THE BEAR'S LAIR Wrong Swiss city
By Martin Hutchinson
The Basel Committee on Banking Supervision last week issued new guidelines for
mark-to-market accounting by banks. The guidelines relax the requirements for
using mark-to-market (MTM) in downturns, failing to address the fundamental
problems that helped to get the financial system into the current mess.
Mark-to-market accounting, like the credit default swap, is a novel technique
that in the recent crash has proven itself a weapon of mass financial
destruction. Bank regulation is being carried out in the wrong Swiss city;
rather than Basel rules, it needs a draconian Geneva convention.
The principal objective of financial regulation should be to prevent the
banking system from destroying itself. In a free market, with
tight monetary conditions and no deposit insurance, banks that became
over-inventive would soon find themselves in difficulties, taken over by one of
their rivals or forced into bankruptcy. Pretty soon it would be realized that
accepting short-term deposits was incompatible with an excessive interest in
the more arcane financial innovations. Those would be left to hedge funds and
brokers, whose bankruptcies would affect nobody except their partners and any
shareholders foolish enough to have entrusted their money to them.
In the world we inhabit, financial destruction is all too easy. On examination
of the recent unpleasantness, it becomes clear that, given the environment of
easy money and moral hazard in which we live, not every financial technique
that can be invented should be. Techniques that may be harmless or even
beneficial in the theoretical perfect market prove highly destructive in the
world of real finance.
Mark-to-market accounting is one such technique. Theoretically elegant in a
perfect market (but as I have frequently discussed, no real-world market is
perfect), in our world it has proved immensely destructive. Under this
technique all assets and liabilities of the institution are "marked to market"
- valued at the price they might fetch in a transaction between willing buyer
and willing seller on the balance sheet date.
When the market for subprime mortgages and their securitized detritus
collapsed, banks using mark-to-market discovered they were compelled to mark
prices down in a draconian manner, even on securities that appeared likely to
pay full value at maturity. This naturally caused distress among eminent
bankers. The Basel Committee has now recommended that banks should be able to
reclassify securities that have become illiquid, ceasing to mark them to their
no-longer valid market price. This recommendation appears to reflect common
sense, but does not address several of the other major problems of this
accounting technique.
One major problem is the effect of mark-to-market accounting on liabilities.
Under this system, liabilities as well as assets must be marked to their market
price. Theoretically, this takes overall changes in credit conditions out of
the system, because liabilities and assets are affected equally. In practice,
it produces absurd results, whereby banks record huge MTM profits as their
credit deteriorates and their liabilities become worthless, then huge losses as
the liabilities recover in value. Under this accounting, the worst thing a bank
shareholder can hear is that the Feds or some other sugar-daddy has steeped in
and prevented bankruptcy - at that point all the liabilities leap in value
causing a huge loss.
Another problem with mark-to-market accounting is that it can make financial
statements pretty well incomprehensible. I am a modest investor in some of the
energy royalty trusts, which take pools of oil reserves, extract and sell the
oil and pay dividends to investors based on the proceeds. The more intelligent
of those trusts hedged their oil sales forward when prices hit $140 per barrel
- in one case the trust hedged its entire output until 2011 at prices of over
$100 per barrel.
Economically, this hedging makes perfect sense, but the accounting doesn't
reflect it. Common-sense accounting would show the fully hedged company having
high, stable profits in 2009 through 2011 while un-hedged companies lost money
in the last quarter of 2008 and the first quarter of 2009, recovering partially
after oil prices rose back to $70.
Instead, the fully hedged company recorded a huge profit in the fourth quarter
of 2008 because the value of its hedges had increased, even though the value of
its reserves had more than correspondingly declined. Then the fully hedged
company recorded losses from its hedge positions in the second quarter of 2009,
even as the value of its reserves increased and it became possible to hedge
2012 production at a price that left a profit. The actual operating
profitability of the energy royalty trusts was very difficult to discern from
published information, even for me and I regard myself as a fair financial
analyst.
An accounting system that takes a company that has reduced risk intelligently
and makes its profits subject to wild uncontrollable swings with no economic
basis in reality is not doing its job. It's as simple as that.
The other more serious problem of mark-to-market accounting arises in bull
markets. When I studied accounting, almost the first principle I learned was
that assets are carried in the books at the lower of cost or realizable value.
That principle is abandoned in MTM accounting. Traders are able to buy illiquid
assets, establish a "market price" for them higher than the price they paid
then, under MTM accounting, mark them up to the new "market" price and record
the profit, no doubt receiving some juicy percentage of that profit as bonus.
Naturally, this is an incentive for those traders to acquire or create more
such assets, whose "markets" are controlled by a small circle of dealers, which
can be used to provide an endless stream of mark-to-market profits. Little
surprise therefore that the balance sheets of Wall Street's major investment
banking operations, when times got tough in 2008, turned out to be full of
illiquid and hugely overvalued rubbish.
Mark-to-market accounting has been blamed by many commentators for wiping out
the capital of the major banks and investment banks, causing a huge financial
crisis. What those commentators don't realize was that MTM's most serious role
in the crash was in allowing traders and managers to mark UP positions during
the boom, paying themselves bonuses for doing so. You can't blame Wall Street
"greed". Traders like other people respond to the incentives put in front of
them. It's up to accounting regulators to avoid incentivizing asset-watering
and balance-sheet fraud.
The history of financial markets in recent decades is littered with inventions
such as mark-to-market accounting, generally based on some aspect of modern
financial theory, that have in practice turned out to have hugely damaging
side-effects. Rather than the Basel Committee, which has repeatedly proved
itself a creature of the banking industry, we need a sterner regulator, one
that will prevent the use of such dangerous techniques. To rely on industry
self-regulation is futile. It's as if the attempt to control weapons
proliferation and limit war crimes had been left to a committee representing
the armaments industry.
Banking thus needs a Geneva convention, an agreement between the world's
financial centers. This should not attempt to control the financial services
business overall - that is much better done on a national level, as lightly as
possible. Instead it would focus on and outlaw the techniques most likely to
inflict huge collateral damage on third parties. In such few cases, the
financial services sector should be treated as defendant rather than as
participant, and its wails of anguish over the loss of rent-seeking scams
ignored.
Mark-to-market accounting, first, should by all means have the bear-market exit
route proposed by the Basel Committee - that seems necessary to avoid bank
insolvencies in downturns. More important, however, the practice of marking
prices up without actual sales should be prohibited. Only when illiquid assets
such as subprime mortgages, hedge positions or private equity are sold should
any profit be recorded. Naturally, banks holding appreciated assets would be
free to disclose information on them in footnotes, but their appreciation
should only be taken into income (and the bonus pool) when the assets are sold.
As a side-benefit, investors may then again be able to understand the accounts
of energy royalty trusts. Again, fancy valuations of those trusts' hedging
techniques can be given in footnotes. The operating statements should record
the prices achieved in that quarter (whether by direct sales or through hedges)
and the associated costs.
Financial techniques that need Geneva Convention treatment include
securitization, which should not be allowed to remove assets artificially from
balance sheets, thereby hugely increasing hidden leverage. Likewise
high-frequency trading, by which the securities industry extracts
insider-trading rents from the economy should be subjected to a Tobin tax,
reducing the rent-seeking capability of electronic trading desks.
Finally, of course, there are credit default swaps. With their unique
capability to cause explosive losses and allow irresponsible game-playing by
creditors in bankruptcy, these are in a class of their own, the germ warfare of
modern finance. They should be banned outright, with their inventors and
designers subject to appropriate moral obloquy.
It is appropriate that global banking regulation should be carried out in
prosperous, neutral Switzerland. However, the 2008 crash demonstrated that
allowing it to be overseen by the Bank for International Settlements in Basel -
"the bankers' bank" - allows financial services malefactors altogether too much
control over their own regulation. A Geneva convention, outlawing the most
expensive and obnoxious practices, should be imposed on the financial services
sector by an outraged world.
Martin Hutchinson is the author of Great Conservatives (Academica
Press, 2005) - details can be found at www.greatconservatives.com.
(Republished with permission from PrudentBear.com.
Copyright 2005-2009 David W Tice & Associates.)
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