Saturday, September 27, 2008

American CDOs Are Not The Same As Japan's Bad Bank Loans of the 1990s

Many people seem to be confused about the role that 'mark to market' accounting has played in the current US financial services sector debacle.

No less than two former leading lights of US financial regulation, Arthur Levitt, former SEC chairman, and Lynn Turner, the agency's former chief accountant, both of whom retired in 2001, wrote an editorial in the Wall Street Journal yesterday on the subject.

As you might expect, they lecture on why anything but that method of valuation misleads investors.

Another frequent analogy is made to Japan and its famous 'lost decade' of the 1990s, due to the false valuation of nonperforming bank loans allowed to remain on bank balance sheets at face value.

Allow me to dispel these myths. Especially the second one.

Levitt and Turner are correct in their assertion that full information on the true value of an asset is essential for investors, in order that they can make informed investment decisions with respect to the value of a firm with questionable assets on its balance sheet.

However, they cannot wave away, as if with some magic wand, the real disparity between two values of a performing (or, in some cases, even a non-performing) asset: the current market price at which the asset can be sold, and the present value of the economic performance of the asset when held to maturity, or for a very long duration.

It is as wrong to penalize owners of a firm whose performing assets, though expected to be held to maturity, are currently valued at a far lower value in the market, by forcing them to value those assets at the current 'liquidation' value, as it is to overstate asset values by denying their nonperforming status.

In the case of Japan, non-performing bank loans were held on bank balance sheets at their full value, overstating the banks' values and causing severe counterparty risk. Their financial system froze up due to these inflated values of non-performing loans.

The current dilemma in the US concerns securitized, structured financial instruments backed by residential mortgage loans.

Because the securities are artificial creations composed of mixes of payments from many underlying mortgages, investors are now concerned that it is difficult, if not impossible, to discern which CDOs are relying on payments from delinquent or defaulting mortgage loans, or loans likely to default. Thus, a counterparty risk has arisen which is depressing the 'liquidation' value of such CDOs.

But nobody disputes that most of these CDOs are, in fact, still 'performing.' Their economic value, held to maturity, is quite high. Far higher than the immediate market liquidation value.

Unlike Japan's clearly non-performing bank loans, most of the mortgages underlying the outstanding CDOs are performing.

Yes, a percentage of the underlying mortgage loans will become non-performing. Some were 'alt-A' or 'subprime,' and will have a higher-than-average default rate. But it won't be 100%.

Thus, there is no comparison whatsoever between the Japanese experience with bad, non-performing bank loans in the 1990s, and American mortgage loans in this decade, most of which are, in fact, still and expected to be, performing.

Levitt and Turner are incorrect to suggest that investors may only be misled by overstated values of performing assets whose immediate, liquidation values are depressed due to factors not related to the actual performance of the assets.

Assets such as CDOs can be performing, but valued much lower for immediate sale, due to a general misperception of the true percentage of non-performance in the asset class, and the inability to distinguish which are non-performing at this time.

That doesn't mean that a firm wishing to hold performing CDOs to maturity owns an asset which is, for the purposes of that firm's use of the asset, worth only its liquidation value.

Friday, September 26, 2008

The Most Outrageous Myth...

Yesterday I wrote this post about what I consider to be some of the significant myths surrounding the current US financial services sector debacle.

Since I published that post, I heard one more myth I feel it is important to expose and refute. The exact language was uttered by the Democratic junior windbag (Senator) from Ohio.

Herewith is my additional myth...

Myth #6: "Wall Street" let us down and broke the public trust. Doesn't "Wall Street" owe the American people an apology (and that pretty much IS a direct quote from this windbag) for creating this mess by being greedy?"

No, it absolutely does not. The lesser-regulated, free-wheeling world of investment banking, hedge funds and private equity are all a recognized equivalent of the Wild West, financial style.

It's buyer beware, pure and simple. For every seller of a toxic, mortgage-backed CDO or dubious swap, there is a willing buyer who thinks s/he is getting the better of the exchange.

Nobody who owns a CDO or credit default swap was forced, at gunpoint, to buy it. Nobody kidnapped the buyer's children and held them for ransom until s/he bought the toxic financial stuff.

No, each party felt they were getting a better deal than their counterparty. There is nothing to apologize for. Shareholders knew, or should have known the type of firm in which they were investing. That goes for union pension funds, too.

Simply put, to the rube Ohio windbag, there IS no trust on Wall Street. That's why exchanges require collateral, as do swaps deals. You only have what you can grab from escrow.

This is how we have built our non-commercial bank financial sector. We want innovation and efficiency. To get that, we have to allow what is basically a free-for-all, free-fire zone of finance. Trading in instruments, securitizing, buying and selling said securitized fixed income instruments, is for professionals.

Any professional at an investment bank, asset management firm, investment committee of a trust or pension fund who says they got taken, didn't understand the risks, or otherwise ducks responsibility, is lying.

Where, I ask are all the originators or buyers of CDOs and swaps at Merrill Lynch, Lehman, Bear Stearns, Morgan Stanley, Goldman Sachs, Wachovia, Citigroup and BofA? At all the various asset management firms or hedge funds which bought the same instruments?

As I wrote here recently, your first mistake, Mr. Brown, is to associate the word "trust" with securities origination, sales or trading.

So, no, do not expect any apologies from anyone working on "Wall Street" for what has happened. They were all just doing their jobs. Some did them better, and some did them worse, than others. Mostly, a lot of risk managers did lousy jobs. Now, many of them don't have those jobs anymore.

As to the first causes of this mess, Windbag Brown, as I wrote here and here, look to Bill Clinton and Bob Rubin, and to your own House....errr....Senate......for demolishing Glass-Steagall and explicitly turning a blind eye to Fannie's and Freddie's practices and growth, while taking their campaign fund cash.

Will you or any of your colleagues apologize to the rest of us Americans for what you did in this mess, Senator Brown?

On Recent Developments At Goldman Sachs

Let me begin by admitting that, in this recent post, I was completely wrong in my prediction of Goldman Sach's fate. I wrote, in part,

"This does not, in our view, alter the fact that Goldman remains the class of the class of investment banks, public or private. So, when everyone else is selling equities, what should the best equity house on Wall Street do? Buy, of course. We believe that, while John Mack's weakened Morgan Stanley runs for cover at a large, mediocre commercial bank, Lloyd Blankenfein and his management team will, in conjunction with selected private equity investors, tender to take Goldman Sachs private again.It makes sense. Goldman's risk management has held up well while all their publicly-held competitors are finally driven from the field. Why should the best managers in investment banking cast their very desirable pearl before the....ah....well, you know....sell to a commercial bank and work for its probably-dimmer CEO?

That's my- our- prediction. It just seems too obvious that when Goldman's price has been unrealistically depressed, due to near-term market conditions, far below its long-term intrinsic value, those who know it best- Goldman's managers- will do a leveraged buyout.You read it here, if not first, early."

Instead of my expected solution, Goldman instead filed to become a commercial bank. Perhaps Lloyd Blankenfein felt that more immediate action was required than that necessary for a tender to take the firm private.

Then again, just what is the firm that is applying for a commercial bank charter? Is it the Goldman Sachs we know, post-Whitehead? The swashbuckling, client-beating, private trading and hedge fund-gone-public?

Remember, Goldman was the last private investment bank partnership to go public. And, as the Street's premier equity underwriter, you had to bet that, if they were selling, it was a market top.

So, why would Blankenfein take his much-feared crew off the field of relatively-unfettered trading and, in a minor way, investment banking, to compete in the stuffy, restrictive, unimaginative world of commercial banking?

Maybe it's this. Goldman, the public entity, will become a commercial bank. But what of its talented, highly-paid, innovative staff? Do you think the guy who was trading exotic swaps yesterday will be sitting opposite you to discuss your application for a home equity loan tomorrow?


No, I think Blankenfein piloted his firm into a safe harbor- commercial banking- in order to let all hands leave the stranded ship for a safer shore, to begin life anew. With their substantial equity stakes in the firm as grubstakes.

Plan on seeing many, if not most, of Goldman's brightest people migrate to existing private equity, asset management and hedge fund firms, and/or start new ones. As I wrote later in the prior post,

"And that will be the finish of the 30+ year-long cycle of Wall Street going public, shearing its clients, then selling the wreckage either to other investment banks, commercial banks, or back to itself. Investment banking will have ceased to be an independent, publicly-held market function.

I'll even predict that, with time, the private investment banks will out-maneuver and -compete the commercial banks which bought the remnants of the poorly-run, remaining publicly-held investment banks. And we'll be back to a de facto version of Glass-Steagal, with a few commercial banks half-heartedly trying to compete with their sharper, better-paid privately-held competitors."

I still believe what I wrote in those two paragraphs. And that Goldman's employees will lead in this remaking of investment banking in the image of the old, legendary days of JP Morgan, the man- not the firm.

It's remotely possible that Goldman's best would hang around to merge with, then takeover and run a larger commercial bank. But I'm just not sure that sort of mind-numbing activity and straitjacketed operation style will be attractive to the best Goldman alums. No matter how large the commercial bank, it's simply not as nimble, nor interesting, as a private equity firm or hedge fund.

And what of Warren Buffett's $5B investment in the firm? Well, as usual, Warren got an exceptionally sweet and unique deal which neither you, nor I could extract. He has locked in a 10% return on $5B. It's really not an equity deal. It's a high-priced private equity loan.

I'm not sure if Buffett feels the firm will be a good equity investment. Sure, he's got warrants, in case it is. But if not, 10% is a good coupon rate for whatever will be left, legally, that Goldman can still do under a commercial banking charter.

But the Goldman we knew is gone forever. There just isn't sufficient wiggle room in a commercial bank charter for the firm to ever return to its heyday of being a publicly-held hedge fund/private equity shop with a few pieces of old investment banking attached- underwriting, asset management and M&A.

However, in truth, the branchless bank model of the old JP Morgan commercial bank and Bankers Trust failed in the 1990s. And they failed, in part, because of a lack of a stable deposit base. So, how will a newly-commercialized Goldman Sachs bank escape that fate?

It's even reasonable, given the excess capacity in the financial system, that, once a sufficient number of top-tier, old Goldman Sachs employees depart for greener pastures, the remaining second-tier staff will merge with some always-commercial bank, e.g., Wells Fargo, Wachovia, or BONY-Mellon.
I doubt the new Goldman will remain unmerged or unacquired for long after its best and brightest have departed.

Thursday, September 25, 2008

The Fundamental Problem With Treasury's Rescue Plan

The more I read and reflect on Treasury's proposed plan to assist banks in their recapitalization, the more confused I am by just how it is supposed to work. I refer often to Fed Chairman Ben Bernanke's explanation.

In brief, he described a process by which Treasury would buy distressed CDOs at near-'hold to maturity' values, thus allowing banks to mark remaining, similar securities at similar, capital-preserving values, plus receive Federal money in exchange for the CDOs.

If Treasury does this, however, no private equity bidders will participate, since they have been arduously 'bottom fishing' these CDOs at fire sale prices. For example, recall Merrill Lynch's deal to offload several billion dollars of CDOs to a buyer, with recourse, at something like 37 cents on the dollar.

Further, if Treasury bids such high, close-to-maximum-economic value prices for these securities, then there is virtually no chance of the US taxpayer realizing any gain on subsequent sales. At best, they may breakeven.

At the other extreme, though, also described by Bernanke, if Treasury's bid is a little above the fire sale price, but well short of the economic, or 'hold to maturity' value, then the selling bank receives little extra capital, and not much more in the form of marking similarly-held securities up to the bid, either.

What is it that I am missing? This isn't going to work!

Not, at least, as advertised. The banks either receive full value, and American taxpayers pay the difference of fire sale and economic valuation, or the taxpayer gains, but the banks still lack capital, as their mandated 'mark to market' prices remain too low to provide additional capital to our financial system.

Myths About the Current US Financial Debacle

Two days of Congressional hearings have begun to wear heavily on my patience and tolerance for stupidity. The sight and sound of Chuck Schumer, the senior sitting idiot Senator from New York, chairing the proceedings and making statements calculated to play to the crowd, have sickened me.

As I've listened to hours of statements by Treasury Secretary Paulson, Fed Chairman Bernanke, SEC Chairman Cox, and a myriad of Senators and Representatives of both parties, as well as the two Presidential candidates, several incorrect, now-mythical aspects of the current US financial debacle are become frequently repeated and erroneously believed.

Myth 1: American consumers are, or should be, worried about the debacle, and have been directly hurt by CDOs and credit default swaps.

This was patently untrue, at least up until politicians began to keep dragging 'the average, hardworking American' into the fray. Few, if any, 'average Americans,' or 'hard working Americans' bought or hold CDOs or credit default swaps. Those who bought equities in failed institutions knew the risks they were taking by investing in equity markets. The financial services debacle is largely a sector problem, rather than a wide-ranging economic problem.

There have been some follow-on effects due to knee-jerk credit tightening by some financial institutions. And, yes, now that the clear impact of Congress' misguided insistence on the 'mark to market' rule has caused a loss of capital by lending institutions, credit is drying up.

But direct losses by most American consumers from the failure of Lehman, Bear Stearns, Fannie, Freddie, AIG, or Merrill Lynch's sale are non-existent, save for those who chose to work for those firms.

Myth 2: Congress can and should do 'something' about financial executive compensation, especially as taxpayer funds are being considered for buying distress-value mortgage-backed structured financial instruments.

Hard as this is for many people, including Congressional legislators and many Americans, this is not the business of non-shareholders of companies in the financial services sector. Shareholders bear the direct price of excessive executive compensation. Regulators functioned to oversee companies, and their executives. If those regulators saw no illegal activity, then there is no reason for the Federal government, with no proof of illegal activity, to arbitrarily 'take' compensation awarded by shareholders of private, publicly-held companies.

The last time Congress meddled with this, they created the options timing/pricing debacle. Remember when, similarly outraged, a prior Congress limited corporate tax deductions for executive salaries at $1MM? The result was to cause boards to issue generous stock options to executives, instead. When timing of the options pricing became tangled and complicated, Congress then punished that, too. It just never ends.

Perhaps Congressmen, knowing, down deep, how unemployable and inept they really are, harbor a badly-disguised envy and hatred of corporate executives who actually accomplish goals?

Finally, just how would Congress attempt to write a completely ironclad law with respect to executive compensation, in 48 hours, that will not have some overlooked loophole, or lead to some horrendous, unintended consequence. As most of their punitive legislation often does.

The proposed plan by Paulson and Bernanke is more of a 'buy, hold and resell' program, rather than just a straightforward, unrecoverable spending of $700B+ of taxpayer funds. As such, it is not a direct payment by taxpayers to already-richly-compensated financial service sector executives for having ruined their companies, damaged the sector, and general wreaked havoc with US fixed income and business lending activities.

Myth 3: Federal regulators knew that illegal or imprudent actions were being taken by commercial and investment banks, but silently let them continue said activities.

This is not true, per se. In the case of Fannie and Freddie, regulators attempted to raise warnings for over four years. However, Congressmen of both parties, but, particularly, those who received the largest political donations from those GSEs- Senators Chris Dodd and Barack Obama- and Representative Barney Frank, all ignored or otherwise rendered ineffective the regulators' warnings. As for investment and commercial banks, there was a buyer for every seller of a questionable mortgage, mortgage-backed security, or credit default swap.

Nobody put a gun to any buyer's head and forced her/him to purchase a financial asset which is now worth substantially less than it was when purchased.

Our economic system allows for individual action to be free of restraint, unless explicitly prohibited. The notion that the Federal government 'should have known what was going to happen' and, absent a crime, intervened, as Bill O'Reilly and others have harangued, is ludicrous. Millions of transactions occurred to create the current mess. Each was performed consensually by an adult or sophisticated investor. To baselessly prohibit these activities, if they were legal, would have been an inappropriate intrusion of government upon private sector activity.

As I wrote here recently, the ultimate risk management technique in financial transactions is 'investor beware.'

Myth 4: Thousands upon thousands of Americans are defaulting on mortgages because of losses in CDOs or swaps at large US commercial and investment banks or insurance firms, and should be 'saved' by interest rate reductions, mortgage loan amount reductions, payment holidays, or some combination of all three.

These two events are unrelated in the way that Congress and other pundits are describing. Yes, delinquencies and defaults by the marginal, risky borrowers with subprime, variable rate and/or alt-A mortgages, will affect the values of the layered-on securities which they underpin.

But causality does not run the other way. The manufacture, sale and purchase of mortgage-backed securities, and their subsequent creation of unmanageable amounts of counterparty risk, does not feed back to current borrowers.

Simply put, the trouble in the banking sector caused by unwise creation and trading of opaque structured financial instruments backed by mortgages in no way argues for forgiving either payments, rate levels, or other aspects of mortgages freely taken on by homeowners.

This is just a fallacy of apparent relationship. Some homeowners borrowed unwisely. Some investors bought securities backed by mortgages, some of which may default.

Hey, let's forgive both of them!

No, it doesn't work that way. Borrowers who borrowed unwisely must pay the price, else the lesson for them, and their children, will become,

'Yes, son/daughter, and if you get overextended on your mortgage, on the too-large home you buy, don't worry. The government will save you by either reducing your loan amount, or your rate.'

Does anyone really want this to be the lasting lesson of this recent overindulgence in residential homebuilding?

Myth 5: We suffering 'the greatest economic crisis in America since the Great Depression.'

No, we are not. We still, as of late September, 2008, are not in a recession, as measured conventionally by consecutive quarters of GDP growth.

Our politicians, beginning with the freshman Senator from Illinois, who, by the way, is apparently too young and inexperienced to know what a Depression looks like, continue to compare the current mess in one part of our economy- the financial sector- with the entire Great Depression.

Nothing could be further from the truth. If a recession is coming, it is going to be far from the Great Depression in severity or length. The current difficulties in the financial services sector are not, in and of themselves, a Depression.

If anything, today's financial services sector mess more closely resembles the late 1980s real estate market collapse. But it is, at root, a financial sector issue, not an economy-wide problem, per se.

A Report From The Field On A Compressed Natural Gas Car

Tuesday's Wall Street Journal carried an article by staff writer Joseph White entitled "Taking Natural Gas for a Spin."

Explicitly referencing Boone Pickens' current push for the use of compressed natural gas in US cars, White sensibly decided to see what it would be like to operate one. Since the topic is one about which I've written in prior posts, and it offers a nice break from writing about the current financial sector debacle, I thought I'd express some thoughts about Mr. White's article.

I liked Mr. White's article. He is clear in his intent and description of his experience. Some excerpts from his article,

"The question for consumers is whether a compressed-gas-fueled vehicle is a better deal.

The only natural gas car on the U.S. market right now is a Honda Civic GX. Honda Motor Co. let me borrow one for a few days to road test the NGV (natural-gas vehicle) lifestyle.
Driving the Civic GX isn't different than driving a standard, petrol-fueled car. My white test car had an automatic transmission and the usual bells and whistles. The adventure of driving a natural-gas fueled Civic only starts when the fuel gauge gets close to empty – and that happens fairly quickly because the car's range is only 200 to 220 miles between fill-ups.

At this point, you'll need an Internet connection to help you find a public natural-gas vehicle refueling station in your metro area. Only if you are fortunate will you find one in your ZIP code, because there are only about 1,100 natural-gas refueling stations in the U.S. The closest one to my house was about 18 miles away at a depot owned by the City of Ann Arbor.

The unmanned refueling station had an imposing looking pump with two hoses that dispensed compressed gas at different pressures. The Civic's manual explained that I should use the one marked 3600 pounds per square inch. Behind the Civic GX's fuel door is a nozzle fitting. After a couple of tries, I got the fitting from the high-pressure hose properly locked on, and threw a lever on the pump to "On" to start the flow.

I realize it was irrational and techno-phobic to worry that I would somehow overfill the compressed gas tank on board the car and turn my Civic into an explosive device. Let's say that I was nervous enough that I had done something wrong that when the pump shut off automatically, I was relieved, even though the system had only refilled the tank to the half-full mark. Mr. Pickens could add another element to his plan: It will create jobs for filling station attendants who can help nervous natural-gas newbies.

Because there is little demand for natural-gas vehicles, the ones that are available come with a hefty price premium, in part because their fuel tanks aren't molded plastic, but are instead heavily engineered, high-pressure tanks. A Civic GX lists for about $24,590, compared to about $17,760 for the mid-range Civic LX on which it is based. Tax credits can offset as much as $4,000 of that price. And in some states, natural-gas cars can use high-occupancy vehicle express lanes – a major perk for time-pressed commuters.

Mr. Kolodziej says he refuels his Civic GX using a Phill home-fueling system. This costs about $5,000 and allows a natural-gas vehicle owner to refuel overnight with gas from the lines running into the house. (A $1,000 tax credit is available for the Phill system.) But the hardware in Mr. Kolodziej's garage isn't all that's different. He also says he doesn't care that the vehicle has a limited range and takes hours to refill using the home refueling device.

"I go to work. I go to the store," he says. "That's what 99% of people do. Americans want to be able to drive to California tomorrow. They won't."

Mr. Kolodziej, president of NGV America, a Washington advocacy group that represents about 100 natural-gas companies and other enterprises with a stake in promoting natural gas as a motor fuel, would say that. But he's right. A switch to natural-gas cars would require a change of attitudes and expectations both by consumers and car makers. More of us would need to accept owning a car that can do one job – commuting and running errands in fewer than 200 miles a day. It's the same fundamental proposition behind plug-in hybrids such as the Chevrolet Volt or plug-in Prius.

The big hurdle for natural-gas vehicles is that somebody will need to invest substantial sums in a consumer refueling infrastructure. The gas industry was hoping that somebody would be Uncle Sam. Unfortunately, Congress just found out last week it may have to spend $700 billion salvaging the global financial system. That could put big federal subsidies for natural-gas cars – and a lot of other worthy ideas -- on the back burner."

The last few paragraphs are of particular interest to me. As I have written previously, here and here, Pickens has glided over some fairly important barriers to widespread acceptance by the American public of his cherished CNG-fueled cars.

Mr. White confirms that fueling will be a problem for the foreseeable future, both due to few fueling facilities, and the rather more complicated act of actually refueling a CNG-fueled car. He also reinforces some of Mike Jackson's comments on the unsuitability of these cars to Americans who would actually have to pay for them, rather than buy other, gasoline-powered cars.

Let's just say, based on Mr. White's review, I won't plan to be buying a CNG-fueled vehicle anytime soon.

Wednesday, September 24, 2008

Defects of Treasury's Proposed Financial Rescue Plan

While listening to testimony from Messrs. Paulson, Cox and Bernanke yesterday morning, I realized that there is a better way to avoid the severe consequences of the current mark-to-market valuation about which I, and others, have recently written. As I read Holman Jenkins, Jr.'s editorial in the Wall Street Journal, I saw that he, too, recognized the same opportunity.

Fed Chairman Bernanke was the soul of comprehensible, clear and focused descriptions yesterday regarding valuations of structured finance instruments by both 'mark to market' and economic valuation methodologies. So clear, in fact, as to have likely been comprehensible even to a group of US Senators.

Essentially, Bernanke described the current 'mark to market' values of mortgage-backed CDOs as 'fire sale' prices. The economic, or net present valuations, he characterized as 'hold to maturity value.'

So far, so good.

What is still mysterious is why Bernanke and Paulson need government money to buy these CDOs at bids close to their 'hold to maturity value,' thus providing the distressed current holders, various publicly-held, capital-starved banks, with the valuation difference between the bid and 'fire sale' prices, thus effectively recapitalizing the banks.

Bernanke even went so far as to note that, once a sale had occurred at this new, higher, economic value price, all similar CDOs could use that price to mark their instruments to this new, capital-preserving value.

Problem solved!

If that's all that is required, why spend $700B to do it? As Holman Jenkins also reasoned, if all that is required to provide a new 'mark to market' value is a bid by some other party, then no actual expenditure of Federal money is required.

How about this alternative? Much like the Treasury's note and bond auction to primary dealers, that department creates a mortgage-backed securities trading exchange. Members post collateral, as is common with exchanges. The new exchange offers counterparty risk protection, so it would be reasonable to expect it to attract quite a few members wishing to buy or sell the CDOs.

Next, Treasury posts bids the 'hold to maturity value' for various CDO types, by CUSIP numbers. Holders of these instruments need not sell them. Once these bids are in the market, holders automatically can justify non-fire-sale valuations.

You see, this entire 'crisis' is about near-term distress, versus long-term economic, 'hold to maturity' value. For performing CDOs, composed of mostly-performing mortgages, the economic value is quite near the face value. Only the lack of a current market bid near that level, due to worries of counterparty risk and the opaqueness of CDOs, requires holders to value the securities at capital-destroying values.

If we, as a society, through our governmental institutions, allow ourselves to bid the economic value of these securities in a well-defined market, then 'mark to market' works to everyone's advantage. The economic value becomes the market value, and no securities have to be marked down or sold at distressed values.

Clearly, this is a superior solution requiring a few tens of millions dollars, at most, to form the necessary mortgage-backed exchange.

All the rest of this debate is really superfluous. This entire 'crisis,' was, as I have noted in posts on others' observations here and here, created by a misguided Congressional mandate to use a particular accounting technique of dubious relevance to securities held to maturity.

There is absolutely no need for Paulson & Co.'s proposed multi-billion dollar plan to buy all these mispriced CDOs and hold them for future sale.

Instead, let's just form an exchange wherein we can, through our government, create a continuously-priced market, via government bids, for the securities which, today, have no existing market in which to trade or be priced near their economic value.

More On Fallacies of Composition In Risk Management: Counterparty Risk

Recently, I wrote pieces here, here, and here regarding risk management and, in two of the posts, the role of 'the fallacy of composition.'

One comment I wanted to make in this piece is an unintended consequence, by way of the fallacy of composition, of the transformation, via structured financial instruments, e.g., securitized mortgage paper, of default risk into counterparty risk.

When individual instruments are traded on a desk, their risk is generally viewed as the sum of the price risk, expressed by volatility, and the counterparty risk, which measures the probabilities that the other party will default, or fail, to deliver on the contract, whether that be interest, principal, or some other security or payment.

As I noted in earlier posts, when instruments are structured from underlying instruments, such as securitized mortgages, and a counterparty to some other trade is suspected of holding large amounts of securitized instruments of dubious, or unknown value, then counterparty risk can be quite significant, although the direct price risk of the positions may not be.

To go further, if a financial services firm is suspected of, or known to be holding large amounts of securitized instruments, continuously-priced markets for which do not exist, then the entire firm's risk as a counterparty may be affected, leading to downgrades by credit rating agencies- S&P, Fitch or Moodys.

Here we have an unintended consequence affect the situation, due to the fallacy of composition.

Such a downgrade leads each counterparty of such an affected, downgraded firm to require more collateral on each position held with that firm as a counterparty. Thus, in the blink of an eye, or the stroke of a pen at a rating agency, the financial collateral requirements for a firm's book of positions with other trading partners rises significantly.

This is what actually drove AIG into ownership by the US Treasury. Its downgrading by a credit rating agency caused AIG's counterparties to require more collateral for swaps and other insurance arrangements it had sold than the firm had capital available to provide for such needs.

Do you suppose any of the quantitative, computer-based risk management systems of any of AIG's counterparties had the capability to model, forecast and integrate into their risk estimations such an occurrence? Did any of AIG's counterparties have enough knowledge of AIG's exposures to allow it to reasonably estimate the effects on that firm's capital position, and, thus, its risk as a counterparty, if it were downgraded?

I doubt it.

Thus, in yet another perverse way, the individual, similar actions of many financial service players, collectively, lead to a result which causes more risk and uncertainty in the system, even as each individual party seems to act to reduce its own risk to its positions and its counterparties.

Tuesday, September 23, 2008

My Recommendations For Ending The Current Financial 'Crisis'

In the face of the looming, complex, multi-hundred page bill which will likely become law to buy the bulk of distressed, mortgage-backed structured finance instruments in the US financial sector, I offer the following outline of the key, simple changes in US financial services regulations to prevent a repeat of the recent chaotic situation in this important sector.

In discussing the unfolding financial services crisis with my business partner last week, several key principles became clear as necessary to a post-crisis, functioning financial system. We agreed that in-depth, micro-managing regulations would be unlikely to solve the problems. Instead, an assumption, if not expectation, of self-serving, opportunistic behavior on the part of financial service firms must be a cornerstone of new regulatory principles. Thus, one wants to consider the fewest number of broad, simple rules which would curb the worst excesses which one can expect to recur.

The behaviors which seem to have caused the most damage in the recent crisis are:

-forced 'mark-to-market' of exotic, structured financial instruments which frequently have no current market price.

-uncertain exposure to counterparty risk due to murky, over-the-counter, non-exchange cleared instruments such as credit default swaps and structured financial instruments.

-underwriting of toxic, opaque structured financial instruments by firms which offload the entire issue, taking only temporary packaging risk, but booking underwriting and distribution fees.

To remedy these weaknesses in the current financial system, the following solutions are proposed:

1. Scrap existing mark-to-market-only rules for securities held by any financial services organization. Instead, allow any financial services entity to:

a. value long-term holdings, including structured finance instruments and/or securitized debt/loans, at acquisition cost or present value while it is performing. This would allow non-banks to treat certain securities in a similar fashion to the current commercial bank's 'investment account,' or a whole loan held in portfolio.

b. Allow one-time switching of long-term holdings to trading accounts, for sale, where they would be valued by mark-to-market methodology.

c. Value impaired, delinquent or non-performing assets according to expected economic value. If no consistent, liquid market exists, best estimated economic values would be used. A variety of accepted methods, under continuing review for modification and enhancement, would be approved by the SEC and the Fed, as regulators.

2. For any institution buying, selling, making markets in or trading any non-exchange-cleared instrument, that activity must be done in a fully-equity capitalized subsidiary. Leverage will be a maximum of 1:1.

3. For issuing of any contracts promising payment of a sum in the event of a third-party event, i.e., insurance, such as credit default swaps or other swap agreements, the transactions must be held in and performed by a fully-equity capitalized subsidiary. Maximum leverage will be determined by the SEC, in the manner of margin account and collateral required for securities positions. The unit may be evaluated like an insurance firm, for ability to pay claims generated by contracts it sells. Where possible, historical actuarial bases of capital ratios for each type of contract will be used to determine maximum leverage.

4. A minimum percentage, by deal value, of any 'structured financial instrument' underwriting must remain on the books of the lead underwriting firm. This is refers to any underwritten financial instrument that is not straight, convertible or preferred debt or equity. If the instrument is not exchange-traded, then it must, per #2, be held in a separate, fully-equity-capitalized subsidiary.

4. Where possible, exchanges will will be used to clear and settle financial instrument trading, so that counterparty risk will be managed by explicit and clear collateral rules. This should minimize the ability of instrument default risk to morph into counterparty risk, even for securitized debt and swap instruments.

If these principles had been in place in 2002, it's safe to say that the US financial services sector would not be undergoing the chaos and crisis of counterparty risk management which it is currently experiencing.

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.

Monday, September 22, 2008

A Long Term View of the Structure of US Financial Service Sector

As I reflected on yesterday's news that Goldman Sachs and Morgan Stanley, America's two largest remaining publicly-held investment banks, are becoming Federally-chartered commercial banks, there seemed to me to be less about which to be surprised than others seem to believe.

The 'modern,' publicly-held, large US investment bank is not your father's Wall Street investment bank. I have known a few people who were partners in some of the older firms during the 1960s and 1970s. Days when Dillon Read's partners could fit around one table in a boardroom.

Today's investment banks are quite different. As one CNBC guest noted this morning, they had morphed into large trading desks with underwriting, M&A, and asset management units. In fact, I can well recall my days as a Director of Planning and Research at Andersen Consulting, now Accenture, in the Financial Services sector, in 1993. Back then, our own business plans reflected the reported growing use of proprietary capital in trading activities among Goldman Sachs, Salomon and Morgan Stanley. It was news that the firms, with only Goldman still private, were using their larger capital bases to compete with their own clients by trading actively in many securities markets.

Gone were the days of John Whitehead's Goldman, when the firm would not so brazenly face its own clients in the markets and use better risk management and information to get the better of them.

But let's step back in time to the last century's signal financial services event- the Crash of 1929. Starting from that point, our nation's financial sector's history can be described by a surprisingly few turning points.

Before we stroll down this memory lane, let's also be clear on one important behavioral point. Competitors in financial services, like those in other sectors, will, absent governmental prohibitions, act in their own, or their shareowners' short to medium-term profit or return-maximizing interests, heedless of the systemic effects of their behavior. If their trading, underwriting or investment behavior accrued superior total returns, but wrecked the financial system wherein they existed and operated, they would probably still continue such behavior until there were no customers or counterparties left with whom to do business.

Now, to my short course on the modern history of the US financial services sector:

1. In the 1920s, integrated commercial and investment banks, operating with then-allowed 10% margin for customer accounts, contribute to the stock market price bubble by stuffing customer investment accounts with underwritten instruments of their corporate clients, from their own investment banking units.

2. After the Crash, Congress passes the Glass-Steageall Act, separating investment and commercial banking.

3. In the 1970s, many of Wall Street's formerly-private investment banks and retail wire houses- First Boston, Morgan Stanley, EF Hutton, to name a few- go public, reaping windfalls and subtly transferring formerly partner-shouldered risks of the firm's positions and businesses to thousands of retail and institutional investors.

4. In the 1980s, computer- and information-management technology begin to radically change the way trading operations at investment and commercial banks, and their clients. "Baskets" of indexes were traded rapidly by computer-driven models. Risk management models relied on 'portfolio insurance' to rapidly sell positions to reduce risk in the event of sharp market downturns.

5. The Crash of 1987 demonstrates that, left unchecked, the haphazardly-controlled software models for risk management and trading among financial services businesses resulted in steep plunges in equity prices of unheard-of speed and depth. In reaction to this crash, 'circuit breakers' are introduced on the NYSE, halting trading when key indices drop by more than a maximally-allowed number of points. 'Portfolio insurance,' used by all major trading concerns, fails, due to the fallacy of composition, when all the trading desks use similar models to trigger similar sales of like instruments, cascading ever-larger and faster sell orders.

6. In the early 1990s, so-called "Section 20" units of commercial banks are allowed to trade and underwrite equities. This expansion of capital available to equity underwriting and trading adds to the over-capacity in the American underwriting and trading business segment. Investment banks and hedge funds continue their headlong expansion of leverage and risk, as margins in their businesses continue to thin, due to excess capacity and ubiquitous risk management and trading technologies among so many financial service firms.

7. Sandy Weill's insistence, in 1998, on merging his Traveler's Corporation with Citibank, a Federally-chartered commercial bank, forces Congress, at the urging of President Clinton's Treasury Secretary, Robert Rubin, to repeal Glass-Steagall. The regulatory and functional climate of pre-1929 America in financial services is formally recreated. As a footnote, upon his exit as Clinton's Treasury Secretary, Rubin is rewarded for his service in Weill's cause by being named non-executive Chairman of Citicorp, the merged firm's successor, with an annual compensation package ranking among the firm's three largest- a rare practice for non-executive board members.

Several wiser heads, among them former Fed Chairman Paul Volcker, warn against the dismantling of this 60-year old, effective barrier in the US financial services sector.

In the fall of this year, Long Term Capital Management, a hedge fund spinoff of former Salomon Brothers' key fixed income executives, using vast amounts of leverage, several Nobel Economic Laureates to develop and operate risk management, and investment and trading across large numbers of asset classes, make bad bets which nearly wipe out the firm. The resulting effect on global asset prices nearly disrupts the world's financial system.

The next year, "Wall Street's" last remaining large investment bank partnership, Goldman Sachs, goes public, signaling a peak valuation for investment banking assets in the publicly-traded equity markets.

8. As interest rates are lowered to historically low levels by Fed Chairman Greenspan in the wake of the equity market's "Tech Bubble" bursting in 2001, commercial and investment banks begin an unprecedented buildup of leverage to compete in the suddenly-wildly growing residential homebuilding and mortgage finance sectors. As the boom in residential homebuilding peaks, Congressionally-chartered GSEs, Fannie Mae and Freddie Mac, take 'subprime' and 'alt-A' mortgages, of lower quality, into their securitized products sold to investors globally. Private competitors, including Merrill Lynch, Citigroup and Bear Stearns buy or create mortgage origination businesses to further profit from the underwriting and sales of securitized mortgage paper. Prominent credit rating agencies- S&P, Fitch and Moodys- give investment-grade ratings to many of the newly-created, untested securities backed by the new, lowest-quality mortgages.

The practices of the 1920s, wherein commercial and investment bank businesses fed each other and mixed risks between the two functions, return full scale, and more, to the American financial services sector.

In the wake of Enron's collapse, Congress passes the Sarbanes-Oxley law, which, among other regulatory changes, mandates that financial firms must mark securities to market prices, regardless of their economic value as performing assets.

9. In 2007, as a slowing economy begins to dampen growth in residential real estate, homebuilding and mortgage originations slow, and delinquencies and defaults begin to occur in recent subprime mortgages underlying some mortgage-backed securities. Because so many mortgages have been wrapped together as securities, widespread concern over how much of these assets are owned by 'counterparties,' rather than easy identification of individually-affected mortgages, causes a freezing up of trading of these assets, and other fixed income instruments.

Early in the year, private equity investment bank/hedge fund, Blackstone Group, goes public, signaling a peak valuation of private equity asset valuations in the traded equity markets.

Despite lowering of interest rates by the Federal Reserve throughout late 2007, and the opening of the Fed Discount Window to American investment banks in the wake of Bear Stearns' failure in March of 2008, counterparty risk fears continue to cause markets for the mortgage-backed structured finance securities to evaporate, driving valuations to extremely low values. Continuing uncertainty of the 'mark to market' value of such structured finance assets causes Merrill Lynch, Lehman Brothers, Citigroup, Bank of America, Wachovia and AIG to continue quarterly writedowns at multi-billion dollar levels.

10. Capping several weeks of investor and trader panic, beginning with the takeover of Fannie and Freddie by the US Treasury, Lehman Brothers files for Chapter 11 bankruptcy protection, Merrill Lynch sells itself to Bank of America, and AIG barely avoids technical bankruptcy and is taken over by the Treasury. One week later, Goldman Sachs and Morgan Stanley, the two remaining, large, publicly-held US investment banks, both file to become Federally-chartered commercial bank holding companies.

Do you see the overall pattern which I see?

Prior to Glass-Steagall, untrammelled, self-interested behavior by integrated American banks caused a financial disaster, the Great Crash of 1929. Subsequent separation of investment and commercial banking, along with the SEC's policing of strict margin requirements, prevented a repeat of this occurrence for sixty years.

In the interim, there were non-macro-economic based financial debacles involving overheated equity markets and real estate or energy lending by, respectively, brokerages, investment banks and commercial banks. However, nothing remotely akin to the scale of the 1929 Crash occurred.

With the advent of game-changing, computer-based technology for trading and risk management, and the removal of Glass-Steagall, America's financial services sector once again enjoyed little effective prohibitions on its natural proclivity to reap short term gains while saddling customers and counterparties with losses.

Just as in 1929, but with greater speed, thanks to modern technology, integrated finance businesses shifted into high gear, using the then-fastest, most profitable asset class, residential mortgages and their structured financial securities, to maximize short-term profits and total returns.

Thanks to Congressionally-mandated use of 'mark to market' rules, when home values began to drop, the mortgage loans to them, now in the form of tradable securities, rather than loans on commercial bank balance sheets, plunged even faster.

The result is a train wreck in the financial services sector on a par with 1929, in terms of damage to financial service sector competitors.

If two elements of this situation were different- 'mark to market' rules mandated for performing securities, the abolition of Glass-Steagall- it's highly probable that we would not today be facing such a mess in this sector.

Once Congress made those two changes, normal, dependable behavior of firms in the financial sector virtually guaranteed that a form of excess would eventually create more risk, and more 'accounting value' destruction, than the sector could sustain with existing capital.

It would be hopeful to believe that our sense of history of the sector would have prevented this latest situation. But, evidently, we are, as a society, more susceptible to forgetting the lessons of history, and common sense, than we able to remember them, and the fundamental self-interest of firms which operate in the financial services sector.

Fallacy of Composition In Risk Management

In this post from last Friday, I argued that allowing the worst risk-managed firms on Wall Street to exit the sector was not a bad thing. In that piece, I wrote,

"You may argue, as Zachary Karabell did in yesterday's Wall Street Journal, that this is all due to the Enron-era Sarbanes-Oxley legislation which mandates 'mark to market' of thinly-traded, poorly-understood structured financial securities.

So be it. But the whiz kids at these Wall Street houses, and AIG, all knew the rules, or should have. What they apparently didn't know, in reality, was what could really happen to complex instruments, and the values of their firms, which held so much of this paper, when markets for such instruments simply vanished.

Ironically, we saw the same miscalculations when the same firms used 'portfolio insurance' approaches to risk management in the crash of 1987. It didn't work.

Wall Street is, in truth, littered with past crises and market crashes during which the predominant risk management solutions of the day failed to anticipate the next risky environment.

Part of the reason, of course, is the concept of the 'fallacy of composition.' I first learned of it in Paul Samuelson's classic text, "Economics," in my undergraduate economics courses.

What the typically-young, inexperienced risk management model-builders on Wall Street usually fail to anticipate is that, when a market is composed of firms operating similarly-run risk management functions, then they will all behave similarly in the face of the same price information. What happens next falls under the fallacy of composition. All desks try to sell at once, and prices plummet even further, triggering even larger sales of even more instruments."

This is a topic on which I have seen almost no ink, whether physical or electronic, spilled. The tendency of major financial service trading houses to employ similarly-vintaged and -featured risk management systems virtually guarantees the fallacy of composition with respect to sudden windshears in markets.

When one model sees a need to dump a security, due to excessive risk, they all do. And what the models don't account for is other desks, using similar risk metrics, piling on with similar actions, all of which rapidly accentuate the pricing moves that first triggered the sales of risky instruments.

What people outside the financial services industry fail to understand is that, like most industries, vendors supply products and services- data, software, information, risk management methodologies- to as many industry competitors as possible. Further, there is a constant flow of people back and forth between vendors, consultants and financial services firms. For example, a former investment management business partner and one-time colleague at Oliver, Wyman & Co., recently left a senior position at Mercer Management Consulting, which acquired Oliver Wyman a few years ago, to join some of his former OWC colleagues at a risk management consulting firm in California. This will speed the dissemination of his observations on industry risk management practices, and weaknesses, to another major sector consultant.

Thus, similar to what occurs in many industry sectors, the same cutting-edge technologies for risk management diffuse throughout competitors in the industry faster than one might expect. And, because risk management systems are the backbone governing position sizes and limits, as well as triggering sales of positions, and they interface each other in the markets, market behavior becomes clone-like. Similarly-built and -functioning risk management systems managing risk for similar instruments cause multiple parties to begin making the same moves nearly in unison, which cascades prices, when risk is judged to be excessive, suddenly lower, with seemingly no bottom in sight.

Just how many of these financial services competitors using similar risk management systems, trading the same instruments, do we really need? Not all that many. Not when there are a myriad of hedge funds, private equity trading desks, fund management companies and other private investment groups all buying and selling the same securities as the few, visible, well-known investment and commercial banks.

If anything, these days, save for perhaps Goldman Sachs, the best-paid financial service executives and traders work for privately-owned firms which the average American would not know if he read their names in a newspaper.

And now, with last night's news that Morgan Stanley and Goldman Sachs are becoming Federally chartered commercial bank holding companies, we see the exit from the field of the last publicly-held investment banks which, for so long, relied on proprietary and customer trading for so much of their profits.

With so much asset trading capacity using essentially the same risk management models, there was overcapacity in that activity for at least a decade. And the phenomenon will still exist, as the same risk management models are traveling with exiting firms. Only capital allocations and, perhaps, numbers of traders devoted to the activities will change.

But the herd-like reactions by financial institutions traders and investors to market prices, as guided by similar risk management models and functions, will remain with us for some time to come.

Sunday, September 21, 2008

Scrap Fair Market-Only Valuation Now!

The Wall Street Journal published two excellent articles this past week.

The first, by Zachary Karabell, entitled "Bad Accounting Rules Helped Sink AIG," describes the damage done by Congress' reaction to the Enron mess,

"The current meltdown isn't the result of too much regulation or too little. The root cause is bad regulation.

Call it the revenge of Enron. The collapse of Enron in 2002 triggered a wave of regulations, most notably Sarbanes-Oxley. Less noticed but ultimately more consequential for today were accounting rules that forced financial service companies to change the way they report the value of their assets (or liabilities). Enron valued future contracts in such a way as to vastly inflate its reported profits. In response, accounting standards were shifted by the Financial Accounting Standards Board and validated by the SEC. The new standards force companies to value or "mark" their assets according to a different set of standards and levels.

The rules are complicated and arcane; the result isn't. Beginning last year, financial companies exposed to the mortgage market began to mark down their assets, quickly and steeply. That created a chain reaction, as losses that were reported on balance sheets led to declining stock prices and lower credit ratings, forcing these companies to put aside ever larger reserves (also dictated by banking regulations) to cover those losses.

Among its many products, AIG offered insurance on derivatives built on other derivatives built on mortgages. It priced those according to computer models that no one person could have generated, not even the quantitative magicians who programmed them. And when default rates and home prices moved in ways that no model had predicted, the whole pricing structure was thrown out of whack.

The value of the underlying assets -- homes and mortgages -- declined, sometimes 10%, sometimes 20%, rarely more. That is a hit to the system, but on its own should never have led to the implosion of Wall Street. What has leveled Wall Street is that the value of the derivatives has declined to zero in some cases, at least according to what these companies are reporting.

There's something wrong with that picture: Down 20% doesn't equal down 100%. In a paralyzed environment, where few are buying and everyone is selling, a market price could well be near zero. But that is hardly the "real" price. If someone had to sell a home in Galveston, Texas, last week before Hurricane Ike, it might have sold for pennies on the dollar. Who would buy a home in the path of a hurricane? But only for those few days was that value "real."

The regulations were passed to prevent a repeat of Enron, but regulations are always a work of hindsight. Good regulatory regimes can mitigate future crises, and over the past hundred years, economic crises world-wide have become less disruptive. The panics of the late 1800s, the bank runs, the Great Depression in Europe and the United States, were all far more severe than what is unfolding today in terms of business failures and jobs, homes and savings lost.

A few years from now, there will be a magazine cover with someone we've never heard of who bought all of those mortgages and derivatives for next to nothing on the correct assumption that they were indeed worth quite a bit. In the interim, there will almost certainly be a wave of regulations designed to prevent the flood that has already occurred, some of which are likely to trigger another crisis down the line. Until we can have a more rational, measured public discussion about what government and regulations can and should do vis-à-vis financial markets, we are unlikely to break the cycle."

On Friday, William Isaac, former chairman of the FDIC, 1981-1985, wrote "How To Save The Financial System." In it, he writes,

"The Securities and Exchange Commission and bank regulators must act immediately to suspend the Fair Value Accounting rules, clamp down on abuses by short sellers, and withdraw the Basel II capital rules. These three actions will go a long way toward arresting the carnage in our financial system.

During the 1980s, our underlying economic problems were far more serious than the economic problems we're facing this time around. The prime rate exceeded 21%. The savings bank industry was more than $100 billion insolvent (if we had valued it on a market basis), the S&L industry was in even worse shape, the economy plunged into a deep recession, and the agricultural sector was in a depression.

It could have been much worse. The country's 10-largest banks were loaded up with Third World debt that was valued in the markets at cents on the dollar. If we had marked those loans to market prices, virtually every one of them would have been insolvent. Indeed, we developed contingency plans to nationalize them.

At the outset of the current crisis in the credit markets, we had no serious economic problems. Inflation was under control, GDP growth was good, unemployment was low, and there were no major credit problems in the banking system.

The dark cloud on the horizon was about $1.2 trillion of subprime mortgage-backed securities, about $200 billion to $300 billion of which was estimated to be held by FDIC-insured banks and thrifts. The rest were spread among investors throughout the world.

The likely losses on these assets were estimated by regulators to be roughly 20%. Losses of this magnitude would have caused pain for institutions that held these assets, but would have been quite manageable.

How did we let this serious but manageable situation get so far out of hand -- to the point where several of our most respected American financial companies are being put out of business, sometimes involving massive government bailouts?

Lots of folks are assigning blame for the underlying problems -- management greed, inept regulation, rating-agency incompetency, unregulated mortgage brokers and too much government emphasis on creating more housing stock. My interest is not in assigning blame for the problems but in trying to identify what is causing a situation, that should have been resolved easily, to develop into a crisis that is spreading like a cancer throughout the financial system.

The biggest culprit is a change in our accounting rules that the Financial Accounting Standards Board and the SEC put into place over the past 15 years: Fair Value Accounting. Fair Value Accounting dictates that financial institutions holding financial instruments available for sale (such as mortgage-backed securities) must mark those assets to market. That sounds reasonable. But what do we do when the already thin market for those assets freezes up and only a handful of transactions occur at extremely depressed prices?

The answer to date from the SEC, FASB, bank regulators and the Treasury has been (more or less) "mark the assets to market even though there is no meaningful market." The accounting profession, scarred by decades of costly litigation, just keeps marking down the assets as fast as it can.

This is contrary to everything we know about bank regulation. When there are temporary impairments of asset values due to economic and marketplace events, regulators must give institutions an opportunity to survive the temporary impairment. Assets should not be marked to unrealistic fire-sale prices. Regulators must evaluate the assets on the basis of their true economic value (a discounted cash-flow analysis).

If we had followed today's approach during the 1980s, we would have nationalized all of the major banks in the country and thousands of additional banks and thrifts would have failed. I have little doubt that the country would have gone from a serious recession into a depression.

If we do not halt the insanity of forcing financial firms to mark assets to a nonexistent market rather than their realistic economic value, the cancer will keep spreading and will plunge the world into very difficult economic times for years to come.

I argued against adopting Fair Value Accounting as it was being considered two decades ago. I believed we would come to regret its implementation when we hit the next big financial crisis, as it would deny regulators the ability to exercise judgment when circumstances called for restraint. That day has clearly arrived.

I can't imagine why we would want to create another government bureaucracy to handle the assets from bank failures. What we need to do urgently is stop the failures, and an RTC won't do that.

Again, we must take three immediate steps to prevent a further rash of financial failures and taxpayer bailouts. First, the SEC must suspend Fair Value Accounting and require that assets be marked to their true economic value. Second, the SEC needs to immediately clamp down on abusive practices by short sellers. It has taken a first step in reinstituting the prohibition against "naked selling." Finally, the bank regulators need to acknowledge that the Basel II capital rules represent a serious policy mistake and repeal the rules before they do real damage."

I wrote about this issue earlier this year, in February and March. The second post opined on Holman Jenkins', Jr., of the Wall Street Journal, article on the same topic.

It's becoming clear that there have been vast, unintended consequences of what was, to start with, a seemingly-simple idea: mark financial instruments to their current market value, in order to avoid Japanese-style hiding of, and overstatement of the value of, rotten assets.

But there are simpler ways to do so than mark-to-market. Karabell notes this by calling for using the economic value implied by prevent valuation, when the asset is performing, but no continuous trading market for it exists.

This is sensible for two reasons. First, just like commercial banks' ability to value performing loans at historic bases, despite interest rate changes in the market, which would, of course, affect the capitalized value of such loans, it would allow even investment banks, or other non-commercial banks, to appropriately reflect the value of performing assets.

Second, it touches on the question of what is a 'market.' And, if no market exists- continuous, price-taking, liquid- fall back to an historical acquisition price for performing instruments, and a present-value of impaired instruments reflecting estimations of payouts.

William Isaac is right. If just his first solution was put into effect tomorrow, no further RTC-style 'rescues' would be required. The amount of capital losses would be much less than they are now, under mark-to-market rules.

With no capricious, totally market-based valuation causing counterparty risk to rise simply due to that approach, 90% of the current 'crisis' would disappear literally overnight, with the stroke of a legislative or regulatory pen.

And, yes, if this had been done in early 2007, Bear Stearns, Lehman, AIG and Merrill Lynch would still be independent, if damaged. Their continuing downward valuation spiral sparked by mark-to-market of structured finance instruments would never have occurred at the scale it has these past few months. Or, really, even stretching back to June of 2007.