking sector is needed. But this malign interaction of accounting rules and illiquidity actually creates an opportunity, making it possible to substantially recapitalise the banking sector at little cost either to taxpayers or to bank shareholders. We believe this can be achieved through a direct solution to the trading paralysis, the setting up of a specialised exchange to allow a large number of traders to exchange information and views on the value of the underlying structured credit products and conduct trades at fundamental not fire sale prices. Prices established in such an exchange will provide more reliable valuations than those emerging from current bilateral over the counter trading and restore much of the banking net worth that has vanished in recent months. Read more