Opportunities in smallcaps header image 2

Accounting our way in and out of the crisis?

September 26th, 2008 · 1 Comment

Some people claim that the way we got into this monumental financial mess is an accounting rule, mark-to-market, that forces financial institutions to value things at present market prices, even if these markets are in the grip of ‘irrational pessimism’. Two months ago we wrote about that. If that’s the problem, the solution is also not so difficult..

In the article we just published, we showed that the main mechanism through which the Paulson bail-out plan is supposed to work is through aiding now disfunctional markets in obscure and illiquid financial instruments in the task of ‘price discovery’.

The theory is that these markets have gotten in such a funk that prices only reflect part of the real value of assets (see previous article), but financial institutions have to value those instruments at those unrealistically pessimistic numbers in their books, which, apart from giving them a headache, shrinks their capital base, which forces them to sell more of these assets, which depresses prices to even more unrealistically pessimistic levels.

If the problem is the unrealistically low values of these financial instruments on the books of financial institutions, why waist $700B to find out their ‘true’ price, why not just get rid of that ‘mark-to-market’ accounting rule..

Banking Bailout: A Modest Alternative
Kevin Baker

  • As a former bank analyst, I don’t think a $700 billion bailout is enough to make up for the fallacy of mark-to-market accounting for one-of-a-kind securities for which there can never be a standardized market. No amount is large enough.
  • Banks and other financial-services firms can create new, complex securities to sell to one another faster than the U.S. government can legislate, appropriate and borrow money to buy them. In addition, Treasury Secretary Henry Paulson does not want to limit the bailout to mortgage-related investments, seeking the authority to buy a variety of so-called “toxic” securities including credit derivatives.
  • Part of the problem …
  • Partly because of these securities, we have seen just this month the government rescue of Fannie Mae and Freddie Mac, the bailout of AIG, the bankruptcy of Lehman Brothers, the purchase of Merrill Lynch by Bank of America and the decision by Goldman Sachs and Morgan Stanley to become bank holding companies.
  • Mark-to-market accounting rules force banks to value mortgage-backed and other securities at less than they would expect to receive if they waited a few years until the investments matured. Since they’re booking losses based on low values, some banks may appear not to have enough capital to safely remain in business. Hence, we have a crisis in confidence that banks won’t be able to pay back their current debts, let alone borrow new money.
  • Do We Even Need a Rescue Plan?
  • With credit decisions, confidence is everything. If a deadbeat bank is bailed out by the government, I will have more confidence in the government’s ability to borrow and spend money. However, this will not increase confidence in the management of the deadbeat bank or on the valuations placed on that bank’s other securities.
  • One possible solution …
  • For one-of-a-kind securities that may never be actively traded in a standardized market, I propose the use of a valuation methodology called “valued & insured-to-maturity.”
  • Step 1: Value the assets. Banks choosing to participate would pay a nominal fee to submit their securities for pricing to a new government agency with all documentation and assumptions. That agency would determine what the security is worth and allow the use of that price for regulatory capital calculations and balance sheet reporting requirements.
  • Paulson’s plan requires fair value pricing of securities to determine how much the government would be willing to pay, so step 1 is not much of a stretch. Plus, this action alone would go a long way toward re-capitalizing the banking system without costing future taxpayers billions of dollars to pay back interest on record government debt levels. Also, a government stamp of approval on a security’s price would give confidence to private market participants willing to buy that investment, thereby unfreezing the mortgage security market.
  • Step 2: Don’t buy the security. Instead of the government removing moral hazard and wasting tax dollars socializing corporate losses, it should just say “no” to buying these securities. There are billions of dollars, yen and euros floating around the world on the lookout for underpriced assets that, with some patience, could potentially generate a nice return.
  • Step 3: Insure some securities. For the securities valued above for which the government has high confidence in the composition of the investment and the determination of fair value, a premium could be charged to the banks to insure the new expected principal and interest payouts. The premiums should be high enough to cover losses over the coming years. This insurance would also make the securities easier to sell.
  • While setting up a new government infrastructure to value and insure securities would cost money, it would be just a drop in the bucket compared to Paulson’s $700 billion budget-busting plan.

Note however that step 1 of this plan also relies on price discovery by public servants..

Tags: The Markets

1 response so far ↓

  • 1 An alternative rescue plan // Sep 26, 2008 at 4:44 pm

    […] reported on The Paulson plan and an alternative. The essence of both is that they argue that the markets for those complex financial products are […]