Bad News Is Better Than No News

We need to know what's mucking up the financial system.

• By L. GORDON CROVITZ

We're now more than $1 trillion in taxpayer bailouts into the credit crisis, and the one enduring certainty is uncertainty. There is uncertainty about what caused the problem, uncertainty that either Wall Street or Washington knows what to do, and uncertainty about financial models that measured risk until they didn't. Markets thrive when information flows freely, and they seize up when uncertainty replaces understanding.

Stefan Rousseau/PA

So we should cheer a growing consensus that it's time to address the information gaps that caused the financial mess. The best-known unknown is the continuing mystery of the true value of the bad mortgage-backed and other assets held by banks whose collapse sparked the credit crisis. Addressing this basic issue was the original purpose last fall of the $700 billion government bailout program, but the Troubled Asset Relief Program didn't live up to its name, leaving the size of toxic debts unquantified.

Plan B is to go back to Plan A. Regulators urge using new bailout funds to return to the original goal of discovering the true value of these securities. "A continuing barrier to private investment in financial institutions is the large quantity of troubled, hard-to-value assets that remain on institutions' balance sheets," Federal Reserve Chairman Ben Bernanke said in a London speech earlier this month. "The presence of these assets significantly increases uncertainty about the underlying value of these institutions and may inhibit both new private investment and new lending."

Banks can't resume lending because they don't know how unsound they are. Private investors can't know how bad bank debt is, so they hesitate to invest in banks. There are echoes from the experience in Japan, where the collapse of a real-estate bubble in the 1980s became a drag on the economy for years as regulators put off the day of reckoning of the full losses.

Former Federal Reserve Chairman Paul Volcker suggests an updated version of the Resolution Trust Corp., which forced the bad savings-and-loan debts to be marked to market in the 1980s. Other ideas include creating a "bad bank" supported by the government to aggregate bad debt. Precisely how the bad debt is to be isolated is less important than the implied commitment finally to assess the value of houses, credit-card loans and other debt.

Achieving this price discovery is hard, but it is only half the battle. Before banks can get back on their feet and start lending again, financial professionals need more confidence that they know what went wrong and how to avoid more mispricing of risk.

Here, too, there is reason for optimism. Wall Street has been asking itself: Were its financial models fundamentally flawed, or did flawed financial professionals misuse the models? Take the example of the metric that banks use to manage their risk, or so they thought. Value at Risk calculations were developed in the early 1990s at J.P. Morgan to measure the different kinds of financial risk using a single measure. Banks analyzed historical data to understand the relative riskiness of a $50 million investment in three-year Treasurys versus 30-year Treasurys, or even a $50 million investment in Japanese yen versus 1,000 barrels of oil.

Bankers now recall the fine print of VaR analysis, which is that it always includes low but real risk that some new element could make the historical data a poor measure of the future. The late Dennis Weatherstone, the J.P. Morgan chairman who led this initiative, used to remind his team that the math of VaR alone could not measure risk in the outlying parts of the bell curve of probabilities. "The reason we pay as much as we do to traders is to manage the risk in the tails of the distribution," derivatives expert Mark Brickell, a former J.P. Morgan managing director, quotes Weatherstone as saying. "That's the hard part. For events inside the tails, it is not so difficult nor so remunerative."

It's now clear that the data that banks used were distorted by years of government initiatives to promote homeownership. Government-mandated loans led house prices ever higher and house-price volatility ever lower. When the VaR models looked back, they wrongly modeled a low risk of default. Wall Street shouldn't make the mistake again of ignoring the impact of politics on economics -- and politicians should find ways to achieve social goals without undermining the integrity of markets.

We've had credit crises before, but as this column has reminisced, a century ago J.P. Morgan was able to resolve the Panic of 1907 simply by gathering all the key bankers in his home library and forcing them to measure and accept their losses. Like all credit crises, the sooner ours is resolved, the sooner we can learn its lessons, take our losses, and move on. Tough as this process of discovering the full losses will be on shareholders and taxpayers, the alternative of continued uncertainty and market paralysis is even worse.