I was reading Greg Mankiw dissing a tax increase proposal by Hillary Clinton, and I thought to myself, “If I could invent a tax increase for Greg Mankiw to dis, what would it be?” Suddenly, the screen began to waver, dreamy harp music chimed, and a vision appeared to me on a tablet of balance sheets: Eliminate the tax deductibility of interest payments by businesses. Debt financing externalizes the risks of business activity and magnifies social costs, while equity financing concentrates risk among stockholders who signed up to bear it. Yet under current rules, taxpayers literally pay firms to get rid of stockholders and take on ever more debt.

Here’s the case-in-brief:

Creditors (people who lend to a firm) and equityholders (those who own stock) are fundamentally the same thing. Both are just investors, people who place money in the hands of a firm in hopes of getting it back later on, with a little something extra for their troubles. Whether one chooses to invest as a stockholder or bondholder is an idiosyncratic matter. Bondholders sacrifice potential upside for predictability and a legal right to enforce payments. Equityholders have no guaranteed payment schedule, but retain a potentially unlimited claim on a firm’s future success. Firms pay bondholders according to a predetermined payment schedule, interest and principle. Equityholders are paid via dividends or share buybacks, but only when management is confident it has sufficient resources to pay debt obligations and fund firm operations. For those who grew up in the era of structured finanace, the equityholder/bondholder distinction is basically a primitive version of the tranching you’d find in a CDO. (There is the control thing that, as a historical quirk, usually goes exclusively to equityholders, but we’ll put that aside for now. Creditors “own” a company as much as shareholders do, though the two groups have different sorts of rights associated with their claims.)

You’d think that the organization of investment contracts would be a private matter between people with money and people with good ideas about how to use it. But, that’s not the case. Large-scale investment is crucial to a modern economy, and getting investors to trust strangers enough to give them their money is hard. So pretty much every government takes an interest in helping things out. Governments define forms of business organization, enforce accounting standards, and develop a body of law that mediates between managers and the various classes of investor. To overcome some of the trust issues, the most nervous sort of investor, bondholders, are given the business equivalent of a doomsday device to enforce their claim on timely payments. If, of malice or misfortune, a firm fails to pay out as promised, bondholders can force a firm into bankruptcy and coercively try to recover what they’re owed. Though bankruptcy may be in bondholders’ interest, it is quite traumatic for other firm stakeholders. There are two facts we should take note of: 1) bondholders owe an especial debt to the state, as the state, often at great cost, much more aggressively enforces creditors’ rights than the rights of other investors; and 2) from a systemic perspective, a great predominance of bondholders — too much debt financing — is dangerous.

When an equity-funded firm underperforms, that mostly is a private matter that harms stockholders who knew the risks they were signing onto. When a debt-funded firm underperforms and cannot meet its obligations to bondholders, a sharp “nonlinearity” is provoked that frequently results in widespread harm to a firm’s employees, suppliers, customers, and the communities in which it operates. If debt financing is very prevalent within the firm’s “ecosystem”, one firm’s bankruptcy may cascade into widespread, even systemic, crises. Fundamentally, the right of bondholders to enforce their claims via bankruptcy is analogous to limited liability for investors of all classes — it’s a legal convention we’ve developed to encourage socially useful risk-taking that partially externalizes the downside risks for some investors. While equity-funded firms fail as well, they have more leeway to temporarily underperform and recover, and the impact on firm stakeholders is usually more gradual and predictable.

Don’t get me wrong. The existence of enforceable debt financing is a very good thing. It’s an essential element of the constellation of institutions by which we are able to fund large-scale capital-intensive projects without coercion. But, the public incurs costs and risks by promising to enforce debt contracts. If a project is going to be funded regardless, any state meddling in capital structure ought to tilt the scales towards equity rather than debt financing.

But that’s not what happens. Instead, corporate tax law strongly favors debt financing. One way or another, firms have to pay their investors. When firms pay stockholders, every dollar an investor receives drops off the firm’s balance sheet. But when a bondholder receives the same dollar, a US firm pays as little as 65¢. The other 35¢ is paid for by Uncle Sam, in the form of a tax deduction. This creates a great incentive for firms to buyback shares and borrow money, that is to convert from equity financing to debt financing, when times are good and thoughts of bankruptcy seem remote. For example, here’s Brad Setser, writing today about how the world looked one year ago:

There was no real risk to taking on more debt to reduce the amount of outstanding equity on a firms balance sheet and, in the process, increase the return on existing equity. Private equity firms had shown the way to arbitrage the difference between the pricing of debt and equity; all that remained was for everyone else to follow suit.

According to canonical financial theory a firm’s debt/equity split, or “capital structure”, should have no effect on overall firm value. It’s just different ways of slicing up the same money pie, in a common metaphor. But if you introduce tax deductions for debt payments, the equation changes. Then the theory predicts that a rational firm should load up on debt financing, in order to capture the benefit of the “interest tax shelter”. If bankruptcy were not an issue, rational firms would move to ~100% debt financing in order to extract the largest possible subsidy. With bankruptcy a possibility, a rational firm loads up on debt until the marginal increase in bankruptcy risk outweighs the marginal benefit of the subsidy. But if imperfect managers underestimate bankruptcy risk during periods of stability, they may unwittingly (or purposefully, if there are agency problems) bring firms close to the brink, provoking traumatic failures when the gales of an untamed business cycle blow strong and hard. By covering a large fraction of corporate interest payments, the government effectively subsidizes financial risk-taking that serves no operational purpose but generates real social costs.

So, here’s my proposal: Put payments to stockholders and payments to bondholders on a level playing field. Eliminate the tax deduction for business interest payments. I’m not sure how much extra revenue this would net the Treasury, but by ending a perverse incentive for firms and eliminating a large subsidy to the wizards of debt, it would pay off hugely in the form of a more stable corporate and financial environment.

Note: Another way to level the playing field between debt and equity financing would be to eliminate corporate taxation entirely. I’d be cool with that too, as long as it was accompanied by a tax increase elsewhere whose incidence is at least as progressive as the corporate tax. Actually, eliminating the corporate income tax while making up the difference with a surge in top income tax brackets would be a fine stealth bailout for stock markets, funded by really rich people. Stocks would instantly be more valuable! And really, if we are going to socialize the costs of our financial meltdown, shouldn’t we socialize it disproportionately to the people who gave it to us?

I really dig Andrew Clavell. But he is misguided in his criticism of an excellent piece by Martin Wolf.

Here’s Andrew:

[I]ndividual mortgage borrowers demanded their chance to improve their social and financial standing with scant regard for the potential consequences of their actions. MBS Investors (read hedge funds, money market funds, pensions, mutual funds as well as banks) demanded ‘attractive’ yields for the perceived risk, and had incentive structures and abundant liquidity available to encourage risk taking.

Mortgage borrowers and mortgage-asset investors were both long housing assets, the former with a call option on the upside, the latter by shorting puts on the downside for yield premium. Investment banks, at whose doors Mr Wolf et al are laying the blame for the outcome of this misguided speculation, just saw an opportunity to intermediate this activity and did so successfully. It was their own badly conceived warehousing of some of the assets which is causing them so much mark to market pain at present, but that is not the issue.

Are we supposed to blame the bankers for being oil in the cogs in the capitalist engine? Are we suggesting that banks should have desisted as they knew a bubble was developing? Why are we ready to pronounce them the bad-guys again? Purely since their pay is the most public and the most despised by outsiders. So let’s regulate it. Claw it back. Withhold it for 10 years.

Never mind that politicians and central bankers set the tone for investors (loosely, the American dream). They don’t get paid much, so let’s not blame them. Let’s also not claw back their salaries or appropriate large fractions of their fees from lucrative speaking tours or book sales following their exit from public duty.

Never mind that the majority of ordinary people are illogically risk seeking in housing markets, or dot com shares. Ordinary people don’t get paid like bankers, so let’s not blame them. Let’s not try to educate ourselves properly about finance before we wreak such destruction.

Never mind all that. Blame the intermediary who earned too much.

Andrew is quite right to note that there is plenty of blame to go around. Ordinary folk herded into scam mortgages, taking a rational bet that this year would be like last year and they could catapult themselves into the upper middle class by taking a chance on the biggest home they couldn’t afford. Institutional managers herded into structured products promising high yield at next to no risk, products that seemed to violate the most elementary rule of finance (no arbitrage), and were shocked, shocked when after four years of great bonuses, their clients learned there was risk after all. And bankers of all ilks and alphabets, I-bankers, C-bankers, M-bankers, discovered there was great money to be made, intermediating (originate and sell!), dealmaking (LBOs, baby, it’s a new era of infinite leverage and no defaults!), and shoving risks where stockholders and regulators couldn’t see them (SIVs are just innovative!). People who face opportunities with stratospheric upsides and largely externalized downside costs take chances. Fundamentally, the behavior of bankers was no different than that of homebuyers with dollar signs in their eyes, the guy who ran a “mortgage company” from an e-mail server in his basement, or you and me in their situation. So, why should we pick on them?

We should pick on them. It’s not because they’re bad people. Most bankers are very nice people. We should pick on them because, as Andrew says, banks intermediate. They are a point where all the lunatics meet to transact, a point where applying pressure can change everything. We can rant and rail against human nature, but who cares? People is people, God bless ’em. But banks are formal institutions, amenable to laws, regulations, and litigable norms and standards that are easily reshaped. We don’t have to throw up our hands at frailty and corruption and watch reruns from the 1930s over and over again. We can actually mess with banks (and other financial intermediaries) in ways that indirectly shape the behavior of the rest of us (and that are not terribly intrusive to most of us). It simply isn’t true, in the general case, that human desires are exogenous and “demand will find supply”. The explosion of misbehavior on all sides of the credit market over the past several years was not caused by a burst of theta-waves from the Earth’s core. We allowed our institutions to evolve to a place where misbehavior was ordinary, caution uncompetitive, prudence a firing offense. If we change the institutions, we change the behavior. We can do that, and we should do that.

I’m skeptical of proposals (by Wolf and others) with regard to bankers’ pay, not because they are harsh, but because they are circumventable. Escrowed cash and restricted stock can be pledged and hedged, regardless of formal prohibitions. (We simply haven’t invented a decent compensation instrument that can’t be cashed out. That would be a profoundly useful financial innovation.)

Unsurprisingly, when Martin Wolf and Andrew Clavell agree, it’s worth paying attention. Wolf:

An alternative suggestion is “narrow banking” combined with an unregulated (and unprotected) financial system. Narrow banks would invest in government securities, run the payment system and offer safe deposits to the public.

Wolf backs off of this suggestion far too quickly. (“The drawback of this ostensibly attractive idea is obvious: what is unregulated is likely to turn out to be dangerous, whereupon governments would be dragged back into the mess.”) Much of this danger could be ameliorated with one parsimonious regulatory principle for the nonbank financial sector — An absolute prohibition on scale. There should be hard limits on the quantity of gross assets under any one entity’s control, combined with strong norms of independence (copycat investing is prima facie poor practice that opens up managers to investor lawsuits), along with antitrust like scrutiny of coordinated action. This would represent a big change. The current legal environment creates artificial economies of scale (the complexity of securities law), rewards herding (“safe harbor” provisions, “Nationally Recognized Statistical Rating Organizations”) and punishes independence (managers who make unusual choices face investor liability). The maximum permissible size should be absurdly small by today’s standards.

Obviously, this is a radical proposal, unlikely to happen anytime soon. But we may yet get to the point where all our choices are scary, so we’d best have some good options ready to go, just in case. One way or another, we have got to improve a financial sector that extracts a large fraction of collective wealth, allocates capital poorly, and creates periodic bouts of instability and human misery. Most of the men and women who work on Wall Street are fine people. But in Manhattan as much as in Michigan, broken institutions ought not be protected from bouts of creative destruction. America’s vaunted financial system does not adequately serve the purposes it is meant to serve. That has to change. Ideally, we should encourage private innovation and follow a cautious, incremental path to something better. But regardless of how we get there, a lot of people who have been well compensated under existing arrangements aren’t going to like the changes. Too bad.

I decided long ago not to have a “blogroll”, figuring that I would naturally link to the people I read. But it hasn’t really worked out that way. There are lots of amazing authors whose every word I hang on, but whom I rarely have occasion to link. This interweb is an amazing thing. Banks may implode and currencies morph to toilet paper, but intellectually, these are the best of times. There has never been a conversation like this, so many wonderful minds communicating in a forum that is open to everyone, but still relevant, even influentual. Thank goodness for this crazy machine, and for all its cogs and pulleys — writers, commenters, and especially readers.

I want to devote my first post of the year to highlighting and thanking some of the people whose words keep my brain pleasantly marinated. [A note about names — I’m a first-name-basis kind of guy, and will thank accordingly. My use of first names implies neither disrespect of nor any personal familiarity with any of the thankees.]

If I had to nominate one blogger for the role of “hero”, it would be Brad Setser. For years now, Brad has been painstakingly documenting the financial backstory of our times. Bubbles pop, this hedge fund fails, that central bank acts, blah blah blah. Every day another headline, but Brad has focused on the slow grinding of plates beneath, invisible to most but actually the source of the tremors. He approaches the task with a Sisyphean work-ethic, remarkable civility, and openness to new ideas and especially new data. (Brad’s comment section also merits note. It is, I think, the best on the web, thanks largely to the caliber of the headline posts, and Brad’s willingness to engage all comers as colleagues.)

Mark Thoma is a different kind of hero. Economist’s View is the New York Times of the econoblogosphere, the place to find the news of the day treated at length and seriously. Like the Times, there is more reportage than editorial, but the quality of the Mark’s editorial is consistently higher than the Times‘.

Within the ghetto of finance, the first place I turn to for my fix of news is Felix Salmon. I’ve been a Felix fan since he first started scribing as RGE‘s original Economonitor. (They were fools not to have offered thrice whatever it would have taken to retain him there.) I owe Felix a special debt, as he was the first widely read blogger to deem my ravings here linkworthy. It’s been less lonesome ever since. I do have a complaint, though. Back in the day, Felix was the first and only finance blogger who consistently had me spitting up Fruity Pebbles onto my PowerBook. He was hilarious, sometimes hilariously mean, to all comers (including, very gratefully, yours truly). Ever since the snooty Condé Nast franchise got him, he’s been so well behaved. The thoughtfulness, range, and quality of content on Market Movers is better than ever, but I do miss having to replace expensive hardware following a particularly artful post.

Calculated Risk and Tanta have done an amazing job at explaining the housing bubble and the mortgage industry, with clarity, depth, and panache. Yves Smith at Naked Capitalism weaves anthology and editorial, keeping us abreast of the intricacies of the financial world and offering a useful perspective from which to view those goings on. I have occasionally linked Yves to disagree with him, but that’s the exception that overwhelms the rule. Yves is usually right, and always worth listening to. Another person who is usually right and deserves special mention for it is Dean Baker.

If you are interested in finance, and don’t read jck at Alea, you’re unserious. jck reads widely and obscurely and unearths some real gems. His posts are often deceptive in their brevity. jck has mastered that art of packing tart commentary and a pair of X-ray spectacles into a couple of sentences, sometimes just in the highlighting. Another underappreciated master of concision is Scurvon. Scurvon comments with a wide and eclectic range in a style that’s straight, direct, and brief. It’s like intravenous information, and you can’t even feel the needle going in. Of course, the most concise bloggers of all are those who only link, and among finance bloggers, Abnormal Returns does a great job of that, except for a few lapses in judgment and taste (he has linked Interfluidity).

Interfluidity, unfortunately, belongs to the subgenre of finance blogs that might be referred to as the we-are-so-fucked-o-sphere. The demigods of our happy realm would have to be Micheal Panzner and Nouriel Roubini. Michael was kind enough to mail me a copy of his book, Financial Armageddon. Michael’s baseline scenario (he often writes in the simple future tense, rather than any hedging with any conditional) is so dark that most of us doomsayers seem like Pollyannas by comparison. The book is worth reading, and the blog carefully documents a world slowly waking up to how bad a fix it has got itself into. Other excellent members of our dingy neighborhood include Michael Shedlock and Aaron Krowne.

Just about one year ago, I got into a lengthy comment debate with one moldbug, whom I first encountered as a commenter on Brad Setser’s blog. moldbug is a wonderful writer, an unusual intellect, and a sharp cookie on all things monetary. We have divergent views about what money ought to be, but similar views of the problems we face now, and he was delightful to argue with. He now has his own blog, Unqualified Reservations (although much of his best financial writing remains where it began, in Brad’s comments).

In no particular order, other finance blogs that I read pretty much constantly, and to whose authors I am grateful, include The Big Picture, Accrued Interest, Financial Crookery, Credit Slips, Cassandra Does Tokyo, Jeff Matthews Is Not Making This Up, The Mess That Greenspan Made, as well as (with a hat tip to Brad Setser) Macro Man and Michael Pettis.

Of course, finance is just one distateful ghetto in the odd, misshapen galaxy of economics. Liking to think of myself as a worldy galaxyly person, I read the economists as well. All this link lovin’ is leaving my fingers sore (don’t go there), so I hope the following authors will understand themselves to be worshipped and adored, despite being so perfunctorily listed: James Hamilton and Menzie Chinn, Brad DeLong, Tyler Cowen and Alex Tabarrok, Dani Rodrik, Thomas Polley, William Polley, Robert Vienneau, Robert Waldmann, George Borjas, Paul Krugman, Gabriel Mihalache, Greg Mankiw, Jonathon Dingel, and knzn .

Of course, there are a hundred, a thousand, a million people, links, stars I’ve missed. The stars in this galaxy, and in other galaxies near or far, are so numerous as to be grains of sand. The texture of the world is not made of isolated points, however many you might catalog, but by the fact that there is somewhere everywhere, a spark in every crevice. (No, that is not why my fingers are hurting.) To all those I’ve named, and those I’ve unforgivably forgotten, and those I don’t even know but might find with a click, thank you for this amazing conversation. To be a small voice in this cacaphony, in this harmony, is a great privilege.

And thank you, whoever you are, who takes the time to read these words. I am blessed by the company of your eyeballs, as creepy as that sounds. (Don’t worry. I’m not hungry.)

Yves Smith at Naked Capitalism and Accrued Interest have both taken very measured views of the Fed’s new Term Auction Facility, which gets its big start on Monday. As Smith puts it, TAF is the “discount window with no stigma and another pricing mechanism”. He also notes that the Fed’s novel device looks just like the same old auctions the ECB has been using as a monetary policy tool for years, and observes pessimistically that “the gap between non-dollar Libor and the ECB’s target rate is higher than the spread between Libor and Fed funds. Not a good sign.” (Bloomberg reports that Friday’s markets shared Smith’s skepticism.) Accrued Interest, responding to my ravings, suggests that TAF is no more a “bail-out” than any other lending at the discount window.

Yves Smith and Accrued Interest are two of the finest financial bloggers out there. If you are dallying here without having read every word they’ve written, your priorities are out of whack. Nevertheless, both are missing a forest of difference among trees of similarity. To call TAF the discount window without the stigma is like calling a person a corpse that is not dead.

In theory, TAF and the discount window are quite similar. In practice, it never mattered what the discount window was, because it was so little used. TAF is the discount window remastered. It is designed to be used, in quantities heretofore inconceivable. James Hamiltion, in an excellent discussion of the facility, shows a graph of historical direct lending by the Fed. Thanks to TAF, the graph through December 2007 will show a spike so tall you’d need a screen three times as tall as a typical monitor just to accommodate. Prior to TAF, the Fed had no effective tool for getting funds to banks in trouble, since loans at the Federal Funds rate are only available to banks that other banks trust, and borrowing at the discount window is expensive, financially and reputationally. With TAF, the Fed can lend directly to the sketchiest banks, and on very generous terms, without spooking depositors. As the ECB’s experience suggests, this funding mechanism can made quite routine. Some commentators view TAF as a temporary means of addressing end-of-year liquidity issues, but I suspect that TAF will be an active part of the Fed’s monetary policy arsenal for the foreseeable future.

If TAF is so similar to the ECB’s facility, why should it matter? After all, the ECB hasn’t succeeded at calming European interbank markets, yet. But, in the words of the maestro (Eric Clapton), “It’s in the way that you use it.” In order to reduce interbank spreads, central banks have to (1) auction money in quantities sufficient to ensure that the “market price” is quite close to the interbank rate policymakers view as healthy; (2) accept a wide variety of bank assets as collateral, and place high valuations on those assets relative to the market bid; and (3) credibly signal that it is willing and able to continue these policies in perpetuity, or until the crisis is abated, whichever comes first. Point (1) immediately drops the cost of borrowing by troubled banks to “ordinary” levels. However, this alone will not immediately reduce spreads on loans are still made between banks. Private banks will still fear counterparty defaults even if the central bank is blasé. Interbank spreads might even widen, as lenders view failure to anticipate and secure adequate funding at auction as a sign of trouble. Point (2), over time, will remedy this. Easy lending against a broad panoply of assets helps ensure that banks have the capacity to bid for all the funding they need. At the same time (as Yves Smith was quick to point out), the price at which assets are accepted as collateral suggests a floor for accounting valuations, helping to assure counterparties that borrowers won’t be thrown into crisis by a sudden write-down. Again, the effect here won’t be immediate — as long as collateral values and market bids are divergent, there will be valuation uncertainty. But, that’s where point (3) comes into play. There’s an arbitrage between exchange value and long-maturity collateral value. If the traders view collateral values as stable, eventually market bids will rise to approach the central-bank set asset prices.

This medicine will take time to work. Central banks will have to establish credible expectations of continued support. Don’t expect “forward looking markets” to reprice spreads until central bankers establish a track record. The ECB is not auctioning enough money yet, but it will. I suspect that, despite Europe’s institutional head start, it will be Bernanke’s radical Fed that shows the way.

Many commentators view TAF as an odd, desperate attempt by the Fed to do something, or to seem to do something, in a desperate situation. That is not my view. I think the Fed is acting quite deliberately here, that it is working out of a playbook that the Chairman developed and described years ago. I am optimistic that the Fed’s approach, if pursued tenaciously, can succeed in undoing the widespread perception of risk and instability in the banking system.

Of course, “optimistic” is not quite the right word here, because I oppose the whole enterprise. All the talk about moral hazard and burning houses misses the point. The financial sector has underwritten gargantuan misallocations of real resources in the United States, and profited handsomely from doing so. The cost of these errors is not just a matter of homes foreclosed, or a period of commercial turbulence and unemployment. We face the prospect of a serious decline in living standards, increased danger of conflict between large powers (which hopefully, but not certainly, will be confined to the economic sphere), and the possibility of social instability of a kind we’ve not witnessed for decades. There are actors in this drama who “deserve” to be punished, under a nineteenth century view of moral hazard. But that is not why we should endure rather than resist a painful restructuring of the financial sector. If we could let bygones be bygones and move on, that’d be great. But the reason for institutional accountability in any setting is not to shame and punish, but to create the conditions under which future actors will not misbehave. Contra Nouriel Roubini, the real economy cannot be “bailed out”. It must be built and repaired via the wise application of present scarce goods and services, rather than salved with promises of future goods and services. We require a financial sector capable of aggregating widely dispersed information into wise choices regarding the use of present resources. We absolutely do not have such a financial sector right now. Which is why the very expensive financial sector that we do have should be let go.

Existing players, including the Fed, won’t see it this way. The Fed will lend to support collateral values at levels higher than conventional valuations would merit. They will work with financial institutions to roll over loans as necessary, even against decaying collateral, rebundling assets to maintain some veneer of plausibility when underlying cash flows develop poorly over time. The proud titans of Wall Street can and probably will be bailed out. The rest of us are not so lucky.

Take a look at a snippet of GM’s last-quarter balance sheet (courtesy of Yahoo! Finance). It’s the part that contains what accountants quaintly call “Shareholder Equity”:

Yes, the accounting value of the firm’s equity is negative 41.7 billion dollars. Now, answer me this. Is GM insolvent?

There is no definitive answer. It’s a philosophical question, a matter of opinion. The market says GM’s equity is worth $15B dollars. All we can say with any confidence is that GM is liquid, it has not yet failed to pay its bills, it is capable of borrowing to finance its operational needs despite a balance sheet with no vital signs. The patient walks and breathes, so it is not dead. Somehow.

There is a meme going around the blogosphere, and now the mainstream-press-o-sphere, that the Fed is helpless in the current crisis because the problem is one of solvency, not liquidity. Here’s Paul Krugman (hat tip Mark Thoma):

In past financial crises… the Fed has been able to wave its magic wand and make market turmoil disappear. But this time the magic isn’t working… Why not? Because the problem with the markets isn’t just a lack of liquidity — there’s also a fundamental problem of solvency.

Here, here, Dr. Krugman. And you too, Dr. Roubini. And Michael Shedlock. And Kevin Drum. I agree with you all. From the tiny legal entities known as asset-backed securities, way up through to a couple of large money center banks, there are a lot of entities out there which, by my Victorian standards, are simply insolvent. But by those standards, GM oughtn’t be able to fog a mirror, let alone borrow money from people. It’s the living dead, a zombie, to use a term fashionable when discussing Japan but never, ever appropriate to the hypercapitalist U.S. of A.

Can a determined central bank “wave its magic wand” and make insolvent entities solvent? I have no idea. But I do know this. A central bank can keep almost anything liquid for a long, long time. And as far as financial markets are concerned, only liquidity matters. The little theory called solvency is only relevant to the degree that it predicts liquidity, or illiquidity. Central banks can undo that relationship, if they wish to. Perhaps they wish to.

I have no idea how “aggressive” the U.S. Federal Reserve will become in trying to resolve the present crisis in credit markets. There are in norms of accounting, regulatory frameworks, laws, that might constrain it. But, central bankers have been remarkably candid in describing their willingness to circumvent these constraints in a crisis. (See here or here for examples.) With the new Term Auction Facility, the US Fed has just given itself a tool by which it can ensure the liquidity of “insolvent” assets, at prices the bank itself determines, indefinitely. Some commentators (e.g. Yves Smith) have wondered how a temporary facility, loans with a fixed term of one month, can make much difference one way or another in the liquidity of assets. The answer, of course, is that they can be rolled over (via new auctions, which are already announced for January, or by other means). The same logic that impels the initial extension of credit suggests that loans will be rolled over, must be rolled over, for as long as “crisis” continues. The Fed has bent over backwards to help out financial institutions. Once it has direct loans to those institutions on its balance sheet, it will own their problems in a way it has not until now. Will the Fed pull the plug and demand payment of a bank that says it cannot pay? Will it force a bankruptcy, as private creditors might, if the bank was in default? Is that even conceivable? The day that happens to a bank of any scale is the day you can be sure the credit crisis is no more.

I’m going to end with a bit of a cheap shot, because really, nothing is beneath me. Remember this?

The aide said that guys like me were “in what we call the reality-based community,” which he defined as people who “believe that solutions emerge from your judicious study of discernible reality… That’s not the way the world really works anymore. We’re an empire now, and when we act, we create our own reality.”

Worrying about “insolvency” is a defect of the reality-based community. For everyone else, all that matters is the price at which assets can be sold or borrowed against. The Fed can set that price, if it acts with sufficient, um, determination. Analyzing underlying cash flows is for pansies.

The latest financial innovation cooked up by the banking system might be described as “postmodern pricing”, whereby the exchange/collateral value of assets is intentionally unmoored from quaint ideas like “true” or “fundamental” value. All for the benefit of struggling homeowners and hard-working ordinary Americans, of course. If you are among the macroeconomic mainstream that has nodded along with Fed interventions to support “liquidity”, but you find this brave new world troubling, well, good. Better late than never, and you are welcome among us. Expect to be mocked. Bear it with pride.

I haven’t time to write properly, I am caught between a million things. But when I woke up to the Federal Reserve’s press release about the TAF, my jaw dropped. It was one of those moments when the world shook, everything was the same, but everything had changed. So, when I step into the blogosphere to read comments like “solid first step“, I feel compelled to spew some first impressions.

1. If you think (as I believe most Fed policymakers do) that the goal of monetary policy in reacting to the current financial crisis is to make it go away, this plan is brilliant.

2. Under traditional discount window borrowing, the best the Fed could do is offer funds at a “penalty” or “premium” and hope that banks borrow, despite a longstanding market perception that direct borrowing from the Fed is a sign of weakness. Now, the Fed has turned the tables. It will set precisely how much money it will lend ($40B just in the next cople of weeks!), and let banks bid on how much they are willing to pay for the use of that money. The scale of this program is immense. Typically direct borrowings from the Fed are under $1B. It was a big deal in August when in a clearly orchestrated and coordinated move, 4 big banks were persuaded to temporarily borrow $2B total, in an attempt to diminish the “stigma”. This is the Federal Reserve saying, “No more pussyfooting around. You will borrow, and not $1 or $2 billion, but $40B, now!”

3. I agree with several commentators (Felix Salmon, Calculated Risk) that the Bair/Paulson Plan, whatever it is, is not a bailout. But this, this is a bailout,. Nearly all government bailouts take the form of subsidized loans, extending credit at low rates to counterparties or against collateral for which the market would have demanded a high premium. That is precisely what the TAF will do. The Fed’s press release claims, of course, that loans will only be available to “sound” banks, and that they will be “fully collateralized”. But no one who can get the same deal from private markets will use this facility. The need for the program arises because private markets are skeptical about the soundness of counterparties and the quality of the assets they have to offer as collateral. The Fed hints at this when it mentions the “wide variety of collateral” that can be used to secure loans. You can bet that whatever it is private lenders are eschewing will be pledged as collateral to the Fed under TAF. The Fed is going to bear private risk that the market refuses to. That is a bailout.

4. The rate at which funds are lent could turn out to be be an interesting number, but probably won’t. This rate will be bounded within a narrow range. It can’t go much lower than the expected Federal Funds rate over the term of the loan (there would otherwise be an arbitrage for very creditworthy banks — borrow TAF, lend Federal Funds). Presuming consistent standards for collateral and creditworthiness, it can’t go higher than the ordinary discount rate (since banks would just go to the discount window directly rather than bid in an overpriced TAF program). In theory, the TAF rate could tell us something about the state of the credit markets. If it is close to the Federal Funds rate, it would mean that few parties are experiencing problems borrowing cash against their assets, while if the TAF rate were near the discount rate, that would signal credit market, um, turbulence. But interpretation of this number is going to be made complicated by the scale of monies being offered. To lend 40B cash fast, the Fed may well have to offer the money at near the Federal Funds rate, because the particpation of very creditworthy banks will be required to get rid of the dough. But less creditworthy banks will be participating as well, and, in a single-price auction, these banks will enjoy the low interest rates effectively set by large-bank bidding. So, it is likely that the TAF rate will be very close to the expected Federal Funds rate, but that noncreditworthy borrowers pledging iffy collateral will gain the capacity to borrow at that rate. The effective discount window “penalty” will drop to about zero, even though the formal discount premium will stay at 50 bps.

There’s much more to say about all this. (Systemic implications? will it be effective against the crisis? what’s the role and meaning of the “global coordination” aspect to all this? etc., etc.) I have a meeting. Very blogospherically, I’m going to hit send and go without even a proofread. Please forgive my enthusiasm, and any errors that might come with.

Update: Of great significance to the workings of the international financial system… I’m Steve! A couple of very fine bloggers have linked to this post, referring to me as Randy. [Both fixed now! Thanks!] I include my middle name in my punditizing to distinguish myself from a more famous Steve Waldman who most emphatically is not me! Also, my last name has just one ‘n’, and I should not be confused with the much smarter and better looking Robert Waldmann, who is blessed with two letters ‘n’. Finally, I’d like to clarify a bit that my “enthusiasm” for the TAF plan, and my suggestion that it is “brilliant”, should be understood in very narrow terms. From the perspective of policymakers whose goal is to put out a fire while minimizing changes the existing structure, I do think the TAF is a stroke of brilliance, although it may lead to some hard choices down the line (more later). But I want to emphasize, that perspective is not my own. I believe that capital markets and the global financial system are in quite urgent need of reform. I don’t support palliative measures unless attached to credible reasons to believe that they will put us on a path to change, rather than extend a quite awful status quo. So I don’t “like” the Term Auction Facility. But I do admire its cleverness.

Update 2: Note Felix Salmon’s comments (with the help of Alea’s jck) on discount window collateral.

The news du jour is a quickening of interest in an idea originally mooted by the FDIC’s Sheila Bair, now adopted by U.S. Treasury Secretary Henry Paulson, that would freeze resets wholesale for certain classes of struggling mortgages. The Victorians among us, cluck and tutt at, yes, the moral hazard and perverse incentives implied by this sort of plan. Fortunately, no one ever listens to us.

Elizabeth Warren offers up a combination of pragmatic and Victorian concerns, among which are that “lawsuits will fly thick and fast, enriching the lawyers and tangling up the homeowners.” Felix Salmon argues not, but he’s mistaken, and he himself explained why. Besides teasing Felix, understanding this issue sheds light on why this plan could be an important tool in resolving the current credit crunch. Big hint: It ain’t (primarily) about helping homeowners.

Here’s Felix, today:

Most loan modifications actually increase the total amount of money that the investors stand to receive. In this case, it’s conceivable that… bondholders might get a bit less money than they would otherwise. But that’s a really hard calculation to make, and unless you can make that calculation with some certainty, it’s going to be very hard for you to show damages. Let’s assume that an investor in an RMBS tranche can compellingly show losses of say 5 cents on the dollar as a result of the Paulson plan. (We’re talking about the difference, remember, between the present value of what that investor will now receive and the present value of what that investor would receive were the plan not in place.) Given the size of individual RMBS tranches, and the number of investors they were sold to, that investor probably has no more than about $20 million invested in the tranche. Which means that he’d be suing for $1 million. Not worth it… What if he put a class action together, and got all the owners of that tranche to sue? Well, maybe the tranche was $50 million in total. We’re still only talking $2.5 million in damages here.

Now, here’s Felix with the answer, on Friday:

In reality, it’s almost certain that some bondholders would benefit from this scheme, while others would lose out.

Suppose it is true that, on-average, cashflows to the whole class of affected securities changes very little under the workout, that the savings to investors from avoiding defaults roughly balances the cost of the reduced income stream. Consider what this workout does to the certainty of cashflows for any particular MBS pool. Prior to the workout, under a low-default scenario cashflows are very high, while under a high default scenario they are very low. In the “good case”, the senior tranches get paid, but so do the tranches a few levels down. In the bad case, the junior tranches lose everything, and the senior tranches lose some fraction of their value. For valuation purposes, the marginal junior tranches now resemble at-the-money call options, valuable when outcomes are volatile, worthless when they are certain.

And what would the Bair/Paulson plan do? It would increase the certainty of the cash flows, to a level where, on average, senior tranches would be made whole, but marginal tranches would lose out. In other words, even if the effect on total cashflows in the aggregate is very small, the Paulson plan would wipe out the option value of tranches at the margin. Holders of these tranches won’t take a 5% haircut, but a 100% haircut off the tranch’s current value. You betcha they’ll sue if they have any hope of relief. [*]

On the other hand, holders of senior debt will be made whole with much greater certainty. The proposal effectively represents a transfer of wealth from junior to senior trancheholders. Which gets us to its clever systemic implications.

The current credit crunch stems not from the absolute scale of writedowns, but from the distribution of the losses. Highly leveraged entities with very little capacity to bear risk, who thought they were holding “supersenior” (but yield enhanced!) securities, are facing catastrophic unexpected losses. If those losses could be shifted to investors with a greater capacity to bear risk, the systemic implications would diminish towards the absolute scale of the losses, that is, towards insignificance.

Less senior trancheholders are being asked to take a hit, because they can, to save other investors who can’t afford their losses. From each according to his ability, to each according to his need. You’ve gotta love capitalism.

[*] To understand this better, recall that the total world of securitized mortgages is divided into distinct pools, each of which (simplifying some) backs a security, which is then subdivided into tranches. Without the Bair/Paulson plan, some of these pools would do well enough to pay the senior tranches and a few junior tranches, while other pools would do poorly, wiping out the junior tranches and forcing the senior tranches to take a haircut. Under the proposal, all of our stylized-just-at-the-margin junior tranches get wiped out, while all the senior tranches are made whole. Prior to the payment streams actually developing, we can’t know which pools would pay-off junior tranches and which wouldn’t, so all these tranches currently have some value, like a lottery ticket. That value would be wiped out under the plan. Note that some junior-tranche investors may have done due-diligence on the quality of credits in the underlying pool (or relied exclusively upon unusually high-quality packagers), and these investors might expect with high probability that the “good scenario” would unfold. Under the Bair/Paulson scheme, these investors would be wiped out anyway, and therefore penalized for their efforts (due diligence is expensive), unless you believe that it’s possible (and equitable) for those executing the plan to separate those who can and can’t afford a reset with very high precision.

On Friday, St. Louis Fed President William Poole gave a speech called “Market Bailouts and the Fed Put” (hat tip Calculated Risk). Poole discusses “whether Federal Reserve policy responses to financial market developments should be regarded as ‘bailing out’ market participants and creating moral hazard by doing so.” Unsurprisingly, Poole thinks not.

How many investors today measure the value of a bond by the likelihood that it will continue to pay interest “under the acid test of depression”? How many investors today maintain portfolios robust against the possibility of inflation of the magnitude experienced in the 1970s or deflation of the magnitude experienced in the early 1930s? The answer, I believe, is “not many.”

The fact that few investors worry about extreme economic instability is a benefit of sound monetary policy and not a cost; changes in investor practice are conducive to higher productivity growth. The same is true for changes in household and firm behavior reflecting the greatly reduced risk of economic depression or even severe recession of the magnitude of 1981-82. If we did not believe that economic stability is good for the economy and for society, why would a stable price level and high employment be monetary policy goals? Just as a deductible changes behavior of insurance policyholders, so also does economic stability change investor behavior.

In other words, investors do take risks they would not have taken absent the “insurance” implicit the Fed’s stabilization policy. But this is not moral hazard. Rather, it is precisely the point of the policy.

Note the sly rhetorical maneuver in Poole’s last sentence, where he likens the change of behavior induced by the Fed interventions to those induced by an insurance policy deductible. A deductible, of course, encourages the insured to limit their risk-taking, to combat moral hazard, while Poole is claiming the Fed’s behavior increases risk-taking, albeit in manner that he claims is beneficial and should not be called moral hazard. Likening the two makes Fed policy seem conservative or prudential, despite Poole’s admission that its effect is to encourage risk taking.

Putting that aside, Poole is right to note that an increased level of risk-taking due to insurance does not in and of itself imply moral hazard. Insurance is crucial to an entrepreneurial economy precisely because operating a business often entails risks that are simply too great for the entrepreneur to bear alone. If there were no liability insurance, workers comp insurance, property insurance, etc., many small businesses would never come to be, and the best of those small businesses would never become engines of creation and growth that enrich us all. Insurance exists precisely to allow people to take risks they would not otherwise take. That is not moral hazard. It’s the insurance business’ core function, and not something insurers discourage at all.

Insurers call behavior “moral hazard” not when people take on risks that they otherwise would not have taken, but when they take on risks greater than those that were priced into their policy. A well-designed insurance policy does not permit an entrepreneur to escape the costs of their risk-taking. It simply alters the distribution of those costs: Instead of experiencing rare but catastrophically large costs, the insured bears the full expected cost of her behavior, but in the form of regular, predictable payments. Ideally, insurance puts a price on risk, and internalizes the cost of risk-taking, so that actors can rationally choose which risks are worth taking, and which are not.

To the degree what the Fed does is offer insurance to firms and investors, it is inherently creating moral hazard, because those actors are not paying an appropriate premium for the insurance. Homo economicus, when insured at a premium that bears no relationship his behavior, will maximize risk-taking, since the cost of risks gone bad will be borne by others, while the take from gambles that succeed will be his to keep. Among the fully insured, prudence is idiocy. In a competitive environment, the prudent will simply fail to survive. Eventually, the aggregate costs of other people’s bad risks become too large for the insurer to bear, and then no one survives. Overinsuring private risk creates systemic risk.

Now Poole claims that this kind of thing is not happening, that whatever it is the Fed does, it does not bail out those who take on bad risks:

Federal Reserve policy that yields greater stability has not and will not protect from loss those who invest in failed strategies, financial or otherwise. Investors and entrepreneurs have as much incentive as they ever had to manage risk appropriately. What they do not have to deal with is macroeconomic risk of the magnitude experienced all too often in the past.

Obviously, Poole is right at a certain level. Firms and investors lose money every day. The Fed does not sit behind each and every actor in economy, absorbing every loss while smiling on private gains. But no critic of the Fed has ever suggested any such thing. The Fed’s propensity to intervene in a crisis reduces the private costs of certain kinds of risk-taking, but does not eliminate those costs. To continue with an insurance analogy, the Fed is like an insurer that collects no premiums, but unpredictably pays out only 20% of all claims. To risk-averse actors, that’s like no insurance at all. But to financially strong, risk-neutral (or leveraged, risk-loving) investors, the “Fed put” reduces the average cost of failure substantially. This leads to a broad underpricing of risk, or an overpricing of assets.

“Overpriced assets” sounds anodyne, even benign. That’s wrong. When assets are overpriced, real resources are destroyed. Real people sacrifice real goods and services to some enterprise that is likely to produce less than the value of the goods and services originally sacrificed. If monetary policy shifts so that the investors come out whole in financial terms, that doesn’t alter the fact of real economic destruction. It simply socializes the costs. Monetary policy and microeconomic outcomes sit far from one another, and the trail of tears evaporates quickly. Perhaps, as Alan Greenspan suggests, we owe the new home development ghost-towns appearing across the country to a post-Cold-War peace dividend. But I think the Fed, and, more broadly, the broken US financial sector had a great deal to do with the tremendous misallocation of real resources that was the late housing boom.

It’s common and easy to criticize the Fed. When histories are written about the hard times ahead, I don’t think the Fed will be the central villain of the piece. There are so many deep flaws in the American and global financial system, so many absurd institutions, shortsighted, foolish, and corrupt players, I think the Fed is more likely to be viewed as inept cheerleader than central protagonist. But Poole’s speech is a defense of cheerleading.

It is the job of financial markets to price alternative uses for scarce resources, which is almost entirely about pricing risk. But in the short run, it is always tempting to hide risk, rather than to price it. When financial alchemists tout diversification and securitization as magic bullets, they are hiding risk rather than pricing it. When, as Poole notes, the wizards of the 1980s sold “portfolio insurance” prior to the 1987 crash, they were hiding risk rather than pricing it. When loan “originators” rely upon FICO scores and stated income to produce assets they quickly flip, they are hiding risk rather than pricing it. When the Fed intervenes to stabilize the US financial system despite Wall Street’s increasingly poor stewardship of the nation’s real economy, it is hiding risk rather than allowing risk to be priced. Unpleasant events in financial markets aren’t to be tolerated because they “punish speculators”, but because financial markets must accurately reflect the state of the real economy in order to allocate resources properly. The longer risk is hidden, rather than priced, the greater the pain when the consequences of poor choices can no longer be ignored. We will have to face that pain eventually, despite the fact that it is least well-off who will bear the brunt of it, rather than the bankers, traders, and dealmakers who got us here. Hopefully the hard times will be short, and we will have a chance to do better next time.

Update: For a more enthusiastic reading of Poole’s remarks, try Mark Thoma. Also, Stephen Cecchetti has published an essay which, while not referring to Poole’s speech directly, makes almost precisely the same points. An earlier essay by Cecchetti in favor of contract standardization and clearinghouse-based trading (frequently highlighted by Yves Smith) was wonderful. But on the question of central banks and “moral hazard”, I can’t quite agree with either of these good professors.

It’s easy right now to view the Fed as trapped. If the Fed fails to lower rates, asset prices will continue to collapse, the housing crisis will worsen, and the broad economy will suffer. If the Fed does lower rates, capital flight from the US will continue, gold, commodities, and foriegn currencies will surge, and weakness of the dollar will eventually translate into a dangerous inflation. The Fed is damned if it lowers, damned if it raises, and damned if it does nothing at all. In the usual cliché, the Fed is “in a box”.

But the Fed has more options than “raise or lower”. Let’s go back to Bernanke’s famous 2002 speech about deflation. Note that the root of the current crisis is deflation, though of a particular kind, a deflation in the value of certain financial assets. If all the terrible paper Wall Street has been producing over the past few years really had been as solid as their boosters and the rating agencies claimed, we’d have no crisis today to fuss about. A collapse in the value of supposedly “ultrasafe” assets held by parties with little capacity to take risk or bear losses is at the heart of the today’s financial mayhem. Whatever its deeper roots, the proximate cause of the crisis is a deflation.

Here’s Dr. Bernanke:

[T]hat deflation is always reversible under a fiat money system follows from basic economic reasoning… [T]he U.S. government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at essentially no cost. By increasing the number of U.S. dollars in circulation, or even by credibly threatening to do so, the U.S. government can also reduce the value of a dollar in terms of goods and services, which is equivalent to raising the prices in dollars of those goods and services… Normally, money is injected into the economy through asset purchases by the Federal Reserve. To stimulate aggregate spending when short-term interest rates have reached zero, the Fed must expand the scale of its asset purchases or, possibly, expand the menu of assets that it buys.

…

Unlike some central banks, and barring changes to current law, the Fed is relatively restricted in its ability to buy private securities directly. However, the Fed does have broad powers to lend to the private sector indirectly via banks, through the discount window. Therefore a second policy option, complementary to operating in the markets for Treasury and agency debt, would be for the Fed to offer fixed-term loans to banks at low or zero interest, with a wide range of private assets (including, among others, corporate bonds, commercial paper, bank loans, and mortgages) deemed eligible as collateral. For example, the Fed might make 90-day or 180-day zero-interest loans to banks, taking corporate commercial paper of the same maturity as collateral. Pursued aggressively, such a program could significantly reduce liquidity and term premiums on the assets used as collateral.

The first thing to note here is the candor and prescience of Dr. Bernanke’s remarks. The future Fed chairman is describing very unconventional monetary policy options, and discussing how the central bank could, in a time of crisis, circumvent regulatory obstacles designed to constrain bank behavior. And obviously, these turned out to be more than mere musings. Bernanke’s first response to the present crisis was to try to lend indirectly to holders of struggling collateral via the discount window.

Suppose that the Fed were not restricted in the sorts of assets it could buy. What might the Fed do about the present crisis? Consider the obvious. The Fed could bail out holders of the compromised paper. It could determine a “fair long-term value” for all those struggling RMBSs and CDOs, something less than par but much higher than the market bid, and purchase securities outright with freshly printed money. You might think that a cash bail-out would be inflationary, and “ceteris paribus”, it certainly would be. But “ceteris paribus” doesn’t hold here. By strategically choosing which assets to buy, the Fed could mitigate the harm that higher interest rates would otherwise do to the financial sector. Becoming the “bagholder of last resort”, the Fed would purchase the freedom to raise interest rates without provoking a “nonlinearity” (knzn‘s delightful euphemism for a meltdown). The Fed would have its cake and eat it too. It would promote full employment by stopping a dangerous financial crisis in its tracks. It would promote price stability by hiking interest rates to support the purchasing power (and FX value, and commodity value) of the dollar.

There would be some danger that, even with the banks bailed out, interest rate hikes would slow the economy. But that hazard is unusually small now, because the binding constraint on lending is not the Fed-set interest rate, but concerns about creditworthiness and quality of collateral. The larger the credit spread is, the less of an effect changes in core rates have upon behavior. Raising rates certainly won’t help homeowners struggling with their mortgages, for example. But it won’t hurt homeowners who have no hope of refinancing affordably anyway. There will always be someone caught at the margin. But in macro terms, a bad situation would be made very little worse by a moderate rate hike, if the financial sector could withstand it.

In reality, the Fed is not permitted to buy up dodgy CDOs outright. But as Bernanke has suggested, lending on sufficiently easy terms can approximate a purchase. Bernanke’s initial try at using the discount window to fight the structured-credit deflation didn’t work. But it was not a very radical attempt. So long as there is a “penalty spread” between the federal funds rate and the discount rate, any use of the discount window signals a lack of confidence by other banks and is reputationally costly. Suppose the Fed were to offer to lend against specific sorts of collateral at a negative spread to Federal Funds. Then all banks would have a clear financial incentive to take advantage, regardless of the quality of their own portfolio. Banks holding the privileged collateral might claim their assets are performing beautifully, but that it would be foolish not to take advantage of the Fed’s subsidy. Lining up at the discount window would suddenly become shrewd rather than shameful.

Of course, this might not work. Markets might be spooked rather than reassured, a l&agrave the Northern Rock fiasco. And even if it would work, I don’t advocate any of it. I don’t mean to be a “liquidationist“. But piling moral hazard on top of moral hazard, making ever lighter the consequences of poor choices by people whose choices are consequential for all the rest of us, strikes me as a bad way to encourage quality decision-making.

Nevertheless, if financials and asset prices continue to struggle, while commodities spike and the dollar falls, expect the unexpected from the Federal Reserve. Ben Bernanke has devoted his career to thinking about how a central bank might forestall financial catastrophe. He will not confine his options to “quarter point or half a point, up or down”.

Apparently GM is going to take a $39 billion dollar writedown of deferred tax assets this quarter. Wow.

The phrase “deferred tax assets” is one of many powerful hexes the accounting profession has invented over the years. Recitation of the words before ordinary mortals causes eyes to glaze and specks of spittle to appear at corners of the mouth. For an explanation, see the end of this post.

Anyway, as all the overnight press on the matter is careful to emphasize, these are non-cash charges, and they could be reversed if GM becomes profitable soon. Nothing to look at here, just move along. It’s an accounting thing, you wouldn’t understand.

But here’s an accounting thing for you. Check out GM’s top-level balance sheet last quarter (the quarter ending Jun-07). Look at the line called “Total stockholder equity”. Yes, it really does say negative 3.5 billion dollars.

Suppose GM offsets the writedown of tax assets with $9B of gains elsewhere, so that the net charge is, um, only $30B. (For example, they’re expected to report a gain of $5B on their sale of Allison Transmission.) A $30B net charge would bring GM’s accounting equity down to negative 33 billion dollars.

Is that a record? What’s the maximum negative accounting equity ever reported by a going concern? Or, consider this: GM is not a penny stock. The market imputes a lot of real value to those claims worth negative dollars on its balance sheet. GM’s market cap as of yesterday was about $20.5B. That’s a positive number. GM’s stock price fell after-hours on announcement of the charge by about 3%. So, incorporating (at least partially) the new information, the market imputes about positive $19.9B of value to roughly negative 30 billion dollars worth of book assets. There’s a nice fifty-billion dollar spread between market and book value. If GM could keep that spread, but bring its book value up to positive a billion, it would look like an incredible growth company, with a market to book ratio of 50 times! Google looks cheap by comparison.

Now, there are serious problems with accounting equity as a measure of value. GM is an old company. Perhaps it owns a lot of real assets that were purchased decades ago and are still valued on its books at 1940s cost. Could be. But it takes a lot of adjustments to get out of a hole $30B deep.

An interesting factoid from the WSJ. GM’s total net income for 1996 through 2004 totaled $34 billion dollars, less than is disappearing in tomorrow’s accounting “poof”.

Here’s a question: What percentage of GM’s market valuation do you think is based on a market-perceived “too big to fail” guarantee by the US government?

For those who want to know, “deferred tax assets” arise when firms recognize expenses before they are allowed to take a tax deduction for those expenses. Let’s say a large New York bank decides some of its assets are worth 10B less than originally thought, and writes those assets down on its balance sheet. If the bank pays a 35% tax rate, 3.5B of that “loss” should eventually be absorbed by the government in the form of reduced tax payments. But companies don’t get to pay fewer taxes whenever they change their estimate of the value of an asset. The bank gets a cash write-off on its taxes only when the assets are actually sold and the firm realizes a loss. In the meantime, the firm recognizes a 3.5B “tax asset”, the value of the future tax savings it expects. This is all perfectly legitimate — writing down the assets without recognizing the expected tax-savings would badly overstate costs. But sometimes a firm’s estimate of future tax savings turns out to be wrong. Say the bank is forced to sell the impaired assets when it is already losing money. Then there is no immediate tax savings, because the bank wouldn’t have paid taxes that year anyway. The firm may still be able to “carryforward” the loss, and recover some of the tax savings. Or it may not. Tax laws are complicated.

GM had previously estimated that it had $39B in future tax write-offs coming to it. Its accountants now think the company might never get the chance to use them. Though this is not a cash charge, it is not a good omen either. Firms realize tax assets when they are profitable enough to have a large tax bill to take deductions from. GM is basically announcing that it’s unsure it will earn enough money to be able to take advantage of its pent-up tax offsets before they expire. Tax asset writedowns are insult-to-injury kind of events. Firms get hit with the accounting charge when, and precisely because, they can’t make enough money to have a tax liability to escape from.

Tax asset writedowns might also be a signal of distress, indicating that a firm lacks the flexibility to time its loss realizations advantageously. Tax laws are complicated, and sometimes tax benefits expire regardless of what a firm does. One mustn’t draw conclusions. Still, it does make you wonder.

FD: I have no direct position in GM, but I am short the Dow.