BLOWING AWAY THE SMOKE FROM FINANCIAL CRISIS

There certainly is a fire at the heart of our financial system. Some of the great icons of the American economy — Lehman Brothers, Merrill Lynch, Bear Stearns, AIG, Freddie Mac, Fanny Mae, Washington Mutual, IndyMac and others — have burned to ashes or been singed beyond recognition. Even more companies face being put on the “burn after acting” list. However, the self-serving posturing of many politicians has created so much smoke that it is difficult to see how to successfully fight the fire.

As usual, in an effort to make it seem as though they are smarter than us, our elected servants (i.e., politicians) are giving us only bits and pieces of information and not telling us the whole truth in this crisis. Their objective is to position themselves so that, when the problem is solved, they will be viewed as the “Great Saviors.”  They fear that, if we really understood how and who allowed this crisis to emerge and how easily it can be resolved, then we would be so angry with all of them that we would turn them out of power. For these politicians, the biggest concern is not the financial crisis or how it can be resolved, but how they can get re-elected. What they don’t want us to know is that, while the crisis is real and has the potential for a catastrophic impact on our economy and way of life, the solution involves just a few simple steps that can be simply taken.

The solution boils down to two things: 1) Get the economy of the critical list. 2) Figure out how to prevent it from getting sick again.

The situation is a little like having a child who has overdosed on drugs and is in danger of dying. You don’t stand around debating how he got the drugs and what happened. The first thing you do is try to save his life. Only after that is accomplished do you worry about how to keep him away from the drugs in the future.

How This Awful Mess Happened

A lot of things went into causing this crisis, but there were three fundamental actions that combined to fuel the fire. They are:

1) The repeal of the 1932 Glass-Steagall Act and the Bank Act of 1933.
2) The FASB requirement that companies “mark-to-market” assets that are available for sale, and
3) The Federal Reserve flooding the economy with huge amounts of cheap funds.

Together these actions opened the door for greedy, incompetent and downright stupid financial executives to gorge themselves in a pool of unregulated “exuberant risk.” With the complicity and duplicity of our politicians, unfettered by regulations that had been shredded and fueled by easy credit chasing loose money, corporations and executives were encouraged to take unsound actions that artificially stimulated the economy. Now those same politicians who were the crisis enablers point fingers at corporate executives even as they wring their hands in despair and work feverishly to jockey for position as our great saviors. As the saying goes, if you look up the word “disingenuous” in the dictionary you will find a picture of your local Congressman or Senator. And, also one “super disingenuous” Presidential candidate.

It may not be politically popular to support a bailout proposal, because the impression created in the media and those seeking political gain is that the plan only “bails out” those rich (stupid, greedy) corporations and executives who created the problem. However, the reality is just the opposite. Since it is the general population who will really suffer from these failures, the real “populist” position is to support the effort.

I am not an expert and don’t pretend to understand all the details (who does?) of the bailout plan, but for me it is simple. Basically, what the government is proposing to do is “make a market” in a security that no longer has a market. Of course, in normal times this is the responsibility of the stock market not the government, but these are not normal times. A government serves best when it serves in a crisis.

The reason these securities “have no value” is artificial. The “value” being bandied about is “market value” not “underlying value.” Since the market for the sale of these securities has evaporated, FASB (that’s the Federal Accounting Standards Board) requires the companies to “write down” the asset, which is close to zero. This has caused artificially wiping out balance sheet surplus, reserves and equity, making investment capital and credit liquidity virtually nonexistent.

In essence we have moved from an artificially stimulated to an artificially depressed economy.

However, the “underlying value” of these securities is something altogether different. It is the present value of all the future payments and interest on the mortgages in the pool. Only if everyone with a mortgage stopped making mortgage payments and the homes had no residual value, would the underlying value be zero.

When people talk about a $750 billion to $1 trillion “bailout” their assumption is that no company or country would ever buy these securities back from the US government and that all the mortgages in the security fail. In fact, if the government were to hold these securities to maturity, there would be little – if any – loss. They might even make some money. In reality, this “bailout” is not writing a check to bail corporations out of their problems; it is investing $750 billion in all of us who have home mortgages. The value of these investments has nothing to do with the mistakes of the financial corporations and so long as we continue to pay our mortgages (as 96 percent of the people do) these will prove to be profitable investments.

No one who understands this financial mess really believes this proposal will “cost” taxpayers hundreds of billions. As evidenced of this, early suggestions are that these securities could be acquired at 65 percent of the underlying value. This offer leaves room and assumes there will be potential for future gains and profit. On three previous occasions – during the Great Depression, the Chrysler loan guarantee and the Savings and Loan scandal – the Federal government has taken virtually the same action, and ended up making a profit.

Taking these “bad” investments off the balance sheets of banks, insurance companies and investment firms will re-establish the credit liquidity that will allow them get back to doing what they do best: funding the real growth of the economy and we will all be the better for it. (Of course, that is assuming that proper check-n-balance controls will be reinstituted to prevent future “stupid” actions.)

Another simple action the government could implement would be to suspend the FASB regulation that requires companies to “mark-to-market” assets that are available for sale and value them instead based on the underlying value. This action would significantly reduce the “artificial” accounting losses that now must be shown and significantly strengthen the balance sheets of the companies.

What about the Future?

From my perspective, the purpose of regulation is to assure a level playing field in an open market economy. A level playing field assures that customers and investors are given the sufficient disclosure of information to make informed decisions. Regulation that is too stringent hampers innovation, creativity and competition. Regulation that is too lax opens the door for the stupidity and abuse from which we are now suffering. Of note is the fact that many of the “failed” securities i.e., swaps, were completely unregulated.

When the dust has settled, we need a new generation of regulation that will re-level the playing field, without going too far and inhibiting the free market to do its job.

Needed is a Sarbanes-Oxley type of regulation for the financial services industry. As required in SOX, the key is disclosure and transparency of corporate accounting actions. It is not possible to legislate or regulate against dishonesty, immorality, fraud or stupidity, but I believe it is possible to regulate against stupid people doing stupid things.

One should note that between the passage of Glass-Steagall in 1932 (which required complete disclosure and transparency of bank actions), and its repeal in 1999, there was not one major bank failure. Unfortunately, all we have confirmed by lowering the bar of regulation is that when we allow stupid people to do stupid things in new and unfettered ways, we create a problem for all of us.

A new regulatory environment that demands disclosure and transparency in all financial services activity will create the level playing field that will allow the strengths of a true capitalistic open market to re-emerge and grow our economy.

In the meantime, just you wait and see. When the politicians finally agree on a bailout bill (perhaps as early as Sunday), the pols who’ll be beating their chest the loudest in front of the national TV cameras will be precisely those disingenuous flacks who are more interested in extending their federal meal ticket than serving their constituents.

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5 responses to “BLOWING AWAY THE SMOKE FROM FINANCIAL CRISIS

  1. Would you be interested in exchanging blogrolls links with my site? Please email me if you are interested

  2. Nice writing. You are on my RSS reader now so I can read more from you down the road.

    Allen Taylor

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  4. During any financial crisis you need cash fast and easily. Business Financial Thumb

  5. Bob: Great article.
    I am E mailing this to my friends. Thanks

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