Tuesday, September 23, 2008

A Mere Stroke Of A Pen.....

It is January, 2006. The US Congress, after hearing testimony on the dangers of mandating 'mark to market' valuation of exotic, structured finance instruments, modifies Sarbanes-Oxley to allow those holding such instruments to value them using economic present value methodologies, so long as the underlying instruments are 'performing.'

Because of its timely, pre-emptive change in this law, Congress prevents the write downs of several hundred billion dollars of valuation during 2007 & 2008 at Bear Stearns, Merrill Lynch, Citigroup, Morgan Stanley, Lehman Brothers, Goldman Sachs, Wachovia, Bank of America, and countless other, smaller financial institutions.

With just one stroke of a pen, President George Bush's signature on this law avoided a severe, self-induced catastrophe in the financial services sector due to a single, dubious requirement to value all instruments, even those held to maturity, at values reflecting daily market-clearing prices.

With material, but manageable delinquency rates of just 6.4%, and default rates also at historically high, but manageable levels for newly-created exotic mortgages, losses of only tens of billions of dollars were incurred by these firms, rather than a $700B Federal government purchase of distressed structured financial instruments backed by mortgages of varying quality, type and duration, plus the several hundred billion dollars of write downs these banks took in 2007 and 2008.

Would defaulted and delinquent subprime and alt-A mortgages still have forced some writedowns? Yes. But these would simply have been higher-than-average mortgage defaults, not wholesale instrument value meltdowns causing massive counterparty risk increases.

If additional government "solutions" were required, they may have taken the form of requiring underwriters of structured finance instruments to retain a minimum percentage of the offering on their own balance sheets.

Yes, only a stroke of a pen was needed to avoid the bulk of the mess of the past seven months in our financial service sector.

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