Thursday, March 26, 2009

Defending the Brand

Why do people buy Tylenol instead of generic acetaminophen? They're the same medicine. Yet lots of people do buy Tylenol. Why? They trust the brand! They believe a bottle labeled Tylenol will contain pure, safe, acetaminophen. That other bottle? Who knows. We don't know who makes it. The brand matters.

Why did our trading partners buy US AAA-rated securities? Lots of credit worthy entities are out there borrowing and paying more interest. Why go for the expensive paper? It's the brand. US AAA-rated. Aside from Treasuries, there is nothing more secure, nothing more reliable. If lenders couldn't trust that rating, borrowers would have to pay an enormous premium to get money. Investors who once looked only at the rating would have to inspect issuers in far greater detail and then form their own fallible judgments, discounting along the way for their own fallibility. Some might stop lending entirely to anyone but the Treasury.

That, indeed, is what happened to our credit markets. The silly interest rates at which our fast-spending government is able to borrow these days result from its having the only good brand name of any seller of dollar-denominated paper. Plenty of "generics" are out there, but they are rated by outfits with tarnished brands. Why would anyone trust those ratings? And the underwriters themselves? Can we count on their probity? Their financial strength? Not hardly.

This, then, is the real challenge facing the stewards of our economy. How do we restore the brand? How do our trading partners find the confidence to lend to and through our financial institutions rather than to the U.S. Treasury?

The rescue and bail-out efforts underway make sense if viewed through the lens of brand protection. In effect, the Fed, the Treasury and the FDIC have collaborated to make good on every AAA-rated piece of paper they can – I hope they find a way to disavow credit default swaps in the hands of non-creditors – visiting losses on the equity holders of the entities that issued them and absorbing the rest on behalf of the US consumer. I say “consumer” rather than “taxpayer,” because it is our continued ability to consume that is at stake. We need to understand that it is as consumers that we have banded together to keep the credit flowing. The tax system just does the bookkeeping.

We also need to understand that no institution has been bailed out for its own sake. No one in government is resisting the equity losses or even the job losses at major financial institutions. What they are resisting is the failure of the brand – the failure of an American dollar-denominated, AAA-rated instrument to pay off. We need the rest of the world to believe that such documents will never cause them a loss. Who has to be saved along the way – and who has to be given a retention bonus to stay and pay – is purely coincidental. That's why all this fuss about foreign banks getting TARP money is completely misplaced. The whole point of TARP was to enable American institutions to pay their counterparties, whoever they were. It wasn't to “protect” anyone from loss, per se; it was to protect the brand by seeing to it that there was no loss to those who trusted it.

The damage to the brand has affected the components that make up the brand, and each must be restored if the brand is to be restored. For example, were we to wake up tomorrow in the presence of a ratings agency that had magically earned the credibility of the world, that agency would be unable to issue any AAA ratings because the rated entities have “toxic assets” on their books, making them unworthy of the AAA rating. Those assets were once AAA-rated themselves, but that was by the old ratings agencies whose ratings don't mean anything anymore. So, the new agency has to re-rate all the bonds on the banks' balance sheets in order to determine whether the bank itself can have a AAA rating. Even then, a market would have to develop for the re-rated assets. It's a very daunting task. And, anyway, there is no such ratings agency.

In the meantime, the banks are at least trying to establish the value of their own capital in light of the government's likely insistence that they bolster their balance sheets. The PPIP plan (see posts below) should do a good job of establishing the capital base of the banks. But then, what of the ratings agencies?

I'm afraid they may be done for. I think something like Underwriters Laboratories, an independent entity funded by users of ratings, is the way to go. Eric Dinallo, the head of the New York Insurance Department, proposed something like that this morning. That model should work, but it will take time to create such an entity. Indeed, the Government should consider nationalizing S&P, Moody's and Fitch's ratings operations, paying fair compensation for the infrastructure – the brand is not worth much – and hand them over to an independent board to merge and run. Once the reliability of ratings is restored, lending to the private sector can begin again in earnest, subject to the capital constraints discussed in my previous post.

Until then, perhaps something like real underwriting will occur, with well-capitalized investment banks standing behind the paper they sell as proof that they are not in it only for the fees. There are lots of way for the underwriter to have some skin in the game, and I don't believe it matters which one is used. But until we have a buy-side ratings agency, the only way the American brand can be saved is for the sellers of our paper to stand behind it.

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