Page 1 of 2 Bankers get a model rush
By Julian Delasantellis
In Trading Places, John Landis' 1983 comedy about the commodity futures
markets, blueblooded and snooty commodity firm manager Louis Winthorpe III is
the victim of a bizarre nature versus nurture experiment that places him poor
and among the dregs of society. Through plot gyrations, he finds himself
awakening on Christmas morning back in his privileged bed, attended to by his
faithful manservant Coleman.
"Oh, Coleman. I had the most absurd nightmare. I was poor and no one liked me.
I lost my job, I lost my house, Penelope [his fiance] hated me and it was all
because of this terrible, awful Negro." (Eddie Murphy)
Now, it looks like this is the next strategy the US government will
use to combat the financial crisis - that it was all just a bad dream - "and it
was all because of this terrible, awful accounting rule, FAS 157".
Last Friday, my Asia Times Online colleague Chan Akya described (See
The G-20 piles folly on folly) how many of the Group of 20 protesters
were animated by equal parts outrage over the world financial crisis and
mind-altering substances, but you should not assume that it was just on the
cobblestones that mind-altering substances were directing events. They were
equally at play in the elegant boardrooms of London's business heartland, the
City, and in the conference rooms of the G-20 potentates gathered in London to
clean up the bankers' messes. Their heady and intoxicating mild-altering
substance, was, of course, money.
"The thing about money," Wall Street veteran Lou Mannheim (Hal Holbrook) warns
young and hungry Wall Street broker Bud Fox (Charlie Sheen) in Oliver Stone's
1987 Wall Street "is that it makes you do things you don't want to do."
Just like the cocaine-addled inebriate who mows down pedestrians in a crosswalk
but then tells police that he "really didn't want to do that", when money
alters your reality it's amazing, and fairly frightening, to see just how far
into the abyss you will go.
You can call it embellishing. Fudging. Overstating. Perjuring, prevarication or
paltering, it's all really the same - lying. Real, actual success in the worlds
of finance and commerce can be an exhausting, lifelong endeavor that offers
absolutely no guarantee of eventual success. In contrast, a simple and relaxing
trip on concoction cruise-lines usually yields much better results in a
fraction of the time than what is experienced by those attempting to do
likewise the old-fashioned, honest way.
It's probably become too risky, as the confectioner of the "Whizzo Chocolate
Company" did in the old Monty Python skit, selling candies whose "steel bolts
spring out and plunge straight through both cheeks", actually to sell dangerous
and lethal products on some of the world's advanced economies of the world. In
the US, that will result in a subpoena to appear before Congress, meaning
you'll have to "lawyer up" with expensive counsel. In China, you won't need
that, since they'll just quickly dispatch the case with a bullet to the back of
your neck.
But if it's harder to lie with actual product, it's probably getting easier to
lie with paper, as in what any publicly traded company must report to its
stockholders regarding its operating results. From being a simple register of a
company's costs and revenue, its outgoings and income, corporate finance
accounting over the past few years has become devilishly complex, with entries
for arcane and esoteric corporate practices whose place on the balance sheet
sometimes belongs in between, or shifts, from the cost to the revenue side of
the ledger. Put a dangerous toy on the market and local TV news crews will
hound you past your funeral; put a questionable item on your balance sheet and
then make a donation to a favorite charity, and you're man of the year.
In 1973, the accounting industry's American Institute of Certified Public
Accountants, recognizing the danger that accounting by standards of hopeful
wishes might eventually pose to the image and credibility of the accounting
profession, united two previously independent accounting self-regulatory bodies
into the new Financial Accounting Standards Board (FASB). Following on that,
the US Securities and Exchange Commission accepted FASB as the organization
responsible for setting accepted accounting standards in the US, a move with
enormous significance in matters such as corporate valuation and taxation.
FASB's mission statement said the new body would be dedicated to "Serving the
investment public through transparent information resulting from high-quality
financial reporting standards, developed in an independent, private-sector,
open due process".
A major issue in determining a company's net worth is the valuation of its
assets and liabilities. Obviously, a company that manages to get its assets
valued dearly and its liabilities valued cheaply will be reporting a much
better earnings statement than one that does the reverse.
Sticking to assets, one must avoid some obvious pitfalls in determining their
valuation.
Let's say you have a company whose main assets is a bunch of tickets for a
Celine Dion concert coming to your town tonight. Assuming that Dion is popular
in your town, on the morning of the concert, this enterprise should have a very
valuable asset. The tickets should at least be worth their face value, maybe
with an extra, added scalper's premium. But at midnight, after the show is
over, the tickets are essentially worthless.
This company would love to report its valuation based on its worth as of the
pre-concert morning, and, it's true that this valuation was accurate - for a
brief while. After the concert, valuing the concern based on the pre-concert
worth of the tickets is, of course, a subterfuge, a fable, a lie.
The most realistic answer is that the maximum possible effort must be made to
value any assets and liabilities according to what they would receive in the
market if put up for sale, a so called "mark to market".
In the banking and financial services industry, marking to market presents a
special type of challenge. Assets for these companies are primarily the loans
they have granted to other companies and consumers and which generate an income
stream through interest payments. Also, these days, banks do not keep on their
books all that many of the loans they write - they sell them off to other
banks, financial institutions, investors and speculators through the process we
now know as securitization. Should assets - that is, bank loans - that are held
to maturity be marked more or less leniently than those brought into the
market?
It is for this reason that the FASB in 1993 proclaimed FAS 115, which allowed
for different accounting standards for those asset securities the bank intended
to hold to maturity (which were generally not required to be market marked) as
opposed to those that are intended to be sold off. In 2007, FAS 157 further
clarified and in some ways strengthened mark-to-market accounting with enhanced
asset-disclosure requirements; it also provided a working definition of
fair-value accounting: "The price that would be received to sell an asset or
paid to transfer a liability in an orderly transaction between market
participants at the measurement date."
Accounting marches on? Maybe, but some people noticed a rather curious, totally
unexpected phenomenon after FAS 157 went into effect late in 2007 - the whole
freaking world seemed to be coming apart.
Yeah, there had been this funny kind of thing called the subprime mortgage
crisis that some malcontents and party poopers had been bleating on about for a
year or so, but very few free-market conservatives and/or George W Bush
acolytes even dreamed that the threat from that phenomenon could possibly
derail the prosperity engine destined to keep roaring down the tracks towards a
supposedly inevitable Republican presidential election victory the following
November.
Then, as the whole thing started to collapse with the failure of Bear Stearns
in March 2008, the fingers came up to point. If the free-market ideology was
infallible, ex cathedra directly from the mouth of Milton Friedman,
someone or something had to be tossing the old monkey spanner into the gears
from the outside. Among the usual suspects taken down to the station for the
line up were former president Jimmy Carter and his promotion of the Community
Reinvestment Act back in the 1970s, Bill Clinton-era housing and urban
secretary Henry Cisneros because he was Hispanic, House financial services
committee Chairman Barney Frank because he is Jewish and gay - and
mark-to-market accounting.
What was FAS 157 doing out there that was so perilous; what made it the
forbidden apple in the Friedman/Hayek paradise?
Mark to market is what is called a pro-cyclical rule - that is, it takes
whatever direction the economy is then trending, and gives it a little extra
added push. (This is in contrast to countercyclical policies such as
unemployment insurance; giving unemployed workers money to live on helps to put
a brake on economic declines, and workers lose it when they are re-employed.)
I once heard a child-development expert claim that the automatic teller machine
(ATM) makes it impossible for parents to teach children the real value of
money, since they see, if the family needs more of it, Mommy or Daddy just
going to this toy on the wall which makes some more. Once your understanding of
the principles of banking becomes a bit more advanced (and for tens of millions
of adult Americans, it never does), you come to realize that banks make money
through making loans and then have those to whom the money was loaned pay back
the bank with interest.
But it's not as if the bank is then waiting all day for the elderly widow to
come in and deposit her pensions check so that the bank has enough money to
fund somebody's car loan. The bank makes the loan, then, through its customers'
deposits, or, more likely as the bank gets larger, the overnight market for
interbank loans called the Federal Funds market, gets the money for it.
So for every $1 in deposits the bank can make $1 in loans? No, in actuality,
the process is a lot more nitro-fueled than that. Depending on the nature of
the loan, whether it be for a car or to buy Treasury bills, the bank can make
loans of $5, $6 or maybe even $10.
But it cannot make $10 trillion in loans based on the widow's $100 check. The
real determinant of how much in loans it can make is what is called the bank's
capital base - what the bank has in actual money to pay off depositors if a lot
of them should come in all at once to get their money (think of the bank run
scene in It's a Wonderful Life). Capital base differs among various bank
regulatory regimes across borders, but at its core is a measurement of
shareholder's capital in the bank, and, depending on the riskiness of the asset
class, some valuation for the income-producing loans on the bank's books.
Here you can see the core of mark-to-market's problems. If loans start not
being paid back they will decline in value; a loan not being paid back is like
a broken lathe in a factory - neither one is producing any income for its
owners. Loans declining in value shear away capital from a bank's capital base.
Soon, they can't make as many loans as before. This bank pulls in its lending;
one bank's lending is perhaps the borrowing of 10,000 customers who all were
hoping to get new loans to pay back other loans to other banks, and so on, and
so on. Soon you've got all the statistically significant phrases of today's
headlines - credit crunch, deleveraging, bailout, and, in the United States
since December 2007 - recession.
My regular readers can probably recognize the heart of the problem here - yes,
it's those said same pesky toxic mortgage securities that I write about so
frequently and which two American administrations have now attempted to deal
with without much success. These accounting issues arise totally out of the
main problem - that banks want the freedom to carry valuations for these assets
far in excess of what the market is willing to pay for them.
For, in the final analysis, the value of everything is not determined, or at
least should not be determined, by what the owner thinks they are worth, but by
what competitive bidders in an informed free market are willing to put up in
cold hard cash. Anything else is just some manner of fantasy. The last time I
sold a used car, I argued that it should have gone for the value stated in the Kelly's
Blue Book of used-car prices; my prospective buyers then told me, as
they held firm with their lower bids, that, if Kelly's Blue Book was so
great, perhaps I should sell the car to its publisher.
The detractors of mark-to-market accounting argue that the market prices for
the toxic securities can't be trusted because these securities trade in the
secondary market so infrequently that the market is "illiquid". The centers of
this thinking are the website and publications of Steve Forbes, publisher of
Forbes Magazine. On the Forbes.com website, Dan Bigman and Maurna Desmond
argued against mark to market this way.
Currently, investments like
mortgage-backed securities are priced based on their last sale. Since the
seller is usually distressed and parts with their goods for a fire-sale price,
all similar assets must be marked to a lower price. Critics of this brand of
"fair value" accounting, outlined in FASB rule FAS 157, say it's crippled the
banking system, forcing firms to continually write down the value of assets in
the worst possible market conditions, regardless of whether or not they're for
sale. This, in turn, has put tremendous strain on balance sheets, forcing
financial companies to hunt for new capital to make up for paper losses at a
time when few investors are willing to put money into banks. The spiral
devastated the industry. As Forbes chairman and editor-in-chief Steve Forbes
has noted in repeatedly calling for ending mark-to-market rules, of the more
than $700 billion that financial institutions have written off, almost all of
it has been book write-downs, not actual cash losses. 'Mark-to-market
accounting is the principal reason why our financial system is in a meltdown.'"
And what valuation system will replace mark to market following the FASB's
decision last week to relax its rules and permitting
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