Thursday, October 02, 2008

The heart of the crisis

A number of British newspapers have picked up on the US "mark to market" story. Bizarrely, though, none cross-link the story with Cameron's speech on Tuesday.

One of the very small crowd is The Daily Telegraph which headlines, "Financial crisis: SEC cheers finance companies with mark-to-market ruling".

Writer Jonathan Sibun then tells us that the Securities and Exchange Commission brought some much needed cheer to the US financial sector after issuing accounting guidelines that could help curb the billions of dollars of writedowns reported by the country's leading banks.

The US regulator, according to Siburn, has told banks that despite fair-value accounting regulations they did not have to use only fire-sale prices to value bad assets but could also use their judgement.

What is really interesting though is the response of the New York Stock Exchange, which conjured up a "late rally" leaving the Dow Jones index up 485.2 to 10850.7 and the S&P 500 up 58.3 to 1164.7, its biggest one-day rise in six years.

As background, Siburn tell us that: "Fair-value accounting requires companies to value their assets at current market prices." He adds that, "Banks have been forced to push through billions of dollars of writedowns in recent months after valuing assets at the same prices raised by ailing companies undergoing last-ditch sale." Thus, we are told that the SEC move effectively allows banks to switch from mark-to-market accounting to hold-to-maturity accounting.

Actually, one of the value of forums and engaging on blog comment section is that these lazy assertions are challenged, prompting more research.

The problem, per se, is neither "mark to market" (or "marking to market" as Cameron inexpertly put it). Nor is it that other jargon issue: "fair value accounting". As Wikipedia helpfully tells us, both accounting devices developed among traders in the 19th Century. There is nothing new about either.

Where the problem lies is in the extraordinarily laborious system of risk assessment, combined with a requirement to structure different types of asset, giving rise to entirely artificial under-valuation, which is the current cause of the bank liquidity problems.

It was this system which emerged from the Basel II process and which was adopted by the United States, the EU and other financial administrations.

Interestingly, the inherent problems with the system were recognised months before the Basel II agreement was signed, when in January 2004, none other than the Financial Services Authority noted: "There's a potential that the capital requirements for some banks and investment firms could rise during a slowdown in economic activity, at the same time that asset values are reduced and mark-to-market losses are incurred."

This is the precise problem that the US authorities have addressed and to which Cameron referred on Tuesday.

It now emerges that EU financial services commissioner Charlie McCreevy was fully aware of the problem in March 2008 when, in front of the Chartered Insurance Institute in London, he questioned the "mark to market" rule, asking whether it was: "always the correct rule when it comes to illiquid assets - or to liabilities for that matter." He continued:

Does it make sense for example that the worse the credit or liquidity risk attached to a company's bond liabilities gets, the greater the boost to that company's balance sheet net assets becomes, as the "mark to market" value of those bond liability falls? Are the "mark to market" rules having unintended consequences especially in these times of turmoil?
It was then that he announced that he was calling for an "analysis" of the issue in order to "draw the lessons from the use of 'mark to market' in the light of current market conditions."

Yet, nothing of this percolates the Telegraph story, even though the very same rules that applied to the US until yesterday still apply to the UK and all other EU member states. All we get is the bland statement that, "Nicholas Sarkozy, the French President, is expected to call for a relaxation of fair-value accounting regulations in Europe…".

We do not even get that much from The Guardian, which is another paper to cover the story. It offers the headline, "SEC gives banks more leeway on mark-to-market," but has nothing on the EU dimension and, like the Telegraph fails to make the Cameron link.

The Times, on the other hand, does frame its story on UK experience, oddly not referring to Cameron either. It tells us that:

The heavy losses that many banks have taken on these assets have seriously weakened their balance sheets, forcing them either to raise more capital or rein in new lending. A number of leading banks have pressed for a suspension of the mark-to-market rules. But others, notably Goldman Sachs, have argued strongly against.

The critics say that such a move would be very dangerous and point to the experience of the US savings and loan crisis, in which the lack of such accounting rules meant that the insolvency of scores of lenders went unrecognised for a prolonged period with very costly consequences.

But if it would be dangerous to scrap fair-value accounting permanently, that does not mean it should be ruled out as a temporary emergency measure. If the American bank bailout plan fails, it should be seriously considered.
Then the great Anatole Kaletsky has a go. He informs us:

In recent years, however, accountants and regulators have replaced such probabilistic judgements of economic fundamentals with a principle called "mark to market". Under this new approach, promoted passionately by conservative financiers and academics who believe that "the market is always right", banks base their profits not on how much income they expect to receive in the future but on how much money they could raise immediately if they sold all their loans and mortgages in the market at the best price they could fetch.

This reform didn't make much difference when markets were working smoothly and financial prices reflected long-term asset values. But in the wildly volatile and panicky conditions of the past 12 months, mark-to-market accounting has contributed hugely to the crisis.
That last sentence ties in exactly with the warning given by the FSA in 2004 and so the conditions have come to pass where the banking system is frozen into immobility by a system devised for the good times, and which is wholly inappropriate for the current crisis.

What is so bizarre about all this is that the MSM around the world is full stories about the freezing of London inter-bank lending – the so-called Libor system.

There can be no doubt of the severity of this aspect of the crisis. The Sidney Morning Herald - to name but one newspaper – is noting that the market is seizing up but, like so many, is missing the real cause and putting the reluctance to lend down to "trust" – something completely dismissed by Prof. Peter Spencer. Thus, says this paper:

All the banks are hoarding their cash, bolstering their balance sheets so they can settle their own obligations. They won't let the cash out of their sight. The total disintegration of trust and confidence is feeding on itself and the disaster scenario is, according to some observers "the mother of all bank runs" should foreign banks panic further and pull their money out of the US system.
Not one media organ has put the whole story together, linking this seizure with Basel II and the EU's implementing directives, the heart of this current phase of the crisis and the very mechanism that prevents it being solved.