Fantasy accounting was at the heart of the bubble. There are, of course, many fingers to point blame toward. The rating agencies were complicit in judging toxic paper to be worth their weight in gold, allowing yet more paper to be issued on top of it. Lawmakers encouraged the issuance of this paper through various "homeownership" programs. Brokerage firms sold it as a "like cash" investment that yielded far better returns than what was typically considered to be safe. And foolish investors unquestioningly accepted this "logic" to the extent they felt entitled to such high returns without having to bear any risk whatsoever. To be sure, there are more parties bearing responsibility.
But the most important enabler of this idiocy was always, and still is, accounting - or the lack thereof. Somewhere along the way it became acceptable to use more than one method of valuing assets. The average person is not entitled to such a luxury. But major financial institutions managed to gain a foothold on this ability, thus allowing themselves to post record profits.
For example, I am in the process of trying to sell an old car. It has over 300,000km on it. CV joints are totally shot. Windshield is cracked. Somebody nearly tore off the side mirror. And the engine leaks a little. Otherwise, it looks like a nice little car. Were I to go to the blue book and obtain the market price for this particular vehicle, I would find that I should be able to get $2500 back for it if sold privately. That, however, is a total fantasy. I'd be lucky to get half. Therefore, in considering my total assets, I must think of what I can realistically obtain for this old clunker (mark to market).
Banks do not have to do this - and haven't for some time. They will go ahead and value the car at $2500 with the conclusion that anyone foolish enough to take into consideration all the issues with it are acting irrationally. They will simply list on their balance sheet under assets "Auto - $2500" with no further information specified.
This is a blatant violation against the spirit of Generally Accepted Accounting Principles (GAAP). In recent decades, it has become acceptable to re-categorize assets, like my car, as "illiquid" - meaning that there is no market price for the asset. Because there is no other Honda Prelude with exactly the same characteristics as mine, it is impossible for me to know the exact price. Therefore, the best that can be done is to go by the blue book price (mark to model).
In the FT article referenced above, the author tries to make sense of the above absurdity. What he suggests is that as markets fluctuate the perception of value will change, thereby affecting accounting principles. Therefore, it is offered, regulations should be required to force accounting principles to be more stringent when asset prices are rising, and less when they are falling. A reasonable, proposition you say? I beg to differ.
First, there can be no metric to empirically measure price. Some prices will be falling. Some will be rising. To attempt a quantitative measurement of all prices at all times is impossible. People's preferences change regularly. It is for this reason that consumer price measurements (like the CPI) are fatally flawed from the beginning.
Second, anyone attempting to find a way around these regulations will find a way if they have an incentive to do so.
Smith argues from another perspective:
Any collateralized lending is pro-cyclical, period. As asset prices rise, banks think their loans are better secured and that their customers are richer, since they have stronger balance sheets. Even if they do not loosen lending standards, the mere fact of rising asset prices means they will lend more against the same collateral. This process tends to continue until debt servicing becomes a problem (unless asset prices are well behaved and do not rise faster than GDP or incomes) and asset prices start to fall because strained borrowers don't want to take on more debt. Fewer buyers for the same assets means prices start to fall, and the leverage leads to a stronger downswing just as it fed the rise. This has nothing to do with accounting, it is a function of how collateralized lending can easily feed an asset bubble.
I agree with this view as well.
We would likely also agree on what the solution is: transparency. Investors in any security (be it common stock, a mortgage backed security or a derivative) need to have every piece of possible information at hand in order to make an informed decision. If I were to consider buying Citigroup stock, I should be able to obtain information on every single asset that they hold on their balance sheet. I should be able to know every single mortgage, the ZIP code they are located in and the credit history of the borrower.
But our conclusions seem to be vastly different. While Smith believes that the accounting shenanigans are the fault of the free-market being let loose, I see it as a form of legalized fraud - having nothing to do with what a free-market would demand. Only in a market propped up by faulty institutional guarantees is this acceptable to investors. In other words, investors are lulled into a false sense of security by regulation. They assume that if something is being done, it is being done with the blessings of regulators.
So while transparency is the obvious solution, it is wrongheaded to believe that some regulatory agency in Washington will be able to ensure that all required information is made available. What will result from such an arrangement is precisely what we have already seen. Regulators will make up a list of all the things a financial institution needs to disclose in detail. However, some new instrument (derivatives, let's say) will be invented to circumvent the existing regulations. By their very nature, regulations cannot interpret new information. If something is not explicitly said to be forbidden, it will be considered fair game.
The way to approach this problem is from a legal standpoint, not a regulatory one. The issues should be left in the hands of judges and juries. The simple law should be made, and enforced ruthlessly, that all material information must be made available to prospective investors. If this means that Citigroup must disclose thousands of pages of information each quarter, then so be it. Should they refuse to do so, then their executives shall go to prison. Full stop. With the rapists and murderers.
Commentators like Smith need to drop their fanciful obsession with regulation. It is far too interpretive and corruptible to be of any use - especially in the financial services industry. Misleading investors to the values of assets on a company's balance sheet is illegal. Matters need not be more complicated than that. It is not required that the person judging such matters be trained by the very institutions they are judging in order to make this determination. Any experienced legal expert can do so.
Removing the interpretive nature of regulations will not only incentivize investors to do their own due diligence, but it will remove the perception of immediate legality of any new instrument or practice (ie. legal until the regulators catch on). The lack of the former and the presence of the latter actually serve to act as a regulatory safety net for the financial services industry. This needs to be removed.
Will investors make uninformed decisions even with the correct information? Of course. But the fairness of their error cannot be questioned. They had all information at their hands. And should they be misled, they can recover their losses in the courts.
Making matters more difficult than this is only of benefit to "the regulated."
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