Mark-to-Market: Numbers Don’t Add Up

The Financial Accounting Standards Board (FASB), an independent agency that sets business accounting rules, announced today an accounting change that may temporarily boost markets but in the long run may bring more harm than good. That change subverts mark-to-market accounting rules, which held that the price of a mortgage security, for example, reflect current market value rather than what someone hopes to get for it in the future. In place of these rules, bankers will have the discretion not to disclose declining values in such assets on their income statements, thus allowing them not to write down toxic assets. As a result, banks will no longer, it is claimed, have to hoard capital to offset bad loans, thus helping to thaw frozen credit markets.

The problem with the change in rules is that allowing banks in effect to hide their bad loans makes transparency a bad joke. Lack of transparency in accounting practices helped to cause the savings and loan disaster of the 1980s. A report in McClatchy News today highlights the problem:

During the S&L crisis, government regulators initially eased federal accounting rules for troubled S&Ls, which hid their negative worth and allowed them to make even worse decisions that led to their collapse and an expensive federal rescue.

Last month, members of Congress and banking interests, according to today’s New York Times, pressured the FASB to change the rule and by extension blamed much of the current financial crisis on mark-to-market rules. But it may have been a lack of mark-to-market rules that enabled the housing bubble to expand, allowing banks to overvalue undeserving assets. It seems that FASB bowed to that political pressure in contravention of its own mission:

Serving the investment public through transparent information resulting from high quality reporting standards, developed in an independent, private sector, open due process.

As a commentator on CNBC put it today, this accounting solution is like giving the fire hoses to the arsonists. What’s likely to happen won’t put out any fires and may, in fact, increase their intensity.

How Worried Is the Fed?

In a move that surprised many observers for its aggressiveness, the Federal Reserve Board on Tuesday, Dec. 16^th, lowered the federal funds rate, the interest rate at which banks lend to one another, from 1% to a range of 0 to .25%. Many observers had expected a .50% cut, not the .75 to 1.0% cut that the Fed has effected. The lowering of the interest rate points to a Fed extremely worried about the health of the economy going forward.

The Fed also announced other efforts to fight the specter of deflation, using, as it says, “all available tools to promote the resumption of sustainable economic growth and to preserve price stability.” These tools include supporting

the functioning of financial markets and stimulat[ing] the economy through open market operations and other measures that sustain the size of the Federal Reserve’s balance sheet at a high level. As previously announced, over the next few quarters the Federal Reserve will purchase large quantities of agency debt and mortgage-backed securities to provide support to the mortgage and housing markets, and it stands ready to expand its purchases of agency debt and mortgage-backed securities as conditions warrant. The Committee is also evaluating the potential benefits of purchasing longer-term Treasury securities. Early next year, the Federal Reserve will also implement the Term Asset-Backed Securities Loan Facility to facilitate the extension of credit to households and small businesses. The Federal Reserve will continue to consider ways of using its balance sheet to further support credit markets and economic activity.

Federal Reserve Building

Together with the interest rate cut, these policies give insight on just how concerned federal officials are about the state of the economy. With job losses increasing, credit still tight, and prices deflating, the Fed wants to pump a flood of liquidity into the system to prevent a disastrous deflationary spiral.

The incoming Obama administration is also promoting an immense stimulus package that will pump even more money into an economy that it and the Fed are trying to reflate. Congress’s cooperation, with Democratic majorities, seems assured, although the defeat in the Senate of the auto bailout bill may portend a willingness on the part of Republicans to be obstructionist if they see political advantage.

The trouble is that if these efforts don’t work, what other ammunition do  the Fed, Congress, and President-elect Obama have left? If the auto companies fail, what will the resulting shock do to the crisis of confidence the economy is in? TARP money for the automakers has yet to be forthcoming (as of this writing), and people generally seem so sour on the automakers, not without reason, that President Bush and Henry Paulson seem reluctant to drink from this cup.

I suppose one could point to the equities market and see a glimmer of hope, but that’s, at this stage, fool’s gold. With the recent volatility of those markets, how can anyone rely upon them?

And even if the Fed and Congress through monetary and fiscal policies manage to reflate the economy, what then? With the world awash in liquidity, a new specter looms: inflation and its attendant risk, hyperinflation.

By the way, lest you think I’m all gloom and doom, Merry Christmas. Look out for the New Year.

Image courtesy of wwarby’s photostream at Flickr and used under license of Creative Commons.

Economy on the Skids, Frenzy of Hatred — Country Imploding?

The Dow Jones Industrial average fell nearly 680 points yesterday, losing value for the seventh trading day in a row. The S & P 500 and Nasdaq also suffered steep losses. This morning’s Dow Jones Futures (still down as of 6:34 CDT) suggests that the sell-off will continue. CNBC has described an atmosphere of panic on Wall Street. Credit markets remain tight, though CNBC reports that the LIBOR loosened somewhat overnight. It’ll take much more grease, however, to thaw frozen credit markets. Risk aversion has taken hold. The President is scheduled to address the nation at 10:25 EDT, and Secretary Paulson seems more willing to inject capital directly into banks, which means the government will have an ownership stake in the banks it saves. Many economists and Wall Street insiders are calling for such action, and the sooner the better.

All of this comes against an election year backdrop that is turning increasingly ugly. This morning’s ($)WSJ online reports (“McCain Campaign Is at Odds Over Negative Attacks’ Scope”) that the McCain campaign is divided about just how far to go in attacking Senator Obama. McCain has approved attacking Obama over his association with William Ayers, a former member of the Weather Underground. Some in the campaign want McCain to ramp up attacks by also hitting the Reverend Wright story again. McCain himself, the story says, seems reluctant to do this, declaring Rev. Wright off limits.

But what is really disturbing is how McCain campaign rallies have whipped up a frenzy of hatred against Obama and Democrats. Monica Langley and Elizabeth Homes, the WSJ reporters, write that

Some McCain campaign officials are becoming concerned about the hostility that attacks against Sen. Obama are whipping up among Republican supporters. During an internal conference call Thursday, campaign officials discussed how the tenor of the crowds has turned on the media and on Sen. Obama.

Someone yelled “Off with his head” at a rally Wednesday for Sen. McCain and Gov. Palin in Pennsylvania. Later that day in Ohio, a man stood outside a rally holding a sign that said “Obama, Osama.” At a rally in Jacksonville, Fla., on Tuesday, someone in the crowd wore a T-shirt depicting Sen. Obama wearing a devil mask.

Gail Collins, in Wednesday’s column for The New York Times, notes that “Sarah Palin has been telling her increasingly scary rallies that [Obama] is somebody ‘who sees America as imperfect enough to pal around with terrorists.’” Such inflammatory rhetoric cannot bode well. Are Republican leaders, especially Senator McCain and Governor Palin, prepared for the possible consequences of such rhetoric? Do they not realize the risk they’re taking? Do they not see the danger? Are we in the midst of something happening in this country that months from now we’ll look back upon this time period and say to ourselves, “That’s when we imploded”?

Picture courtesy of earthpro’s photostream at Flickr under Creative Commons License.

No Confidence — in Leadership

If banks won’t lend to other banks, let alone to customers, then credit markets will dry up. And that’s exactly what has happened. Fear, lack of confidence and trust, not only in capital markets but also in leadership, are creating a perfect storm.

The way to liquefy the markets, as administration and Congressional leaders advocate, is to follow the basic outline of the plan that the House defeated yesterday. The problem is that this is an election year, and the public views the bailout as something solely for Wall Street. In fact, it’s enjoying the pain and discomfort and anxiety that the markets are now experiencing, a perfect example of schadenfreude. Investors and banks and those who support them and benefit from them deserve what they get, or in this case not getting. We seem, even, in a punishing mood, and forgiveness may be a long time coming. That’s why Congressional leadership is having such a difficult time getting their caucuses to go along with the $700 billion rescue. Congressional rank and file, particularly in the House, simply won’t go along with a package that appears to bail out Wall Street. Their constituents are opposed and enjoying the spectacle, and their representatives won’t lead. They lack the courage.

Of course, such a do-nothing view is extremely shortsighted and troubling. Frozen credit markets are devastating not only to Wall Street but to Main Street as well. Endangered are not just the rich and wealthy; they’re not islands, and neither is the middle class. To think that what happens in one doesn’t affect the other is myopic. If you feel good about the pain that Wall Street is undergoing, how will you feel when the wave hits you?

The trouble is that if there is a crisis of confidence in financial institutions, there is also a crisis of confidence in leadership. President Bush, Paulson and Bernanke, Congressional leaders, public opinion makers, simply are not trusted. We’ve reached a state of mutual distrust, and no clear way out of this thicket seems apparent.

Save! Don’t Spend!

Begin building cash, now! That’s the word from Brent Arends of the WSJ online in his R.O.I. column for today (see $“Stash Your Cash,” WSJ online, 30 Sept. 2008). A market of chaos argues against further investment in the stocks at this time, he writes. Here’s a brief glimpse of what he says:

Drop your cable package and TiVo. Say goodbye to Applebee’s and Starbucks. Cancel the ski trip.

Slash every single penny you possibly can from your household budgets and start building up cash.

Yes, I’m serious. The shocking collapse of the rescue package on Capitol Hill threatens a disaster on Main Street. Unless this gets reversed almost immediately, it could turn a slowdown into a slump, and a slump into a depression.

Arends isn’t the only one making the argument for a Main Street collapse. CNBC, The NY Times, The WSJ, all deplore Congress’s refusal yesterday of the bailout package. Credit markets remain so tight that if not loosened up in the next few days, the situation will be dire for all of us within the next few weeks. There appears to be so little support among the populace as a whole or among Congressional rank and file, especially Republicans, for a bailout package that the risk to Main Street grows each day. Whether or not the House can come back on Thursday or Friday and deliver a package remains to be seen. Personally, I’m not hopeful. And we don’t know, of course, that credit markets will be loosened sufficiently to unclog capital arteries even if Congress delivers something similar to what they defeated on Monday. That’s the dire situation the world economy is now in.

Of course, if Arends’s advice is followed, then increased savings means less spending, which will further exacerbate a downturn. But his message, filled with hyperbole as it may be, is prudent. Begin building cash reserves, as much as you can.

Hedge Funds Next?

NYTimes reports today that hedge funds may be the next trouble spot in the nation’s financial health. “After years of explosive growth, losses are mounting — and so are concerns that some investors will head for the exits,” writes Louise Story.

The key is what happens in reaction to the funds’ worsening losses. As losses worsen, more investors will want to get their money out, which will cause more funds to cash out their investments, which will cause values to plummet, which will cascade into more investors’ wanting to redeem their fund investments. The key date to watch is this Tuesday, September 30, when a fair number of funds accept redemption requests from investors for the end of the year. If those requests show a dramatic increase, then fear and loss of confidence will have overtaken the hedge funds.

How does that affect you and me? Well, as the article points out, hedge funds are not just for the wealthy anymore. Since 2002, pensions, endowments, and foundations have forked over billions of dollars in investments, expecting bigger returns. Now those investments may be in jeopardy.