If You’re “Too Big To Fail” Are You Too Big?
It’s a question that has aligned an interesting mix of people. As impossible as it might seem, everyone from House and Senate Republicans to the AFL-CIO, Ralph Nader, and Democrats of virtually every stripe agree that the answer is a resounding, “yes.”
Admittedly, liberals and conservatives have their own reasons for drawing the same conclusion, but they agree that Citigroup, Bank of America, JPMorgan Chase, and others that are too big. And the sentiment is shared on the other side of the Atlantic as well. European politicians are pushing for the break-ups of ING, KBC and Lloyds.
The bankers are understandably not so keen on the idea of being broken up. They do present the valid argument that their size makes them a powerful force in the world market. If forced to break up, they maintain, banks in countries that are not forced to downsize (Possibly themselves after they move?) will have the advantage.
The option to a break up is more regulation — so much regulation, in fact, that these banks would function as quasi-public institutions like AIG, Fannie Mae or Freddie Mac.
So what will happen? That’s easy. When you have two unpleasant options and banks pushing millions into campaign coffers to keep the status quo, all the consensus in the world is useless. Not only will nothing happen, these mega banks will have less incentive than ever to avoid staggering risks … because they’re “too big to fail.”
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Make No Little Plans
The President’s Economic Recovery Advisory Board, headed by the venerable Paul Volcker who has seen his share of economic woes, is pushing to double exports as a percentage of GDP.
And we’d all like to be thinner, younger, and richer.
That’s not to say it can’t be done, but given that our policies over the last 30 years have all but outsourced our manufacturing sector and of hundreds of industries, about all that we have left to export are agricultural products and bulldozers.
The US was once the world’s leading manufacturer of near everything but chopsticks. We have traded that to be the world’s biggest shopping mall.
With that said, the goal is ambitious. To rebuild America’s manufacturing infrastructure implementing 21st century technology to effectively compete with clumsy labor-intensive manufacturing from the third world is exciting. This may be more than the Economic Recovery Advisory Board had in mind, but Americans have never been known for thinking small. As the oft-quoted architect Daniel Burnham once encouraged, “Make no little plans; they have no magic to stir men’s blood…Make big plans, aim high in hope and work.”
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Dollar Daze
Every administration has pledged to hold our currency strong since Nixon devalued the dollar in 1971. Since the Euro was introduced only ten years ago, the dollar has lost more than 50%. During the same period of time, the dollar is down almost 25% against the Yen.
The inconvenience of more expensive European vacations aside, the precipitous slide is something that needs to be stopped. The idea that a weak dollar is good for American exporters is a fallacy. Except for agricultural commodities, we export virtually nothing. All a weak dollar will do is exacerbate our trade deficit, bring on inflation, lead foreigners to sell off US investments, and make it more difficult to pay down our debt.
A weaker dollar devalues everything — our assets, our incomes, and particularly our nation’s role as the preeminent economy. The dollar is still the reserve currency for investors, but the pace at which it is falling means it will be only a matter of time until the Euro has the critical mass, or investors start to become comfortable with a communist Yuan, and the dollar will lose its position as the world’s currency of choice. Every administration has pledged to hold our currency strong since Nixon devalued the dollar in 1971.
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Is Everybody Happy?
The mark to market debate doesn’t need to be winner-takes-all. We can create a system that will satisfy the FASB and investors.
Assets and liabilities can both be held at cost on the balance sheet while current market value is disclosed. Investors will get the fair value number they need to determine current shareholder value, and the FASB gets their market value. Maybe we also disclose a weighted average rate and term for bonds, loans and the like. We can even post the margin based on fair value.
Well, maybe the FASB will be happy. The critical piece is that assets need to be held at cost. The balance of the information is simply disclosed.
No matter how fishy mark to market prices may be, there is no mistaking it. They do force real world investment and credit decisions that have painful and unnecessary consequences. When mark-to-market losses reach “stop loss” levels, solid AAA-rated securities are dumped at steep discounts for accounting reasons that are purely contrived.
Good for the guy who buys the assets, of course. Not so good for the guy forced to sell. And the FASB is smug in its thinking that they have done the world a service. Let’s make everyone happy instead.
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Sunny Days Will Return
Say what you want about the deposed junk bond peddler at Drexel Burnham Lambert, Michael Milken, you have to admit that he’s right on this one. He once noted, “Liquidity is an illusion. It is always there when you don’t need it and rarely there when you do.”
To elaborate, in volatile times, money moves toward rock-solid investments. Specifically the Federal Government (Have you seen the short-term Treasuries recently?). In more stable times it moves toward investments that deliver a better return.
The last year or so can hardly be called stable. Predictably, money fled the markets, depressing the value of everything. When compounded by the housing collapse and the problems that rating agencies have had assessing bonds, long-term assets held to mark to market accounting rules got hammered.
But these are all temporary events that are impacting long-term investments in the short-term. Nonetheless these are the criteria mark to market uses to evaluate an investment. It’s a bit like valuing the convertible you bought yesterday at 10% of its purchase price because it’s raining today.
There will again be a sunny day. And as bizarre as it sounds, the FASB should take advice from Mr. Milken. Liquidity will return. When we need it least, of course, but it will return nevertheless. We need accounting rules that acknowledge this.
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Mark To Market Morals
Mark to market accounting is fundamentally flawed in so many ways, but perhaps one of its most egregious failings is that it requires the holder of an asset to play a silly game of make-believe: “Imagine you’re going to sell this long term asset today, what do you think it’s worth?”
Let’s assume this asset is in year one of rock-solid, 30-year investment with absolutely no chance of failing. And it pays 5%. Now let’s say the market makes a dramatic short-term shift so rates are now suddenly at 10%. Do I lose a corresponding percentage of the value of my capitalization because some mope – who only wants to buy my rock-solid investment to flip it when rates fall again, says so? Even if I have no intention of selling it for another 29 years?
That is crazy. That is mark to market accounting.
Markets go up. They go down. Over the next 29 years, the true value of that bond can only be determined by its performance. Market value changes should be disclosed, and are for transparency. But don’t focus capital reallocation for short-term price changes. The price of “transparency” is volalitility. Trying to value long-term assets to a tiny sliver of time and a price measured by something as capricious as the market is more than goofy given the damage it does not just to corporate balance sheets but also to peoples’ lives and careers. It is immoral.
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Should we listen to these guys?
Those arguing for mark-to-market evaluation of long-term securities that banks and other organizations are holding are doing so primarily on philosophical and moralistic grounds. Invariably they couch the discussion in vague terms of right and wrong. They have yet to present a single argument for mark-to-market that presents any tangible advantage.
This moralizing mind you is coming from members of an accounting profession whose job it is to ensure, in part, that the financial community plays fair. This is the same financial community that just a few weeks ago brought the world’s economy to the brink of disaster.
Why attack the one change that actually helped to stabilize banks and insurance companies and restore credit markets?
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Why Go Back?
There were mark-to-market rules during the Great Depression. Franklin Roosevelt had the good sense to suspend them in 1938. For the next 70 years? No problems. Then in 2007 the Federal Accounting Standards Board (FASB), went back to those halcyon days of 1936 and brought back mark-to-market accounting and forced banks to take losses before they happen.
You can burn a lot of calories wondering why the FASB didn’t leave well enough alone.
After a virtual banking collapse, in April of this year the FASB re-suspended the rules. And surprise, banks are suddenly in better shape. What’s more, it didn’t cost any one a dime, taxpayers have probably saved billions in bailout funds, and there is widespread optimism that the economy is turning around.
And oh yeah. The investments the FASB wanted downgraded by mark-to-market? Using the same mark-to-market rules, they’re worth more, too.
So why does the FASB now want to go back yet again to an archaic rule that exacerbated the Great Depression and clearly made the Great Recession far worse than necessary?
We can only speculate. But it’s clear that more than a few FASB members are miffed that they look like they caved to political pressure. I agree that having Barney Frank and Paul Kanjorski in your kitchen isn’t fun, but do you really want to see banks and the economy crumble again?
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FASB Update
While there are some in the media that are suggesting this is a sudden reversal of the decisions made last April, it is actually part of a process that started years ago. Both the FASB and the International Accounting Standards Board (IASB) have a long term stated objective that the primary accounting for ALL financial instruments including liabilities should be fair value. They are now in the first steps of a very long process on how to exactly do this.
The initial recommendation is that fair value be the default accounting for financial instruments on the balance sheet. However, other factors such as the institution’s business model (buy and hold versus trade, for example) and characteristics of the financial instrument (cash flow volatility, derivative, market activity), along with other factors will determine whether the unrealized gain or loss is recorded in the income statement or the balance sheet via other comprehensive income. These determining factors have not been laid out in detail yet as they are at the conceptual stage. It very well may be that they are the same concepts used now for securities (primarily based on intent) with a few twists. What is happening now is the first step in a long process on the best way to do this, which includes seeking comments from the industry. The ABA came out quickly with a letter to the FASB with their opinions.
This is an important issue that we will follow closely and may ultimately result in significant changes to accounting for financial instruments. It will also probably force regulatory changes to capital requirements and calculations. However, it is not a sudden reversal of the April decision that changed how fair value is determined in inactive markets or how it is used for impaired securities. It simply is the first step in implementing a long stated common objective of the FASB and IASB.
As fair values become more part of the accounting process for less active financial instruments, it will put more of the spotlight on pricing models that value credit such as loans. I’m very curious to see if the loan fair value models used by many big banks that resulted in fair values of their entire loan portfolios (including commercial, construction, land development loans and consumer) in the high 90s for the last several quarters receive a little more attention.
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SEC’s Schapiro Said to Weigh Kroeker, Ciesielski as Accountant
July 30 (Bloomberg) — U.S. Securities and Exchange Commission Chairman Mary Schapiro has two finalists to be chief accountant: acting director James Kroeker and Baltimore money manager Jack Ciesielski, people familiar with the matter said.
Read the full article at Bloomberg.com
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