A Self-Inflicted Nightmare?
There has been plenty of criticism of public policy related to credit markets. Supervision of ratings agencies, lack of transparency, bad incentives — you name it. No objection here.
The Fed, the Treasury, the SEC, the Administration, and the Congress have all gotten their share of blame.
GSE's are criticized as an inappropriate vehicle for implementing public policy to provide more affordable housing.
What agency has (mostly) escaped criticism? The Financial Standards Accounting Board (FASB). This private group has been authorized by the SEC to determine the accounting standards that everyone uses.
How did this group perform?
Marking to Market?
At "A Dash" we mark our positions daily. Like any other investment manager, we respect the market verdict about the value of securities. We do not deal in illiquid securities, so our own marks are not a problem.
Markets are excellent when the security is trading freely. When it is not, the prevailing marks may reflect undue optimism or pessimism. In the current case the marks reflect the distressed sales from firms forced to liquidate at fire-sale prices. This is neither sensible nor reasonable.
Those with a strong opinion, and often with short positions in financial stocks, have an interest in getting the lowest possible marks. Some of the indexes used, like the ABX, have been criticized as open to manipulation. This has forced institutions to raise capital at poor prices in order to hold assets that may perform at much higher levels than reflected in the asset sales. The recent Merrill Lynch trade is an example of a company where management felt compelled to sell.
A Revealing Conversation
Today on CNBC there was an interesting exchange involving David Malpass, now head of a new research firm, Encima Global, Chris Whalen (an astute observer with Institutional Risk Analytics, Joe Kernan, and Steve Liesman from CNBC. There was plenty of disagreement, with Joe Kernan advocating the mark-to-market approach. Whalen predicted plenty of bank failures and saw the need for more capital at the largest institutions. Smaller banks, he felt, were OK.
The key debate over FAS 157 occurred in the following exchange:
Malpass: These writeoffs and the added capital…. is because banks are writing down something without any cash flow model….
Whalen: And they're using estimates. I've been all over fair value accounting. It was a bad idea, and it was badly timed. The FASB was the last one to get the joke about efficient market theory. And they impose this thing just as our markets are about to collapse.
Whalen: If you are in insurance company, if you are a commercial company, and you have the time where you do not have to liquidate [interrupted by Joe} The only business model that needs mark-to-market discipline is a broker-dealer or the dealer subsidiary of a bank. I think banks, if they have the capital to hold long-term assets like this, they should be able to [something] the short-term swings.
Malpass: They are forced to raise capital because accountants are saying this instrument [interrupted].
When the history finally gets written, we will see the implementation of FAS 157 as ill-timed at least, and perhaps ill-advised as the original rules were written. The non-review of this implementation is something that political scientists call a "non-decision." It is something that just happens because information and policy builds up, gaining a life of its own. It often lacks a complete review.
If this implementation had been better considered and better timed, the financial crisis would have been mitigated. The new rules could have been implemented in a better form at a better time.
Please be clear. It is not our contention that excessive leverage should not be addressed. Nor do we say that there were no excesses.
There is a time and place to implement radical change. Doing so in a period of great stress is something that policy makers generally avoid. In this case, no one was monitoring the FASB decisions and the consequences. It was important policy making ceded to an outside group that was focused on a single aspect of the issue.
At "A Dash" we are big fans of Joe Kernan. Having said this, we disagree with Joe's example, repeated later in the day on CNBC, that these instruments were like a simple bond at 3% when rates moved to 8%. These instruments trade freely, not in a distressed market.
Here is the entire spot for readers to review.