You Read It Here First...

I've posted a number of times here on the problems of Fair Value in accounting: not it appears I'm not the only one who is concerned.

William M. Isaac, in the WSJ (link here) has this to say:

I am astounded and deeply saddened to witness the senseless destruction in the U.S. financial system, which has been the envy of the world. We have always gone through periods of correction, but today's problems are so much worse than they needed to be.

The Securities and Exchange Commission and bank regulators must act immediately to suspend the Fair Value Accounting rules, clamp down on abuses by short sellers, and withdraw the Basel II capital rules. These three actions will go a long way toward arresting the carnage in our financial system.

Bingo. The first and foremost lesson to be learned is that problems have been made worse by attempts to solve them, not better: the massive write-offs of the last several days, let alone months, are a fiction of accounting rules, rather than real-world losses, and we are seeing the catastrophic effects of pro-cyclic effects, of error-correcting mechanisms that fail to correct errors and instead magnify them. That is true folly.

At the outset of the current crisis in the credit markets, we had no serious economic problems. Inflation was under control, GDP growth was good, unemployment was low, and there were no major credit problems in the banking system.

This is why McCain can say that the economy is fundamentally sound: it is.

The dark cloud on the horizon was about $1.2 trillion of subprime mortgage-backed securities, about $200 billion to $300 billion of which was estimated to be held by FDIC-insured banks and thrifts. The rest were spread among investors throughout the world.

The likely losses on these assets were estimated by regulators to be roughly 20%. Losses of this magnitude would have caused pain for institutions that held these assets, but would have been quite manageable.

And let us do remember where the subprimes came from: from the severely misguided CRA intervention in the market operations of issuing banks, requiring them to issue the subprimes regardless of merit, coupled with Democratic malfeasance and corruption at Fannie Mae and Freddie Mac, abandoning prudent and functional risk management for political gain at taxpayer cost.

How did we let this serious but manageable situation get so far out of hand -- to the point where several of our most respected American financial companies are being put out of business, sometimes involving massive government bailouts?

Lots of folks are assigning blame for the underlying problems -- management greed, inept regulation, rating-agency incompetency, unregulated mortgage brokers and too much government emphasis on creating more housing stock. My interest is not in assigning blame for the problems but in trying to identify what is causing a situation, that should have been resolved easily, to develop into a crisis that is spreading like a cancer throughout the financial system.

The biggest culprit is a change in our accounting rules that the Financial Accounting Standards Board and the SEC put into place over the past 15 years: Fair Value Accounting. Fair Value Accounting dictates that financial institutions holding financial instruments available for sale (such as mortgage-backed securities) must mark those assets to market. That sounds reasonable. But what do we do when the already thin market for those assets freezes up and only a handful of transactions occur at extremely depressed prices?

This is why accountants and lawyers should be banned from policy making: both groups lack the fundamental understanding of how markets actually work and what the goal of accounting actually is: it is not and cannot be the attempt to present the status of a company as if the company were to be liquidated on that day, but rather is a snapshot of that company as a going concern on a given day.

The answer to date from the SEC, FASB, bank regulators and the Treasury has been (more or less) "mark the assets to market even though there is no meaningful market." The accounting profession, scarred by decades of costly litigation, just keeps marking down the assets as fast as it can.

This is the key: what is the fair market value? I've worked doing exactly that - fair market valuation of the sale of radio and TV stations - and it is nothing other than the price of a going concern - in this case radio and TV stations - based on the physical plant and equipment, properly depreciated, plus the dollar amount that can be generated by using the company's business model to generate a future cash flow that is then used to finance the purchase. That is the fair market value, and it corresponds very well to actual price developments for the sale of radio and TV stations (there are additional factors that go into this, but that is the core).

But that isn't what we are talking about here: it's an accountant placing an arbitrary value on assets without having any idea of what those assets are actually worth: it elevates the accountant to a position way beyond their pay scale, which was the point of implementing such rules, if you pardon my cynicism.

This is contrary to everything we know about bank regulation. When there are temporary impairments of asset values due to economic and marketplace events, regulators must give institutions an opportunity to survive the temporary impairment. Assets should not be marked to unrealistic fire-sale prices. Regulators must evaluate the assets on the basis of their true economic value (a discounted cash-flow analysis).

Absolutely correct: the regulations as they exist today, with fair market valuations, will destroy the banking system. Otherwise you will see massive losses and gains during the business cycle, which is something that almost any economics major could have told the accountants. Instead, the accountants wanted the power, so to speak, of corporate valuation, and they are now in the position of a 13-year old who is out driving Dad's Hummer, knocking down mailboxes and bouncing off of cars like there is no tomorrow. Which there won't be if things are not changed.

If we had followed today's approach during the 1980s, we would have nationalized all of the major banks in the country and thousands of additional banks and thrifts would have failed. I have little doubt that the country would have gone from a serious recession into a depression.

Again, bingo: the remedy is killing the patient.

If we do not halt the insanity of forcing financial firms to mark assets to a nonexistent market rather than their realistic economic value, the cancer will keep spreading and will plunge the world into very difficult economic times for years to come.

This is not a forecast: this is what will happen and is a function of the laws of economics. Destroying capital like this is criminally stupid, and even worse, it's a mistake.

I argued against adopting Fair Value Accounting as it was being considered two decades ago. I believed we would come to regret its implementation when we hit the next big financial crisis, as it would deny regulators the ability to exercise judgment when circumstances called for restraint. That day has clearly arrived.

Again. absolutely correct...

Equally egregious are the actions by the SEC in recent years lifting the restraints on short sellers of stocks to allow "naked selling" (shorting a stock without actually possessing it) and to eliminate the requirement that short sellers could sell only on an uptick in the market.

Naked shorting is nothing less than direct fraud: it is selling you something that the seller does not have legal right to (you can short with the appropriate options, but without the options you are defrauding your customer).

On top of this, it is my understanding that short sellers are engaged in abuses such as purchasing credit default swaps on corporate bonds (essentially bets on whether a borrower will default), which lowers the price of the bonds, which in turn causes the price of the company's stock to decline further. Then the ratings agencies pile on and reduce the ratings of a company because its reduced stock price will prevent it from raising new capital. The SEC must act immediately to eliminate these and other potential abuses by short sellers.

Naked shorting, in other words, is a license to destroy a company: it creates an open-ended positive reinforcement loop that benefits only one person, the one who is doing the naked shorting.

The Basel II capital rules adopted by the FDIC, Federal Reserve, Office of Thrift Supervision and the Comptroller of the Currency last year are too new to have caused big problems, but they must be eliminated before they do. Basel II requires the use of very complex mathematical models to set capital levels in banks. The models use historical data to project future losses. If banks have a period of low losses (such as in the mid-1990s to the mid-2000s), the models require relatively little capital and encourage even more heated growth. When we go into a period like today where losses are enormous (on paper, at least), the models require more capital when none is available, forcing banks to cut back lending.

Again, correct: this is a system of positive reinforcement, a pro cyclical system, which is exactly the opposite of what is actually needed.

As I write this article, I am seeing proposals by some to create a new Resolution Trust Corp., as we did in the 1990s to clean up the S&L problems. The RTC managed and sold assets from S&Ls that had already failed. It was run by the FDIC, just like the FDIC. We needed to create the RTC in the 1990s only because we could not comingle the assets from failed banks with those of failed thrifts, because we had two separate deposit insurance funds absorbing the respective losses from bank and thrift failures.

I can't imagine why we would want to create another government bureaucracy to handle the assets from bank failures. What we need to do urgently is stop the failures, and an RTC won't do that.

Again, absolutely correct: stop the cause, not deal with the symptoms.

Again, we must take three immediate steps to prevent a further rash of financial failures and taxpayer bailouts. First, the SEC must suspend Fair Value Accounting and require that assets be marked to their true economic value. Second, the SEC needs to immediately clamp down on abusive practices by short sellers. It has taken a first step in reinstituting the prohibition against "naked selling." Finally, the bank regulators need to acknowledge that the Basel II capital rules represent a serious policy mistake and repeal the rules before they do real damage.

We are almost out of time if we hope to eradicate the cancer in our financial system.

And the problem is one of a cancer: someting that takes a long time to develop, insidious and invisible until it suddenly crops up. Remember what a cancer is: it is the cells of the body becoming autonomous, working for their own aims and living off the body until the body can no longer function.

And the real problem is that this isn't limited to the US: if the US goes down because of these fundamental errors of policy, it takes the rest of the world with it.

We are living in interesting times. Let's just hope we can survive them.

And the Democrats in Congress want to adjourn and go home rather than deal with this?

Don't believe that? What of this?

Wall Street would respond positively ``if the president and Treasury Secretary Paulson and a couple of Cabinet members and the Republican and Democratic leadership all went on the White House lawn and said that we are resolved to taking additional measures in the coming weeks despite the elections to ensure that confidence is restored,'' Gabriel said.

``But the odds of that seem very, very low.''

In other words, instead of banding together and dealing with the problem, political considerations have a higher priority for the Democrats, and the country's economy can go to hell as a result. "We don't know what to do" is about the lamest thing I've ever heard.

Of course, some are using this for political advantage, trying to pin the blame on someone convenient and desperately trying to avoid having anyone see their blood-smeared hands:

Some committee chairmen have scheduled hearings and promised better oversight.

Representative Henry Waxman, chairman of the House Oversight and Government Reform Committee, will hold two days of hearings on Oct. 6 and 7 ``to examine what went wrong and who should be held to account'' at AIG and Lehman Brothers, which filed for bankruptcy on Sept. 15.

...

House Speaker Nancy Pelosi defended the decision of Congress to adjourn. Lawmakers can always be recalled to Washington ``if there is a need to do so,'' she told reporters yesterday. In the meantime, House and Senate committees will hold hearings and the financial crisis will be studied by Congress, she said. ``Our work will continue even if we are not still on the floor,'' she said.

In other words, Congress is irrelevant to the whole situation: what is really going on with Congress is that it is paralyzed in fear that them chickens is coming home to roost and that the resulting revelation of fundamental incompetence will tear down the carefully constructed facade of fraud and deceit.

Then again, the relevance of Congress is deeply in question at this point:

Senator Johnny Isakson, a Georgia Republican active on housing issues, scoffed at suggestions that lawmakers postpone adjournment to rewrite laws governing the financial markets.

``The last thing you need,'' he said, ``are 535 people, not many of whom are that well-versed in financial markets, trying to do quick fixes to a market correction that's one of the more significant that we've ever seen.''

That's perhaps one explanation of why Congress' popularity is at an all-time low: the level of competence here is probably significantly lower than a sample of 535 people chosen at random.

From the world's population at that.

Christ, this is turning into a real nightmare: I'm not one to call out "The Sky Is Falling", but ... this is increasingly a case of unintended consequences: the creation of a market inequilibrium with the subprimes; accounting rules that creates positive feedback; and reserve requirements that creates positive feedback.

These are all politically motivated interferences in the market: as an economist who has been preaching the sheer stupidity of this for decades, all I can say now is this:

I TOLD YOU SO.

Unfortunately, that doesn't make me feel better. Better figure out what your options are besides Plan A, because if you don't have Plans B, C and D, you're not going to be a happy camper.