Wednesday, April 16, 2008

A Fictional Crisis

Yves Smith points to a scary story in the Wall Street Journal suggesting that banks aren't telling the truth about how high their short-term borrowing costs are. If true, this means that the LIBOR, and thus the TED spread (the difference between the 3-month LIBOR and Treasuries), are even higher than we think. And as Yves Smith points out, the official TED spread is already uncomfortably high:

So as we come to accept that the LIBOR doesn't measure banks' real short-term borrowing costs, it's important to remember that banks' balance sheets also don't represent their real financial condition, because the SEC has basically suspended mark-to-market rules for the most risky securities, telling firms:

"It is appropriate for you to consider actual market prices, or observable inputs, even when the market is less liquid than historical market volumes, unless those prices are the result of a forced liquidation or distress sale."
In other words, "mark to make believe": if you'd rather not report the actual market price of a security, you can just make up a price.

Combine the unreliability of both the LIBOR and banks' balance sheets, and we're now operating in a largely fictional world. What's worse, the TED spread is still very high, and banks are still taking huge write-downs. We can't even make up a world that isn't in a financial crisis!


Lockstep said...

Good summary on the issue. I read the WSJ article also. I am wondering what events will force an honest disclosure by the banks. I am short JPM and a lot of these bleeding banks. I think it would be good to discuss any o the scenarios that might trip up this charade. Any ideas?