Looking for Government Help? Here is the Scorecard

If it were not so serious, it would be amusing.  So many who generally believe in free markets and small government are suddenly unhappy whenever there is no government intervention.  Whenever we hear a criticism like this, we try to look back at the history for that pundit.  Did the criticism appear before or after a problem was evident?

At "A Dash" our focus is on interpreting actions and helping investors, but  a summary assessment will prove helpful.

The Mission and the Players

The Congress has done a good job.  Anyone who does not understand this has no grasp of the legislative process — especially the passage of completely new ideas.  A bi-partisan stimulus bill was passed in record time.  Congress also passed the requested Treasury authority to intervene with Fannie and Freddie and a mandate to do more for housing.  This legislation was delayed for a month because of a single GOP Senator.  History may take note of this, although his electorate will probably not get it.

The Fed has been imaginative.  The various Fed lending facilities, agreements with European Central Banks, the Bear Stearns intervention, to name only the most important, were important additions to the simple and major reduction in interest rates.  If one goes back one year, none of the pundits were recommending actions like this, so the Fed gets credit for imagination and resolve.

Hank Paulson has been on the case.  Working within an administration that wants to limit government involvement, Paulson has walked a tightrope.  He preferred not to intervene, famously wielding a bazooka, but was ultimately left with no choice.  He recognized the need to increase mortgage lending, something that could not be accomplished with independent GSE's.  He and Fed Chair Bernanke were probably responsible for selling this within the Bush Administration.  In so doing, he probably pronounced a death sentence for public/private partnerships of all types for the next generation.  This may prove to be a wise recognition of the failure of this model.  Or maybe it goes too far.

The SEC has been a non-entity.  The only action has been a controversial temporary restriction on naked short selling.  The end of this ban coincided with the attack on Fannie and Freddie.  We certainly do not object to short selling, and the rules for stock borrows should have been enforced consistently over the past several years.  This is an area of SEC responsibility.  The action probably affected the market temporarily, but generally sparked confusion and criticism.

The Bush Administration has followed the Paulson lead and approved the key legislation, but this was not enough.  Our political system requires leadership, and this comes from the President.  The sad historical fact is that leadership was required at the very moment that our President had a low standing in polls and a disinclination to act.  It was the wrong man, in the wrong place, at the wrong time.

Market Expectations

The market and leading pundits have focused their fire on the Fed.  There is a simple reason for this.  The Fed is the only institution that can act without additional approvals — by legislation or by voters.  We have come to expect them to solve all problems, even though the tools are limited.

We look to the Fed because we have nowhere else to turn.

The Bailout Decisions

Government intervened decisively with Bear Stearns and with Fannie/Freddie.  Government actors have chosen not to act in the cases of Lehman and AIG.  Why the distinction?

In the case of Bear, the Fed acted because there was no alternative.  The investment bank model requires short-term borrowing and confidence by counter parties.  There were no facilities in place to provide temporary lending when these requirements broke down.  Bear Stearns suffered from being the first victim.  The firm lost essential confidence, and there was no choice.

In the case of Fannie and Freddie all of government wanted to act in support of mortgage lending.  The legislation empowered the Treasury to act because Congress wanted to expand mortgage lending.  When it became clear that the market would not support an expansion of the balance sheets of the GSE's, Paulson was left with little choice.

Neither of these situations set a precedent for a general bailout of any financial firm.  All of the major players embrace a free-market philosophy and strongly prefer private solutions.

Looking Ahead

In this context, today's policy pronouncements make sense.  No government agency embraces a policy of absorbing bad paper from private corporations.  They seek to achieve some stability by cooperating with and facilitating the actions of the private sector.  This is what we should expect.

The Real Culprit?

There is a body which has exerted maximum influence in the current situation.  This body was not elected by anyone and has no direct accountability to the people of the United States.  The accountability is two layers deep.  It is empowered by the SEC, the weakest actor during this crisis.

The body in question is a group of accountants making up the Financial  Accounting Standards Board.  In one of the worst-timed new policies in history, they instituted a radical change in accounting standards, FAS 157, at a time of maximum fragility to the financial markets and the economy.

Even if one agrees that financial entities should recognize mark-to-market principles (something that we generally endorse, as noted here) this was not the time and place to implement and enforce this policy.  It is not embraced by other countries, probably affecting LIBOR.  Given the US commitment to merge with international accounting standards, it will probably be abandoned in the next few years.

Briefly put, we will use this standard only for a few years, at the worst possible time in history.

[Readers who recognize the need for a de-leveraging of financial markets please note that our objection is not with the end, but with the means and the timing.]

The Conclusion?

We embarked upon a self-induced death spiral, forcing the marking of assets for which there is no valid market method due to extreme illiquidity.  When historians look back at this black period of policy making, they will find that important decisions were delegated to a group that had no concept of the big picture and no accountability.

At "A Dash" we were early critics of this decision and the delegation of power.  Interested readers can review the history of our commentary from this list.  The mainstream media were missing in action on this topic.

The biggest positive for the market would be a recognition of this mistake.  Those supporting the abandonment of FAS 157 now include David Malpass, Vince Farrell, and Larry Kudlow — all people who are strong supporters of free markets.

The Treasury and the Fed cannot solve this problem.

Is Christopher Cox paying attention?

While we do not really expect a change in this policy, investors and traders should pay attention.  Were action to be taken, it would be a strong bullish signal.

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  • Lord September 16, 2008  

    Nice summary. The problem with FASB though is that it is prevented from acting when times are good in order to maintain a rosy picture and can only act when times are bad and credibility of markets and power of government to pressure it to do as markets want has waned.

  • Jeff Miller September 16, 2008  

    Lord — I don’t follow. FASB has made a number of moves that were opposed by most companies – the treatment of options is one example.
    I am very interested in any ideas you have about when the catered to some political pressure.

  • barry September 16, 2008  

    Third world kleptocracies nationalize failed companies, destroy shareholder equity all in the name of ‘financial stability’ and ‘protecting the common good’.
    We have met the enemy and he is us.

  • VennData September 16, 2008  

    Another point of view is that this accounting rule saved American capitalism by finally forcing a realistic look at the balance sheet. If companies go under, sobeit. The first word in tought love, is “tough.”
    They knew it was coming, and now we have a market-based system of valuations. We should request as many market-based principles be incorporated by the ISAC rules as we adopt them forthwith.
    I would give more credence to complainers about mark-to-market if they would point out the inane 2004 SEC rule “Alternative Net Capital Requirements for Broker-Dealers That Are Part of Consolidated Supervised Entities” which allowed the ibanks to adopt any leverage they saw fit. Kudlow et al simply spin a partisan tale without it.

  • gaius marius September 17, 2008  
  • Lord September 17, 2008  

    The options treatment was first proposed in the mid 90s. Market and political pressure on FASB prevented its adoption until after Enron blew up. This is the common weakness of regulators compared to other forces.
    I have to agree with VennData as well. If facing reality causes problems, the problem is reality, not facing it.

  • Jeff Miller September 17, 2008  

    Lord – You are correct in noting the change in FASB policy. In our office we discussed the options issue many times at lunch. There were good arguments on both sides, including leading academics. I am not sure what Enron did to change things. To me, the issue was more about tech companies.
    Back in the day, I taught a unit in the Public Administration class on regulation. The instances of political pressure come more from the “captive agency” argument than what you are citing here. In some agencies, the participants are either past or future employees of the regulated parties. Not so good for the public interest.
    That is not the case with FASB. If anything, it is the opposite. These guys act like accounting nerds who are tone-deaf to reality.
    So I am most interested in any real evidence you have to the contrary.
    As always, I appreciate your continuing contributions and willingness to engage.

  • Jeff Miller September 17, 2008  

    Marius — thanks for the good link!

  • Jeff Miller September 17, 2008  

    Venn — As usual, you have an informed opinion. I am interested in the examples you cite, but cannot take them up in detail right now. If I get around to writing up this history, perhaps I’ll seek you out for some counterpoint here.
    Meanwhile, I urge you not to take the viewpoint that you have a monopoly on “reality” with FAS 157. I work with many different portfolios, early-stage companies, real-estate assets, and the like. Many of them lack liquidity and raise problems of valuation. The fact that someone chose to make a trade does not establish the value for everyone else. I really wish that critics would engage on the main point, that illiquid markets are not good at establishing fair value.
    On a day like today, one wonders even about the liquid markets……
    Please give this a little thought. Let us suppose that you had a mortgage on your house. A neighbor made a distress sale for personal reasons. Now imagine that you were forced to liquidate because of this. (Your loan agreement unwisely permitted this). That is a closer analogy to what is happening in the markets.
    I struggle so hard to show two sides of an argument, carefully stating that FAS 157 did not CAUSE these problems.
    What would you do if you were the SEC head? Would you just endorse the death spiral?
    Thanks for helping to stimulate thought and discussion. As I told a colleague in a recent board meeting, I never object to those who disagree. We should all embrace intelligent argument.

  • Lord September 18, 2008  

    An agency like FASB that is less likely to succumb to direct industry pressure is still subject to political pressure, up to and including being stripped of their authority through the SEC by congress,
    Enron undermined political support for deference to industry allowing FASB to proceed with options expensing even though these were much more important to tech companies that also failed around the same time.
    An nice analysis of the issues involved in financial market regulation is
    I haven’t studied FAS 157 but understand there are level 3 assets that involve illiquid assets such as these have become though I assume it isn’t much help or they would have already been used more then they already have, which is plenty. Fear will have to hit the levels greed previously did before trust will be reestablished.

  • Jeff Miller September 20, 2008  

    Lord — I wrote a rather lengthy reply a few days ago, but it seems to have disappeared! Can I blame my own editors?
    I appreciate your links. We read the CFO article a bit differently. I see it as a rather minimal level of political influence. Do you really want these accountants to be treated like the Supreme Court? In our system there is supposed to be some oversight of agencies — even independent regulatory bodies – -to make sure that the public interest does not get lost along the way. I am not very disturbed by what I read in the article, despite the obvious viewpoint of the author.
    I’ll study the othe paper more later, and try to sharpen up future pieces to reflect this analysis.
    I really appreciate your contributions and the links —

  • Rob Reynolds September 21, 2008  

    Shame on you for trying to perpetuate the lies that have been heaped upon us for so many years.

  • Jeff Miller September 21, 2008  

    Rob – Normally I do not reply to comments that are judgmental and devoid of substantive content.
    I embrace the many thoughtful participants at “A Dash” whether they agree with my conclusions or not. Often they raise new arguments and new evidence.
    Having said this, I am well aware of a certain reality. Many of those reading my work have made up their minds in advance. They do not really read. It is impossible to write anything important without getting dissent.
    On FAS 157 for example, they think that I do not believe in fair value accounting. A careful reading shows that not to be true. I am questioning the measure, not the purpose. If you have a lot of experience in valuing illiquid assets, please share it with our readers.
    So feel free to cast shame if it makes you feel good. My purpose is to help investors.
    One thing you might consider — If we had handled this FAS 157 issue properly, when I first advanced the issue, we might not be facing a trillion dollar bailout.
    Just a thought, and feel free to join in again!