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Thursday, October 2, 2008

A giant step backward in solving the financial crisis

One of the features of most of the "rescue" (bailout) proposals floating around Washington, D.C. is to let banks show their assets on their books at something other than "fair value," which was the required standard until the SEC more or less suspended it the other day. "Fair value" is the price that an asset could fetch on the open market as of the date of the company's balance sheet. Banks who have made bad investments and are afraid to tell the truth about it have convinced the SEC, and even well intentioned reformers like Peter DeFazio, that the current open market is so panicky that the free market price isn't really a "fair" reflection of the assets' true worth.

And so the SEC, and our leading lights in Congress, are going to let the banks show assets not at "fair value," but at "economic value," which in a recession is usually quite a bit higher -- unrealistically so. To come up with "economic values" to put on their balance sheets, banks can ignore real market conditions and make up their own pretend market in which everything is "orderly." The numbers that result are nothing more than glorified guesswork, with no anchor in reality. It's faith-based accounting.

A large part of what got America into the mess we're in today was creative bookkeeping. By abandoning the "fair value" standard and substituting a strictly hypothetical, theoretical measure of value, the SEC and Congress are letting the bankers continue to obfuscate their true economic positions. It's like going to the doctor, and when she tells you you're terminally ill, you demand that she tell you how you'd be if your disease wasn't fatal. It's like standing on top of Mount Everest, freezing to death, and telling your companions that you're fine because if it were 80 degrees, you'd be hot. It's a major move in the wrong direction.

The SEC's unilateral action Tuesday, which came just in time to distort banks' September 30 quarterly financial statements, is particularly misguided. Maybe hothead McCain was right and we need a thorough housecleaning over there.

Comments (24)

You think that's a distortion? I served on our little town's budget committee for a few years...that is real distortion. I followed Portland's open budget meeting , under Katz and that was even worse. Yup audits of Districts and cities is a horrific hoax. So why not financial empires? While all the fretting over the supposedly Underground Economy was going on, I worried over the above ground economy.
Ever tried reading an annual report? Pure hogwash. A friend once remarked the slicker and prettier the report the more devious.

Fair Value was one of the reasons this "death spiral" happened. SEC mandated a market value approach to balance sheets. That was a "good thing". The accountants, through FASB and the AICPA, came up with Fair Value - not Market Value, but Fair Value. Market Value is well known, has been well defined and takes care of panicky markets. Importantly, no compulsion is allowed, knowledge on the part of both buyer and seller is demanded, normal contracts and terms are included, along with a host of other items that protect Market Value from getting off base because of temporary conditions.
The accountant's Fair Value did not have a ban on compulsion, or any of the other protections built into Market Value. It had the requirement of a "market" (not well defined)and if there was no market, then usually a formula (that never worked in the best of times). So, when times were good Fair Value was too high. When the tide turned and the housing market topped out, Fair Value started the other direction - rapidly. When the first panicky sale happened, by a bank that was FORCED to raise capital, all the other banks had to mark their assets to the new, lower Fair Value. All this would be only an interesting sidelight except that the regulators demand banks meet certain capital ratios - think the amount of debt vs. amount of assets. Now, once the first panic sale lowers the value of all other banks' assets, their ratios start to get too low and more panic sales happen, which leads to more widespread asset write downs, etc. Thus the "death spiral".
Under the old rules, as an individual mortgage failed it would be written down and dealt with - individually. Importantly, the whole class of similar assets would not be written down as is true under Fair Value.
Why, you ask would accountants put the financial system at risk by inventing a new standard of value? My answer is greed and control. The accountants wanted to control the accounting process and have standards they and they alone controlled. [In the international world, that has had market value balance sheets for years, there is one group that controls the accounting standards and one group that controls valuation standards. That division works.] In the USA the accountants wanted to have a system from which accountants would earn the fees for the valuation, not appraisers, not Realtors. The Big 4 firms ruled FASB and the AICPA. Good people who knew what they were doing were on the committees that designed these standards. They got "confused" about what the end goal was and the country got bad standards that could not stand up to troubled times.
Ending Fair Value as it is now constituted is the first step in recovery from this mess. Mark-to-market is a valuable concept, one that will help all aspects of the financial marketplace. But Market Value has to be the standard.

This must have come up earlier this year, when auctions failed for "auction-rate securities". What is market value when there's no market? I know what it's not -- zero.

"the free market price isn't really a "fair" reflection of the assets' true worth."

I understand the hesitancy, but if no one knows the value of these portfolios since no one knows what the default rate is, it's hard to establish pricing. It may be par or $0.10 on the dollar. Again, it's like having a sale and no one comes to buy because of an ice storm. Just becaause no one buys doesn't mean your inventory is worth nothing. However, that's the flip side of this $700B - What price are they going to pay for these?

They may get a bargain (like Chrysler) or get stuck (like RTC)

Honesty is still the best policy. Our President and Congress have been leaders in dishonesty. How can we expect business to to better? Take the tax break for Oregon makers of arrows for children. I'm told it's buried in the current bailout for banks and finanacial institutions. Huh? It's up to us to change this.

Brother, Can you spare a derrivative?

Greg, Its ironic that mark to market came about at the REQUEST of hifi. Greed, indeed. If you suspend mark to market but allow mark to model the market ceases to function just as much as when the bid is zero.

Hey Ejs, with 6 derivatives you get one egg roll..

The problem with the "market" is not just the "ice storm" ... its that all the products are sold in unmarked boxes and buyers don't have a way to look inside. So, very few want to buy and those that are willing don't get to shop -- they have to buy on faith.

The fair value v. market value comparision in interesting. Any hope that's what's going to happen with the new valuation scheme?

"They may get a bargain (like Chrysler) or get stuck (like RTC)"

We know what the price of many of these assets should be. Quite a few mbs were sold at 20-30% haircuts last year. The problem is financial institutions are insolvent at even these relatively high prices. By spending precious capital on non-productive assets we will worsen the economic crisis. The banking system needs a restart not a liquidity infusion.

Also, you are misinformed. The RTC is widely considered to be a resounding success.

"The RTC is widely considered to be a resounding success."

By what measure?

"We know what the price of many of these assets should be."

I really don't see how you can say that. The portfolios were sold as ield instruments with an allowance for non-performing portions. That's the issue, how much is non-performing.

"buyers don't have a way to look inside."

You can look inside (if you wanted to), but establishing value is still the issue. That is what is keeping the buyers away.

Oh, derivative only has one "r". I thought it was from the same root as derriere.

1. The bill the Senate passed yesterday won't save the banks or the economy. You can't restore Wall Street's lost capital by buying junk at market. And if you overpay, it's like throwing cash out the window. Why is the Treasury doing this? It looks like they're just rewarding their friends and foreign institutions.
2. What the financial markets need is (a) a moratorium on foreclosures and interest rate resets for owner-occupied homes; and (b) substantial investments of government money in real things, like public infrastructure and alternative technologies for energy production.
3. We've had eight years of our government taking from the many (as in FICA surpluses) for the benefit of the few (as in income tax cuts). This bill is $700 Bn of the same, with lots more pain to come.

"FICA surpluses"
When has that ever happened? We're down to cash flow on FICA payments, forget about an actual account with money in it.

"a moratorium on foreclosures and interest rate resets for owner-occupied homes"

YOu still have the same problem of debt on the market with no takers and we're still locked up. If you freeze rate resets after you told everyone that owns the portfolio to expect a certain cash flow, now you've really bombed the portfolio.


Steve, I don't think you are thinking about this clearly. Are meds a problem perhaps?

Check your facts on FICA surpluses. They are huge. As a result, after China, the Social Security Administration is the largest holder of Treasury securities. Remember the "lock box" in 2000? None of that has changed. Cash flows from FICA are positive until at least 2017 under all reasonable projections.

And think about how it is better to have the option of foreclosure and rate resets for mortgagors who can't pay, who will have to leave their homes, creating vacant houses that drag down values generally in so many neighborhoods. How is that better than keeping those people in their homes on renegotiated terms? Either way, the aggregated mortgages, sliced and diced into MBS instruments, is going to have a diminished market value. I'm just arguing that the second-order effects from what i am proposing are smaller.


How was that for you?

Oh, and Steve, for a lot less money than the bailout contemplates, one could imagine the government subsidizing rates on outstanding mortgages so that the payment stream from mortgage-backed securities is not diminished.

If I had some ham, I could make ham and eggs, if I had some eggs.

"how it is better to have the option of foreclosure and rate resets for mortgagors who can't pay"

OK, if we would have started a year ago when everyone knew this thing was going south instead of waiting until it blows up, I could have seen it. However, most politicians have a planning horizon of about 20 minutes. Besides, once the $700B buys the debt, then govt can decide what they want to do with the mortgages that are left in the portfolios if they want to stall foreclosure.

"FICA surpluses. They are huge."

Does it matter if they get spent buying special T-bills that finance projects we blow money on. Besides to take your argument, even if we are cash flow positive 'til 2017, what happens after that? Shouldn't we start planning now or just wait?

I think one of the contributing factors to this financial mess is that CPA firms can provide both financial auditing services and tax services to their clients. In tax accounting, the legitimate goal is to minimize the amount of tax that has to be paid, and it requires learning the rules well enough to take advantage of them.

On the other hand, financial accounting and auditing should be principle-based. There are lots of detailed financial accounting rules, but at the end of the day, financial accountants should make their valuation/booking decisions based primarily on generally accepted accounting principles. They should not be deliberately bending or going around rules to maximimize the client's earnings or assets. Yet when the same folks provide both tax and accounting/auditing services, their tendency is to be rules-oriented, as that is how they have to be on the tax side and it provides the greatest opportunity to please the company CFO who pay their bills.

One solution would be to further limit CPA firms so that they can do tax work, or financial accounting/auditing work, but not both.

Does it matter if they get spent buying special T-bills that finance projects we blow money on. Besides to take your argument, even if we are cash flow positive 'til 2017, what happens after that? Shouldn't we start planning now or just wait?

You seem to want to change the subject. The issue was whether more comes in to FICA than goes out, currently, as benefits in the Social Security Administration. The answer is, emphatically, yes. That the federal government takes this money (leaving some paper behind) was my point to begin with. What this means is money is taken from working people (as FICA) and passed on to the rich (as income tax reductions). It's not hard to understand if you're open to it.

"You seem to want to change the subject."

Funny, I thought the subject was the bailout. FICA will blow up soon enough.

The media has been rife with anecdotal stories of soccer mom marge failing to get a loan for her suv, or joe and jane unable to clear their mortgage, or mr. whimple who is unable to get a loan to fix his soda fountain.

Well it turns out to be complete bull s***.

How bad is it?
Credit freeze hasn't hit small firms hard yet, but economic slowdown has
By Andrea Coombes, MarketWatch
Last update: 2:33 p.m. EDT Oct. 3, 2008
The portion of small-business owners who said credit was harder to get was "up a point or two" in September, but there was "no signal in the data that things suddenly got worse," according to William Dunkelberg, chief economist with the National Federation of Independent Business, a trade group representing small firms. NFIB surveys small-business owners every month.

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