Thursday, December 11, 2008

Would asset price fixing have solved the problem?

The response to the crisis has been fast and powerful. The question is - is it the correct response? As Percy Mistry puts it in his Financial Times column, the first montary expansion was directed at averting financial collapse. The second, the one thats currently underway, is about kickstarting the system - getting a consumption driven US economy to consume.

Was there any other way out of this? A possible way could have been US government fixing the price of housing across the country through use of a formula based mechanism. This would have paved a way to price the derivatives and resolve the matter between market participants hopefully without government intervention. Any derivative is first a derivative and gets priced as soon as the asset is priced with fair degree of confidence.

Guaranteeing the home loans at this prices could be a second prop. This would have protected the individual financial system by fixing the floor. 

Beyond this the government should let the financial system resolve itself. First the market participants should start from the floor price set by the government and price discovery will help establish a price level far lower than what we currently see but definitely higher than otherwise. 

This would have created a huge amount of collateral damage. Firms would have been wiped out but the markets would have continued to function because the value of underlying asset was known. But its possible that we would have avoided further cascading effects and impact on individual financials. In the end both will be equally costly - but this one would be much saner.

Now am I missing something here? Probably concurrent devaluation of overseas assets and mark-down of about 600 trillion of derivative positions into something equal to 60 trillion. This looks potential hunting ground for creative accounting standards. But this seems one interesting way. What say?