For example, if the haircut was 10% and the value of the security was $ the most the investor could lose would be $ Thus, the facility eliminates much of the downside risk that would arise from a very deep recession or the fire sales of assets that could cause prices to drop sharply temporarily. This is a very exciting program because it provides balance sheet capacity to risk capital that cannot currently get leverage. It goes beyond current programs. Just as important, once it is up and running it can be scaled up and out in many different dimensions. In principle, it could be applied to other distressed asset classes, it could move down the credit spectrum to lower-rated tranches, and it could be used to fund older vintage assets. Two other important initiatives are also in train that deserve note. Last week the Treasury and the major banking supervisors announced the details of a capital stress assessment process for all bank holding companies with assets in excess of $ billion. This process is designed to ensure that the banking system has sufficient, high-quality capital to be able to absorb the losses that would likely be generated by an economic scenario considerably worse than generally expected. The stress assessment assumes an adverse economic environment. For example, under this scenario, the unemployment rate is anticipated to average more than 10% in 2010, considerably higher than the consensus economic forecast. The stress assessment will unfold in three steps.
This desire to postpone capital raising stems, in part, to the fact that bank executives often do not want to dilute the existing shareholders (which, of course, include themselves). I believe that the management calculus has often gone like this: In good states of the world, I have enough capital. In bad states of the world, perhaps I don’t. But to raise enough capital to guarantee I can endure all the potential bad states of the world, I will have to massively dilute my existing shareholders now. So the self-interested thing to do is to avoid the dilution and hope for a good state of the world. This does not always work well in practice. Once capital preservation becomes paramount, deleveraging intensifies and counterparties grow more wary about engaging. This dynamic, in turn, makes a bad state of the world more likely. What may be sensible for each institution individually, may collectively be a bad idea. That is because each firm does not internalize the cost that their decision not to raise capital has on the overall financial system. A healthy banking system is always essential. But never has that been more true right now given what has happened to the securitization markets and the broad “shadow” banking system. So where are we now? In my view, the deleveraging process is still far from complete. Hedge fund redemptions have soared.