• Under CRA, forced lending by banks to minorities for mortgages despite poor credit scores.


• Under related government pressure, generally relaxed mortgage lending by banks and erosion of lending standards to applicants.
  Availability of Fannie and Freddie to buy these subprime mortgages until their own capacity was maximized.


• Structuring of many of these mortgages as ARMS, sometimes with balloon payments.


• Prominence of unethical mortgage companies and home appraisers who arranged loans.


• Prominence of CDOs and various securitized combinations of mortgage loans, often of the subprime variety. The thinking apparently was that, if bad credit risks were paired together, the law of large numbers (or some law) would mitigate losses.


• Exponential growth of credit derivative swaps, in which one corporation guarantees performance of another’s debt.


• Use of models to "confirm" soundness of these securities, when neither the model workings nor the securities themselves were understood. This is a variation of the "black box" syndrome.


• Widespread purchases of all the above securities by investment banks, such as Goldman Sachs, Merrill Lynch, Bear Stearns, and Lehman. Since these firms did not have regulatory capital requirements, and traditionally had operated with high degrees of leverage, any market value drops would hit them particularly hard.


• Use by Citigroup and, perhaps, other banks in holding riskier assets outside of their balance sheets. This practice, involving "special purpose entities," continued after Enron, with a slightly different twist, but with the same intent of non-disclosure to investors and the SEC. Apparently, in 2007, accounting or regulatory rules were changed, so that these assets had to be brought back to the main balance sheets.


• In the summer of 2008, overall U.S. economic conditions were hit by the spike in gasoline prices. It is uncertain at this time whether hedge funds and speculators were instrumental in this horrible price jackup, perhaps tied to a desire to influence the presidential election campaign. Since our economy remained so dependent on foreign oil, this vulnerability to price instability remained.

All these pockets of instability, combined with unprecedented economic and stock price growth in the U.S., meant that some corrections had to take place.

Accounting Haymaker

The above conditions meant that corrections were needed. However, the additional "fly in the ointment," the "last straw," or whatever term, was arguably a key accounting rule. Market value requirements for most invested assets of banks and other financial institutions had been in place for some time. Now, a subtle change in the rules had taken place. Along the way, the definition of market value had changed.

A little noticed Accounting pronouncement, EITF 99-20, stated that, in computing the present values of cash flows for securitized assets, the basic determinant of market values, management estimates, could not be used. Instead, "market participants" could be the only determiners of market values. By implication, at least, if there were no market participants, only net current realizable value (realizable immediately) had to serve as market value.

At the same time, due to related economic conditions, availability of the elusive market participants was drying up. Cash flows thrown off from these securities were showing some strain, but were by no means falling apart. Some noticeable reductions in market values would surely have occurred, if objective management-determined present values of cash flows could have prevailed. Instead, net realizable values at that point in time, drastically reduced fire sale values, were required by auditors as balance sheet market values.

Balance sheets included, of course, surplus. Both were hit in dire fashion by reduced asset values. Often, required surplus or capital values for banks and required values for loan collateral became violated by the sudden, unprecedented strain on asset and surplus amounts.

Very likely, sharply reduced realizable values deserved disclosure in financial statements. Investors could make their own decisions about the viability of financial institutions. But, this would have been a big difference from balance sheet hits themselves.

Widespread bitter complaints about fire sale accounting were made in journals, by respected columnists. If the government had listened to them, it could have mandated to the SEC and FASB that sensible accounting and valuation practices had to be followed. There were still no reports of widespread collapses of riskier assets, even of credit derivative swaps. Return to management determinants of present values of cash flows might well have kept the situation in hand.

Current Time Tumult

Massive government bailouts of banks, AIG and other financial institutions have not eased market uneasiness or, apparently, the financial conditions of these organizations themselves. Even though the SEC and the FASB have apparently backed off on the above draconian definitions of market values, there are no indications from banks and others that they are taking advantage of liberalizations. Instead, there is a continued call for more bailouts.

A newly proposed variation of bailouts is government purchase of "troubled" assets from banks and other financial institutions. These assets are sometimes called "toxic" or "risky," but the flat out description "in default status" has not been used as yet (with the exception of direct bondholders or stockholders in Lehman).

Other segments of the economy, such as the Big 3 automakers, have also lined up at the federal trough for bailouts. These companies were clobbered by the summer gasoline surge, which greatly lessened sales of their highly profitable SUVs. Now, with prices back to normal, they have apparently not gone back to past manufacturing output of SUVs. With their uncompetitive UAW contracts and benefits, they cannot compete with foreign automakers, on any basis short of past SUV output and sales.

The Big 3 (that is, two of the three) certainly should not have received such bailout. If the government had stepped in with aggressive investigation of causes of summer gas spikes, it might have been able to thwart some of the economic pain for them, airlines, and others.

Conclusions

In summary, several government actions in the summer and fall of 2008 could have mitigated the economic panic. Instead, massive bailouts and government intervention have made matters worse. There is no admission whatsoever that all the above Big 10 (Infamous 10) government actions initiated the treadmill of instability in the first place.

Worst of all, both the SEC and FASB are passionately defending market value accounting, without ever admitting to the fire sale corruption of market value that, at least for a while, had been mandated. This means that there is a widespread blank out of the possibility that continuation of prior accounting rules could have allowed a soft landing, instead of serving as the economic last straw.

For the long term, the solution is to remove all the government controls and programs that promote this inherent instability. This cannot happen in just one generation. In the shorter run, I believe the only course is to buy time--buy time for as much stability as possible, in the hope for eventual removal of controls. Avoiding knee jerk impositions of new programs and regulations, whether from governments or accounting rule-makers, that demolish uneasy stability is one absolutely essential ingredient.

To an extent, it can serve as a trap to dwell on what could have been. But often this is the only way to have a chance to avoid the same mistakes in the future.

The above views are my own and are not necessarily those of any professional organization.

Norman E. Hill, FSA, MAAA, Member AICPA, ASCPA
Norm's Thoughts
Books by Hills
Winner and Final Chairman

Labels: accounting crisis, acounting, economic crisis, financial crisis, norman e hill, political

posted by Norm  Thursday, June 25, 2009

Labels: accounting crisis, acounting, economic crisis, financial crisis, norm thoughts, norman e hill, political

posted by Norm  Saturday, June 20, 2009