Thursday, September 18, 2008

"Mark to Market" And The Law of Unintended Consequences - Updated!

Steve Forbes has spoken up with an insightful prescription to cure this mess.  Again, one of the chief issues is "mark to market" elimination.  He's got a very effective analogy that helps explain the impact of this deadly rule:
How to Cure This Sick System
Steve Forbes 09.11.08 Forbes Magazine dated October 06, 2008

Not even during the Great Depression did we witness what is now unfolding--a sizable number of big financial institutions going under. What enabled their taking on so much debt and so many questionable assets was, primarily, the easy-money policy of the Federal Reserve. Chairmen Alan Greenspan and Ben Bernanke created massive amounts of excess liquidity. If the dollar had been kept stable relative to gold, as it was between the end of WWII and the late 1960s, the scale of the bingeing in recent years would have been impossible.....
Also of immediate urgency is for regulators to suspend any mark-to-market rules for long-term assets. Short-term assets should not be given arbitrary values unless there are actual losses. The mark-to-market mania of regulators and accountants is utterly destructive. It is like fighting a fire with gasoline.
Think of the mark-to-market madness this way: You buy a house for $350,000 and take out a $250,000 30-year fixed-rate mortgage. Your income is more than adequate to make the monthly payments. But under mark-to-market rules the bank could call up and say that if your house had to be sold immediately, it would fetch maybe $200,000 in such a distressed sale. The bank would then tell you that you owe $250,000 on a house worth only $200,000 and to please fork over the $50,000 immediately or else lose the house.
Absurd? Obviously. But that's what, in effect, is happening today. Thus institutions with long-term assets are having to drastically reprice them downward. And so the crisis feeds on itself.
The SEC should immediately reverse its foolish decision to get rid of the so-called uptick rule in short-selling. That would provide a small road bump to the short-selling that's helping to destroy financial institutions.
At the same time the SEC should promulgate an emergency rule (which we thought was already the rule): No naked short-selling. That is, you have to own or borrow shares in a company before you can short it. The rules should make clear that short-sellers must have ample documentation proving they truly possess the shares at the time of the short sale. Otherwise, each violation will result in heavy fines. Thatwouldn't be a road bump but a wall of Everest-like proportions. Regulators should also be told to instruct banks to keep their solvent customers solvent. The last thing the economy needs right now is for the banking system to seize up.
The federal government should also consider setting up a new Resolution Trust Corp., which was devised during the savings and loan crisis nearly 20 years ago as a dumping ground for bad S&L assets. Today's bad assets could then be liquidated in an orderly way. And, finally, the financial industry should be encouraged to create new exchanges for exotic instruments. This would result in the standardization of these things, which would mean more transparency.
These steps would quickly revive financial markets. Already mortgage rates are coming down. It won't be long before American homeowners start an avalanche of refinancings, which would be an enormous boon to confidence and the economy. MORE....

Since the beginning of the housing bust and subsequent banking / financial meltdown I've been having discussions with one of my sons and daughter-in-law.  I'm just a marketing and sales guy, they're both finance people with MBA's.  My contention all along has been that the "mark to market" requirement that FASB and the SEC initiated after Enron are the main cause of the problem.  They're not in agreement with me.
When a mortgagee defaults on the loan and the house goes into foreclosure, it still has an intrinsic value way above zero.  It's still worth a hell of a lot, even if there may be a time element involved in realizing that value.
"Mark to market" however, requires that the institution holding that financial instrument that's now in default value it at zero.  Now, however, that debt has been sold, re-sold, bundled with other like-structured obligations, and then re-bundled in some very interesting and artful ways, then fractionalized so that a number of investors can share in bearing the risk. This has gone on to such an extent that the end holders can't determine if the investments that they hold have been devalued by any of the original defaults.  So.....they're required to value them at zero.  The chaos that has ensued is not hilarious - far from it.
I may not be skilled at manipulating number, but I’m fairly good on understanding concepts.  My initial perspective that “mark to market” has been the causal element in the current financial crisis seems to be validated.  It’s not the only problem, but to me it’s been the absolute catalyst for the entire mess. I now seem to have some support in the argument.  In today's Wall Street Journal, Zachary Karabell lays out a persuasive argument that the current crisis has been unintentionally designed by Congress, and then unintentionally engineered by FASB and the SEC.  MORE....
Bad Accounting Rules Helped Sink AIG
 ......Let's get a few canards out of the way: First, yes, stupidity and cupidity and complacency and hubris are involved, and yes, there is gambling in Casablanca. Second, the idea that there is this thing called "the free market" that governments tame or muck up with regulation is a fiction. Governments create the legal conditions for markets; markets shape what governments can do or are willing to do. Regulation versus free-market is a false dichotomy. Maybe in some theoretical universe, if we could start with a blank slate and construct society anew, it wouldn't be. But we exist in a web of markets and regulations, and the challenge is to respond to problems in such a way so that we decrease the odds of future crises.
And that is where AIG becomes instructive. Even good regulations can't prevent all future crises, especially ones that are the result of new technologies and changes that result from them. The capital flows, derivatives contracts and nearly frictionless interlinking of global markets today are the direct result of the information technologies of the 1990s. The implications weren't known until very recently, so it would have been nearly impossible for regulations to have prevented what is happening. But if good regulation can't prevent crises, bad regulations can cause them.
The current meltdown isn't the result of too much regulation or too little. The root cause is bad regulation.
Call it the revenge of Enron. The collapse of Enron in 2002 triggered a wave of regulations, most notably Sarbanes-Oxley. Less noticed but ultimately more consequential for today were accounting rules that forced financial service companies to change the way they report the value of their assets (or liabilities). Enron valued future contracts in such a way as to vastly inflate its reported profits. In response, accounting standards were shifted by the Financial Accounting Standards Board and validated by the SEC. The new standards force companies to value or "mark" their assets according to a different set of standards and levels.
The rules are complicated and arcane; the result isn't. Beginning last year, financial companies exposed to the mortgage market began to mark down their assets, quickly and steeply. That created a chain reaction, as losses that were reported on balance sheets led to declining stock prices and lower credit ratings, forcing these companies to put aside ever larger reserves (also dictated by banking regulations) to cover those losses.
In the case of AIG, the issues are even more arcane. In February, as its balance sheet continued to sharply decline, the company issued a statement saying that it "believes that its mark-to-market unrealized losses on the super senior credit default swap portfolio . . . are not indicative of the losses it may realize over time." Unless one is steeped in these issues, that statement is completely incomprehensible. Yet the inside baseball of accounting rules, regulation and markets adds up to the very comprehensible $85 billion of taxpayer money.
What AIG was saying then, and what others from Lehman to Bear Stearns to the world at large have been saying since, is that the losses showing up aren't "real." Yes, the layer upon layer of derivatives built on the foundation of mortgages is mind-boggling. One reason that AIG had floated beneath the radar screen of the business media (relative to Wall Street investment firms) is that its business model is so complex and opaque that it is impossible to describe simply. It was briefly in the news in 2005, after it was accused of improper accounting by the SEC and the New York attorney general. Then it faded from view, until now.
Among its many products, AIG offered insurance on derivatives built on other derivatives built on mortgages. It priced those according to computer models that no one person could have generated, not even the quantitative magicians who programmed them. And when default rates and home prices moved in ways that no model had predicted, the whole pricing structure was thrown out of whack.
The value of the underlying assets -- homes and mortgages -- declined, sometimes 10%, sometimes 20%, rarely more. That is a hit to the system, but on its own should never have led to the implosion of Wall Street. What has leveled Wall Street is that the value of the derivatives has declined to zero in some cases, at least according to what these companies are reporting.
There's something wrong with that picture: Down 20% doesn't equal down 100%. In a paralyzed environment, where few are buying and everyone is selling, a market price could well be near zero. But that is hardly the "real" price. If someone had to sell a home in Galveston, Texas, last week before Hurricane Ike, it might have sold for pennies on the dollar. Who would buy a home in the path of a hurricane? But only for those few days was that value "real."
The regulations were passed to prevent a repeat of Enron, but regulations are always a work of hindsight. Good regulatory regimes can mitigate future crises, and over the past hundred years, economic crises world-wide have become less disruptive. The panics of the late 1800s, the bank runs, the Great Depression in Europe and the United States, were all far more severe than what is unfolding today in terms of business failures and jobs, homes and savings lost.
But bad regulation is something to be feared, especially as industries become more complicated. Legislators and agencies would be wary of passing rules regulating how a semiconductor chip is programmed; they would recognize that while the outcomes those chips produce might be simple, the way they produce them is not. Yet financial service regulations sometimes act as if we still live in a time when deposits consisted of sacks of money in a vault.
A few years from now, there will be a magazine cover with someone we've never heard of who bought all of those mortgages and derivatives for next to nothing on the correct assumption that they were indeed worth quite a bit. In the interim, there will almost certainly be a wave of regulations designed to prevent the flood that has already occurred, some of which are likely to trigger another crisis down the line. Until we can have a more rational, measured public discussion about what government and regulations can and should do vis-à-vis financial markets, we are unlikely to break the cycle.
Mr. Karabell is president of River Twice Research. His "Chimerica: How the United States and China Became One," will be published next year by Simon & Schuster.


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