Friday, July 17, 2009

Regulation or Transparency?

Yves Smith of the Naked Capitalism blog was commenting on an Op-Ed piece in the Financial Times yesterday. It is in regards to an issue that I believe is more important than any other at this moment: accounting practices.

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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Anonymous said...

Interesting post.

Along the lines of regulations and how new instruments are difficult to regulate. A newsletter I receive mentioned a day or two ago that the New York and Tokyo commodity exchanges have been permitting their gold futures contracts to be settled not in real metal but in shares of gold exchange-traded funds.

Of course, this will work fine in steady-state markets, but in times of turmoil you're now exposed to counter party risk as the exchange (who guarantees futures contracts) washes their hands and walks away.

I don't know how long this has been going on, but this is a recipe for disaster. How would regulators deal with this? Will it spread to other futures markets?

As you play through the implications of this and possible scenarios how this might unfold, it boggles the mind. The lunatics are running the asylum...

mannfm11 said...

The settlement is kind of absurd isn't it? Aren't the ETF's at least marginally based on futures contracts, as the management of them would be near impossible? I happen to believe the stories that come out of the gold camp are greatly exaggerated. The gold market is too big to ever be dominated by the futures exchanges, the estimated value of all above ground gold in the $5 trillion range. If you can't take delivery on gold at the exchange, the exchange is in default.

As far as free markets? As long as one group is accorded an advantage over another, then regulation has no power. I am convinced from what I have been able to deduce over the past 10 years or so that entities like Goldman Sachs are accorded or allowed to do things that would land any of us in prison for a long time under insider trader charges. This is not capitalism and to call it capitalism is a joke. In fact, I had a small trading account early this year and entered a trade in 5 purchases of equal size. I closed half the trade and was charged with daytrading a small account on a patterned basis. There is no doubt that this was outlawed or at least the regulation was put in to limit outside trading to allow for Goldman and others to have the scalping market to themselves.

Another title of nobility is in what is called banking. It appears that the government has pulled out all stops to allow for the continuance of fractional reserve banking, first establishing a central bank, then demonetizing the money, then putting in deposit insurance to eliminate the worry that the system is being kept straight and now the fiction called accounting. Again, this isn't free enterprise, but the opposite.

What system allows for continued operation of Citicorp and even a near sale of Wachovia to Citi when Citi was as broke as Wachovia? In fact, when it is all said and done, Wells will probably be as broke as well. It appears that regulations only apply to those the people the government chooses to apply them to. Has our system rotted to the point that some have immunity while others are persecuted? Where is the equal protection under the law when Goldman can systematically minute by minute trade and propagate trends in their favor as their position as market maker while the public is forced to pay? The whole idea of stock investing was sold to the public as legitmate, while in fact it is likely less legitmate than a horse race. At least you know you are gambling and the horse you pick could be doped.

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