Why the Stock Market is Crashing and How to Recapitalize the Banks

Today, the Dow Jones Industrial Average fell 7%. It's fallen for seven straight trading days now, for a total drop of 21%. This is a market crash. Wall Streeters would euphemistically would call it a "market break." But if it walks like a crash, squawks like a crash, and looks like a crash, we'd better face the fact that it is a crash.

Although there are many cross-currents in the market, there is an overriding reason for the crash. Our leaders in finance and government prepared us very poorly for this moment. For way too long, Wall Streeters demanded palliatives from the government that would make all the boos boos of the mortgage crisis go away. Government leaders, in turn, acted as if that was their intention. The Fed was creative and the Treasury Department was aggressive. Interest rates were lowered. New programs were devised and implemented. Federal loans became available to new classes of borrowers. Rarely, if ever, was anyone heard to suggest that a blissful fix, with no losses or pain to anyone, wouldn't be possible. We seemed to be in a world where six impossible things could be accomplished before breakfast, and the government could protect the values of all assets and investments.

Thus, when bailout after bailout produced only falling stock prices, newer and bigger bailouts, and an internationalization of the credit crunch, investor confidence was not simply shaken, but shattered. As stocks kept falling, some of those who were previously calm have joined in the selling, creating more sell pressure that further depressed stock prices and triggered more selling. There have been waves and waves of selling, because hope, so assiduously cultivated by corporate and government leaders intent on discouraging runs on the banks, is gone. No one knows how bad things will get and everyone simply wants out.

There is no way to predict when the market will bottom out. We're dealing with panic, and irrationality cannot be quantified. Nor can we predict when things will settle down. We can only know the fear and panic will eventually subside. They did before, in 1987 and in the 1970s, both times when the market fell sharply. They did in the 1930s, when the stock market fell 85% before taking the road to gradual recovering.

Let us remember, though, that the unwillingness of our corporate and government leaders to level with us about how bad things could get is much of the reason for today's panic. Of course, they were trying to maintain confidence, the key to all financial dealings. But unwarranted optimism will be eventually belied by the truth, and nothing undermines confidence as much as unexpected, unpleasant surprises. This market crash is what results when undue hope is allowed to triumph over knowledge of the truth.

Now, on to the truth. One can reasonably infer that the industrialized world's banking system is effectively insolvent. Maybe some institutions are individually strong, but the system as a whole is broke. Bank regulators haven't admitted this, but it's obvious from their conduct. Government officials worldwide are taking extreme measures to administer financial CPR, and every week comes with a new program or proposal. One of the most recent ideas is for the government to make direct investments in distressed banks. This nationalization of the banking system (let's not pretend that it's anything else) isn't a bad idea. For every dollar of capital invested in a bank, it can reasonably make ten dollars of loans. That ten for one ratio is a pretty good bang for the buck. Purchasing toxic assets (i.e., the heart of the $700 billion bailout program enacted by Congress), would probably free up less lending power for each federal dollar spent.

But federal investments in banks should come with a demand for housecleaning writeoffs of the toxic mortgage-related assets and derivatives that have been bedeviling the banks and tying up their capital. The most important reason for the credit crunch is that banks seeking to borrow from the private sector haven't been transparent enough about their balance sheets to inspire lender confidence. That's why the federal government has thrown a lot of liquidity at the financial system, with little tangible benefit. No one wants to lend, even if they have the money, when they can't discern the borrower's ability to repay the debt.

By way of analogy, consider whether you could get a loan from a bank without telling the bank about your other debts and liabilities. Maybe a few years ago, you'd have gotten a liar loan with a teaser rate. But now, you couldn't hope to get a loan without spelling out your financial condition and circumstances to the nth degree. Many large banks are still trying to borrow in the interbank market without being candid about their potential losses from mortgage-related assets and derivatives. It should hardly be surprising that they get the brushoff.

Time to come clean. Clarity and transparency are crucial to inspiring lender confidence, and writeoffs are essential to cleaning up borrower balance sheets. The price of federal capital should be full disclosure of the toxicity in the recipient bank's balance sheet. Moreover, the values of the nasty assets should be written down to amounts determined through prudent and conservative application of the relevant accounting principles. No smiley-face interpretations of the mark-to-market rules should be allowed. This trip by the banks to the woodshed may reveal that they're actually insolvent. So be it. We know that anyway and no amount of relaxation of the accounting rules will fool investors into believing otherwise (banks and regulators only fool themselves if they think that changing the accounting rules now will mollify investors, who may be stupid but aren't that stupid).

Full disclosure and writedowns would likely increase the amount of federal capital needed. That's okay. We should use the process of taxpayer bailouts to cleanse the banking system and get it started on the road to health. Simply burying the losses while giving the banks some financial methadone won't solve the problem. It will simply delay the day of reckoning. And when that day of reckoning arrives, the panicky selling that will be seen in the stock markets will make these days seem like a walk in the park.