Possible Outcomes from the 2008 Financial Situation: Part II

Our last blog discussed three areas of likely political and regulatory change as the result of the financial crisis of 2007-2008. Here are four more areas for change.

4. The Organization of Regulation. Although functional regulation continues in the financial industries, the passage of deregulation through GLB permits financial companies to enter any financial area. This situation of inadequate oversight may have been a major element in the 2008 credit crisis and strongly suggests the need for consideration of a consolidated regulatory scheme similar to that used by the Financial Services Authority in the U.K. (For a more complete discussion, see James Sagner, Is U.S. Business Overregulated? How Government Destroys Our Ability to Compete Globally, York House Press, 2008, particularly Chapter 7.) The matching of the integrated strategy permitted by GLB to an appropriate regulatory structure has been suggested by Secretary of the Treasury Henry Paulson and others, and is likely to be considered in the next Congress as omissions and errors made both by the regulators and the companies are investigated.

5. Government Market Actions. The theory of a free market clearing supply and demand at an equilibrium price may not be working in certain situations, and governments will not stand back and watch chaos and instability destroy long-established consumer expectations and behaviors. The most obvious recent problem has been with commodities, from metals to energy to food, although the precise role of speculators and hoarders has yet to be definitively established. In any event, governments will stockpile, subsidize, set price floors and ceilings, prosecute and change the procedures by which these products trade.

6. Restrictions on Business. Congress is loath is interfere with the free market system and realizes that it knows less than business managers how companies should operate. (Most Congressmen have never worked in the corporate world; for statistics on the professions of the current Congress, see “Membership of the 109th Congress: A Profile,” CRS Report for Congress, pages CRS 3-4, at www.senate.gov/reference/resources/pdf/RS22007.pdf). The disastrous post-World War II experience in Great Britain with nationalization ended with Prime Minister Thatcher’s decision to privatize most of British industry, and we are not about to go back to the days of a Labour Party under Prime Minister Clement Atlee. However, there is considerable pressure on executive pay, particularly regarding disclosure and limitations.

It is possible that many companies could be subject to new rules as the asset-purchasing program of the U.S. Department of the Treasury begins. Executive pay is affected in several ways, including limitations on tax-deductible compensation (now $500,000). Board committees that approve executive compensation may be required to examine the risks a senior manager might be motivated to take on to meet his/her goals. Members of Congress have indicated that the current financial rescue package approach to compensation could be extended to all publicly-traded companies.

7. Government Senior Administratorship. One of the most unfortunate outcomes from this entire credit market disaster has been the growing recognition of the weak stewardship at certain of the regulatory agencies that should have been monitoring the situation. The country does have two strong leaders in Chairman Bernanke at the Federal Reserve and Secretary Paulson at the Treasury. Congress may begin to realize that awarding senior-level jobs to former colleagues, the relatives of former cabinet secretaries, or other political hacks is a poor method to choose Executive Branch senior managers.

Just as some states write qualifications for cabinet-level positions, the Congress may choose to insist on banking, accounting, legal or other relevant agency-specific experience for these critical positions. Furthermore, the old tradition of rewarding cronies who were defeated in a recent election must be very carefully examined; the voters probably knew what they were doing, and the framers of the Constitution never intended the Senate to be a rubber stamp in approving jobs for the pals of the President.

Possible Outcomes from the 2008 Financial Situation: Part I

We have discussed the financial crisis in previous blogs. Inevitably, several changes will be considered by government policymakers and the private sector as the result of the events of 2007-2008. Political considerations will drive these reforms regardless of issues relating to free markets and capitalism.

1. New Regulation. There will be new financial regulation, including rules to reduce leverage and to control markets that have been unregulated. The use of 30 to 35: 1 debt-to-equity financial leverage used by certain securities firms to enhance returns will be limited to the same rules as apply to banks, about 10:1. Unregulated instruments like the credit default swap market will be subject to controls, somewhat like the rules that exist for the futures markets. Banks may be limited in their securitization activities and could be forced to retain ownership of portions of loans as an inducement to better lending practices.

2. Existing Regulation. The operational regulator for banks is the Comptroller of the Currency, an agency that has been in existence since the American Civil War. (The Federal Reserve is a strategic regulator for the entire financial system as well as the central bank of the U.S.) The supervision expected of banking practices includes the appraisal of asset quality, including the terms and documentation of loans; the competence of management; and sensitivity to interest rate, operating and other risks.

New levels of examination will be required, including analysis to predict situations that may lead to non-performing loans, verification of the value of collateral, proof of earnings and assets, review of performance on loan repayment, and other steps to improve the balance sheets of banks. This should prevent future distressed bank sales like Wachovia Bank in 2008, but will inevitably deny credit to marginal borrowers who may be struggling to buy their first homes or keep a business afloat.

3. Government Political Actions. Government helped create the current financial problems largely for political reasons. Some examples:

· To satisfy homeowners: deductions for homeowners on mortgage interest and property taxes on residential real estate
· To appeal to those at lower incomes: encouragement to Fannie Mae and Freddie Mac for loans to borrowers with questionable credit histories
· To induce borrowing activity: unrealistically low interest rates as set by the Federal Reserve
· To placate business managers: the business deduction for interest on debt

Political decisions will again be made to satisfy angry constituents and place blame. It is difficult to know who will bear the brunt of this anger, but a reasonable forecast is that the financial industry will be the target. The restoration of the pre-deregulation regime is unlikely – the period before the Gramm-Leach-Bliley Act of 1999 (GLB) – but some changes are inevitable; see the following section on the organization of regulation. However, we must remember “the law of unintended consequences” which basically states that passing new regulations inevitably causes other (and possibly worse) problems.

Additional possible changes will be discussed in our next blog.

I’M FROM THE GOVERNMENT AND I’M HERE TO HELP …

The year 2008 has been tumultuous, with economic changes that would have required decades in normal times. It required years of lobbying for the two major financial deregulation laws to be enacted; it took less than a month in early Fall to nationalize Fannie Mae and Freddie Mac; rescue and seize control of AIG, the world’s largest insurer; extend FDIC coverage to money-market funds and to increase bank deposit guarantees; temporarily ban short selling in nearly one thousand stocks in the financial industry; commit to the continuing liquidity of the commercial paper market; and provide $700 billion to assume control of non-performing bank loans, primarily mortgages.

The major investment banks have disappeared, with Bear Stearns and Merrill Lynch now owned by commercial banks, and Goldman Sachs and Morgan Stanley becoming commercial banks. Of course, smaller investment banks exist for regional transactions, but the securities industry has been transformed in ways considered unthinkable even a year ago. How could this happen and what will be the new look of the financial system, both with regard to the financial companies providing the services and the corporations that depend on credit and equity to conduct their business operations?

Financial markets are probably inherently unstable, as banks and other institutions seek new methods to enhance the fairly small return from lending or fee-based activities. It is a struggle for a bank to earn one per cent on its asset base even in prosperous times, and the innovations developed by the quants were largely intended to enhance these fairly puny returns while limiting the amount of equity capital required to support normal activities.

Can government develop a better system to improve stability while avoiding the chaos that has recently been experienced? The history of federal law on finance has been uneven, with Congress often ready and willing to find a scapegoat rather than getting to the real sources of a problem. A positive result was President Roosevelt’s creation of the SEC (through the Securities Act of 1934), and for many years, it did a very credible job in supervising the investment banking industry.

A negative result was the Glass-Steagall Act of 1933 that separated commercial and investment banking for two-thirds of a century, on the theory that these institutions somehow caused the 1929 stock market crash. However, we now understand that there were other far more important causes, including the use of margin to buy stocks (as much as 90% of a stock’s cost could be margined or borrowed in those years), and the decline in farm prices throughout the Midwest and West Coast in the 1920s, due largely to mechanization, the use of fertilizer and overproduction, that eventually destroyed banks and small businesses in those areas.

In my next blog I’ll review likely government actions as changes are debated on the regulation of the financial markets.

What’s Fair About Fair-Value Accounting?

Our recent blog discussed the credit freeze being experienced in the current financial crisis, which can only be thawed by coordinated actions of the U.S. Treasury, Congress and the President, and the world’s central banks to bring confidence and liquidity back to the markets. Many of the necessary steps have been taken, and there are few additional major actions that should be required to restore some elements of which President Warren Harding called “normalcy” during his 1920 campaign. This blog focuses on valuation and the failed concept of mark-to-market accounting.

Banks are required to mark-to-market most financial assets other than loans. The practice of marking-to-market (or fair-value accounting) began with commodities dealers who accepted nominal amounts of margin (often as little as 5 or 6%) to hold futures contracts for clients. Each night that day’s settlement prices from the exchanges were used to revalue positions, so that margin calls could be made the next morning if the value of holdings had deteriorated and more cash was required. The idea was extended to bank investments in FAS 157 issued by the Financial Accounting Standards Board (FASB), taking effect after November 15, 2007. This re-pricing works when there is a deep and liquid market, and willing buyers and sellers can clear the market based on normal conditions of supply and demand. The concept does not work when the market is illiquid and/or when there are insufficient numbers of buyers and sellers.

We are going through a period of panic selling and sharply falling prices for certain assets, and mark-to-market is inappropriate in these conditions. The alternative is to use discount cash flow valuations of assets, bringing the expected future stream of interest payments and the repayment of principal back to present value. The unknown is whether the issuer can reasonably be expected to honor its debt contract, that is, will those interest and principal amounts be paid or has the quality of its assets or earnings been so affected that there is a permanent deterioration in its financial position? If so, the asset would be written down to reflect that change. What a radical idea – recognizing losses (or gains) when the investment has clearly lost value or when it is actually sold!

The SEC and FASB issued new guidelines on fair-value accounting just about the same moment that Congress was debating the $700 billion Emergency Economic Stabilization Act of 2008 (EESA), Public Law 110-343, October 3, 2008. The new rules permit the designation of “distressed” to certain investments so that less emphasis is placed on market prices. The EESA instructs the SEC to investigate whether mark-to-market rules deepened the problems in the credit markets and to suspend the rules if appropriate.

The SEC should instruct FASB to abolish fair-value accounting once and for all. Instead, banks should treat investments in the following manner:

1. Model the value based on discounted cash flow projections of the present value of interest and principal payments.
2. If permanently distressed, write down the assets as appropriate, based on reduced or omitted interest and/or principal payments.
3. Subject all asset write downs and valuation to external auditor reviews.
4. Further subject all asset write downs to bank examiner reviews.

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Deep Freeze?

My last blog recommended a consolidated approach to financial regulation to oversee the strategic objectives and decisions of financial services organizations, rather than the specific product lines and operations considered in our current ineffectual regulatory approach. Beyond that change, there are several other issues to consider. Should we put a halt to the real estate lending practices of the banks? This involves making loans, the earning of origination fees, the sale of the loans, and then making new loans with the freed capital. 

 

There is nothing inherently wrong with this process so long as borrowers have adequate income and the collateral (the house or other real estate) is properly appraised at an amount reasonably close to the market value. However, real estate has been inadequately examined, borrowers were  not been adequately vetted as to income and other debt obligations, real estate became overpriced and overbuilt, borrowers stopped making payments, and financial institutions found themselves with properties that could not be sold.

 

The problem was exacerbated by the securitization of loan packages, pieces of which were wrapped into securities and then sold and re-sold. (“Securitization” involves bundling a pool of loans into debt securities with various maturities and credit ratings that could be sold to investors.) This process is so complex that it is impossible to know the worth of these securities, and so, in the current atmosphere of ultraconservative short-term trading, there is no market for them.

 

The current financial crisis has shocked all of the parties who normally are quite willing to be counterparties (buyers or sellers), and fear has put a hold on what previously were commonplace transactions. Normal business and consumer lending cannot resume until the government intervenes to clear the market through bankruptcies (e.g., Lehman), liquidity guarantees (e.g., AIG), forced mergers (e.g., Merrill Lynch with Bank of America), and government purchases of troubled investments (e.g., the $700 billion package that was requested by Secretary Paulson to buy troubled bank loans).

The freezing up of the financial system occurred because counterparties could no longer trust in the value of the assets being offered for purchase and sale. One of the problems is the concept of getting to a market price that will clear the market. In the next blog I will talk about valuation and the failed concept of marketed-to-market accounting.

Crooks and Scandals: Punish One at a Time

In my previous blog I suggested that business regulation is about a decade behind the times for financial services, citing AIG as an example of a company that failed when it overinvested in non-insurance assets. We got into this situation when the Gramm-Leach-Bliley Act of 1999 deregulated financial services but the government structure of oversight failed to change. There is nothing wrong with regulation as long as it reflects the current strategy of an industry. The problem is that Congress has not really adjusted the regulatory responsibilities since the passage of the three securities acts (1933, 1934 and 1940) and the banking acts (1864 and 1913); there never has been federal oversight of the insurance industry.

What we need to do once the dust settles is to refocus on the functions of these industries in the 21st century and not of one, two or even three generations earlier. As I wrote in my book, Is U.S. Business Overregulated? (York House Press, 2008), we need the appropriate level of consolidated regulation, probably by categories of risk. First, each type of investor should receive a directed form of regulation by risk category.

For institutional investors, management of financial services businesses in terms of such risk categories as-

• Insurance risk for the safety of customer funds that are on deposit with a financial services firm. This would include the segregation of customer funds and administration of account insurance (like the Federal Deposit Insurance Corporation).

• Business risk to protect the integrity of the intermediation process used by all financial services companies. This would include assurance that adequate collateral exists for loans, that appropriate due diligence has occurred in deciding whether to establish and continue relationships with customers, and that necessary documentation exists to support financial transactions.

• Systemic risk for the security of the financial system. This would involve uniform capital requirements, payment system regulation, and the monitoring of financial system liquidity.

For individual investors, depositors and consumers, protection for those who are too weak, uninformed and scattered to defend themselves. The securities industry has long recognized that institutions and other sophisticated market participants do not need the same regulatory protections as unsophisticated investors. Financial services for retail customers would be subject to regulation and the protections afforded such investors, policyholders and depositors across product lines. This would include the prevention of deceptive sales practices, credit counseling prior to the acceptance of a loan, and prosecution against the “churning” of securities and of fraudulent profit claims.

The single regulator approach permits financial regulation from the larger perspective of the strategic objectives and decisions of a financial services organization, rather than of specific product lines and operations. The model would be the Financial Service Authority of the U.K. British regulators have learned from long experience that, while there will always be scandals and failures, each should be dealt with accordingly and with remedies specific to the circumstances. This is in sharp contrast to the current American approach to business regulation: that fraud and the misappropriation of company funds can only be prevented by severe civil and criminal penalties. In my next blog, I will discuss some related issues to the current financial situation.