Who Da Heck is Ferdinand Pecora?

It’s understandable if your first guess was midfielder for the Italian soccer team. Pecora’s stature, regrettably, has fallen to a footnote in history.

Ferdinand Pecora led the Congressional investigation into the Wall Street collapse of 1929. He unearthed J.P. Morgan’s “preferred list”
that sold steeply discounted stock to influential friends, including former President, Calvin Coolidge. He revealed that National City sold off bad loans by packing them into securities and selling them to unsuspecting investors. (Sound familiar?) He exposed how top officers at National City helped themselves to $2.4 million in interest-free loans from the bank. But the news that made everyone in the soup lines nauseous was hearing that J.P.
Morgan and many of his partners paid no income tax in 1931 and 1932.

This all sounds pretty nasty, but believe it or not in 1929 it was all legal. As a result of these revelations Congress enacted the Securities Act of 1933 and the Securities Exchange Act of 1934.

Sadly we need someone to emerge again from the depths of the bureaucracy to expose the foulness of how we buy and sell investments as well as manage risk. Derivatives, credit default swaps, collateralized debt obligations, and other instruments can be powerful and useful tools, but we need to be assured they are being used properly and transparently.

They need to be regulated.

With any luck, abusing these tools in 50 years will sound as egregious as the conduct Pecora exposed in 1933. The only problem is that we need another Ferdinand Pecora.

Timothy Geithner, American Hero?

Regardless of what you think of Timothy Geithner, you have to feel sorry for the guy. There is no shortage of self-proclaimed pundits around the world who have beat him like a piñata. Cruelly, unjustifiably, and without offering a single alternative solution bigger than a sound bite.

So it is remarkably refreshing to read the advice of Hernando de Soto in Newsweek (March 2, 2009). First he says, back off. Speaking from his experience with third-world economies, de Soto says that Geithner is right to focus on trying to get the toxic paper out of the banking system. We need to restore faith in credit.

Second, and this will be surely give one pause and hopefully shut up a few blowhards, we have cleaned up toxic paper many, many times before. Specifically de Soto urges us to look at how:

…in the past U.S. and European lawyers and bureaucrats have proved brilliant at sorting out toxic paper whether it referred to bad debt, confusing claims or opaque legislation. In doing so, they have untangled claims after the California gold rush, picked up the pieces of Europe’s crumbling precapitalist order, converted Japan’s feudal enclaves into a market economy after World War II and reunified Germany after the fall of the Berlin Wall. That’s the process of capitalism: continuous detoxification.

Wow. We’ve been “brilliant” before. And we can do it again.
And who is “we?” Timothy Geithner…and the angel on his shoulder.

Just so long as he doesn’t gum up the detoxification with a social goal achievement.

Berry’s Take on MTM

John Berry on Bloomberg posits the supporting argument for modification/ clarification of MTM.  He makes a great point that separating the loss attributed to credit and the potential loss due to market illiquidity gives investors more transparency.

I think clarifying MTM to support the banking system generally, is worth the risk of some large banks gaming MTM specifically.

Please click here to read Mark-to-Market Rule Gives More Clarity, Not Less: John M. Berry

Congress Fuming after MTM Hearing

This article from CFO.com, Congress Members Fume at Fair Value, provides a clear summary of last week’s congressional hearing on fair-value accounting, emphasizing that Congressmen called for changes to mark-to-market rules, rather than an outright suspension of those rules. As most of us know by now, the meeting culminated in a promise from FASB to have some fair-value accounting rules guidance ready in three weeks. However, only time will tell whether this guidance will actually solve the issue or not. In the meantime, Representative Alan Grayson (D-FL) and FASB Chairman Robert Herz both believe that some institutions are waiting to write down damaging assets until potentially beneficial rule changes are enacted.

More MTM Pain

This WSJ article on the FHLB provides a solid real-world example of how mark-to-market accounting has drastically affected banks. In the fourth quarter, the FHLB recorded a combined loss of $672 million-their first loss in about 20 years. This loss resulted from massive write-downs on mortgage securities that some home-loan banks had picked up in recent years in hopes of attaining higher yields.

Further obstacles may await home-loan banks with regards to their main business, which is making loans, or advances, to the commercial banks, credit unions, insurers, and thrifts that make up the home-loan banks’ membership. Banks’ demand for advances has gone down after receiving direct financial aid from the government, and this demand may decrease still further if the FDIC enacts a planned rule change that would require institutions with high dependence on advances to pay higher fees. Considering these complications, it seems further challenges are in store for home-loan banks.

Read this article that was in the WSJ yesterday:  Mortagage Securities Drag FHLB to a Loss.

McTeer testimony to the Financial Services Subcommittee

Former Dallas Fed Governor Robert McTeer’s testimony to the Financial Services Subcommittee on mark-to-market accounting:

MARK-TO-MARKET ACCOUNTING:  Practices and Implications

Today’s FAS Hearing – LIVE

Handout:    http://www.fasb.org/board_handouts/03-16-09.pdf

5 Step Recovery Plan for America

The views expressed in this commentary are solely those of Richard S. Berg.

Step #1:  Restore confidence in housing market.

Solution:  Offer price protection for 5 years to any new purchase of a home for owner occupied purchasers.

Rationale:  People who are interested in purchasing a home are still aware that the market has not bottomed, and they may become upside down.  If the U.S. Government offers “price insurance” of 95% of the purchase price for 5 years in exchange for a monthly insurance premium added to the mortgage, that risk has been eliminated for the homebuyer.  The government is currently insuring virtually every mortgage loan written today to the lender; why not to the borrower?  Hyundai has established a similar program for new car sales, and it has been extremely successful.  This would be revenue positive for the U.S. Government.

Step # 2:  Increase spendable cash flow for every homeowner by almost $3,000 per year

Solution:  The US Government should offer a 4.50% fixed rate 30 year refinance to every mortgage borrower regardless of loan size and appraised value.

Rationale:  Assuming an outstanding mortgage amount of $250,000 at a 6.5% interest rate, the annual savings by refinancing that loan into a 4.5% rate would be $3,768 per year.  That extra cash would certainly work its way into the economy!  The only criteria is that you have to be current on your payments for the past 12 months in your previous mortgage.  This would be revenue neutral to positive for the US Government because they can currently borrow for 30 years below 4%.  Freddie and Fannie Mae can sell these refinanced loans as government guaranteed mortgaged back securities.  Freddie and Fannie Mae already have most of this exposure;  let’s use their mandate to help current homeowners.

Step #3:  Eliminate 50% of the “toxic” assets, increase the valuation of the remaining ones and recapitalize the banking system

Solution:  See #1 & 2

Rationale:  Since the majority of the “toxic” assets are mortgage related, and because the majority of mortgages have been securitized, solutions like the TARP and mortgage remediation have fallen short.  What you may not know is that a minority of “bad loans” inside a security can cause the entire security to be viewed as “toxic”.  Refinancing the good loans will significantly reduce the amount of outstanding “toxic” securities, and also allow banks to “write up” many of their previous “write downs”.  Hundreds of billions of capital and market value would be restored to the financial system without direct government intervention.

Step #4:  Heal the banks and restore lending in America

Solution:  Pass a 3 year reduction in capital requirements in banks, reduce rather than increase the regulatory scrutiny, and redefine “Fair Value” for OTTI to the “expected loss incurred.”

Rationale:  Banks are not lending because they are preoccupied with self-preservation.  Banks must keep a minimum level of capital or they will be deemed insolvent and closed.  Write downs of “anticipated” losses in advance of the realized losses can be very tricky, especially in this market.  Many of today’s write downs will not ultimately result in anywhere as severe as realized loss.  Regulation and accounting both contribute to this downward spiral of capital (as well as falling asset values, which #1 will certainly positively impact).  Regulators are under intense pressure to “regulate” better, which has an adverse reaction, banks refuse to lend out of regulatory and accounting fears.  If we enact numbers 1, 2, and 3, banks will actually become much healthier over a reasonably short time frame period because many of their “write downs” will be certainly not be realized.

Step #5:  Stop draining capital from the system that requires more bailouts

Solution:  Enact a “mark to market” holiday for 3 years.

Rationale:  Did AIG really lose $60 billion dollars?  For reported earnings and capital levels the answer is yes, although much of that write down and others’ write downs reflect very long term commitments that may actually turn out to produce vastly different cash flow results.  Unfortunately, in a regulated business such as banking and insurance, once your reported capital levels are below minimum, you are effectively out of business unless “bailed out.”  MTM caused wildly inflated asset prices on the way up during the boom. Can we at least agree that the current MTM accounting rules are causing wildly negative unintended consequences, and if not halted may ultimately put every financial institution and insurance company out of business?  There is a better solution and let’s take 3 years to study what it should be before we cause additional damage.

Interestingly, the implementation of this 5 step program would likely not cost the US taxpayer a dime, but we believe the impact to the US and world markets and economy would be profound.

Copyright 2009. Richard S. Berg. All rights reserved.

Battle comments on alternative to MTM

Last night, Brian Battle was interviewed for a MarketWatch article discussing the mark-to-market controversy: Mark-to-market rule compromise is on the way.

One alternative would be to allow banks to develop a model and analysis of what they believe their illiquid assets are worth and what they forecast the securities will be valued in the following quarter. In this approach, a bank must also explain the asset’s value if sold today, said Brian Battle, vice president at Performance Trust in Chicago.

One hypothetical scenario: A bank produces analysis and documentation that its asset is worth $80, its value will be $90 next quarter and it can get $50 in the market today. Analysts and investors would become more or less confident in a bank’s asset valuations, as it becomes clear whether or not they meet these estimates.

“Some banks will become known as sandbaggers while others would be perceived more favorably because they met their modeled forecasts,” Battle said.

Along with Battle’s proposed change, Ronald D. Orol lays out a few other alternatives to mark-to-market given the unlikeliness of complete elimination of the rule.

Warren Buffett on MTM

Here is a sensible view of mark-to-market from none other than Warren Buffett.  He weighs both sides of the debate.   While he’s not for suspension of mark-to-market, he proposes the best way to handle mark-to-market is to continue to report those market figures to investors, but not write-down capital based on these numbers.  Exactly Warren!

Additionally, one of the greatest investors of our time is stating that at their current market prices, some of these “toxic” assets – distressed mortgages – represent the best potential returns going forward because they are trading below fair value.  This is further evidence that the market, or liquidation value of many of these securities is well below their true economic value.

Conclusion: Mark-to-market accounting rules are forcing banks to write their securities down to values well below their economic value.

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