Hope there s money in that mattress A Cruel Accounting

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1 And they all rolled over and one fell out there were eight in the bed and the Little One said, rollover, rollover,, Regulator a control that maintains a steady speed... Our current U.S. financial situation is serious for many reasons, but a seemingly arcane and technical one may be the root cause of what seems to be a banking and liquidity crisis: Unregulated mark-to-market adjustments of assets (and only some liabilities) have caused massive swings in financial capital and lending capacity. F. Hill 9/25/2008 1

2 Before addressing this concern, two things must be emphasized: First, over the last decade, most entities in the U.S., public and private, have overspent relative to their long-term earning power and wealth. A correction/recession was over due. Nevertheless, the potential severity of the current sitation goes beyond the pain associated with usual business contractions. Second, the structure of derivative transactions, and especially credit default swaps, is non-existent relative to the needs of those in these markets. Though the NY Fed pushed for rationalization of reporting and control in this market, it is still likely that many market participants have no idea as to the standing of these agreements individually and in aggregate. Until these types of contracts have gone through a signifcant instance of credit problems, any work out is, basically, unknown even to the level of defining both what credit default really is and when it occurs. Since so much value and so many parties are involved in these transactions, it is possible that many entities could have their values evaporate. Without full credit disclosure and consolidation, no lasting recovery will be possible. Rollover, almost every entity and individual in the United States (and much of the world) borrows, and, at some point in time, looks to refinance that borrowing. Currently, there is no borrowing rollover room. In the past, problems for borrowers and associated remedies worked out over time based on judgement of situations, and subsequent transactions. Of course, this more passive and arbitrary approach led to many previous problems. Nevertheless, the mark-to-market remedy that was hoped to quickly channel resources to success and draw them away from failure has now seized. The time needed to evaluate the fairness of a transaction and the ability to settle that transaction is far greater than the time in which the value may move a great deal. The cruel thing about mark-to-market accounting is the lack of accrual and amortisement. Extremes roll through the financial system with no smoothing and, hence, no regulation. Looking back over recent years, the ups were really high, and we re beginning to see the downs may be really low. Furthermore, the tracks taken to the highs were, relatively, smooth. The paths down have been very rocky. The associated ups and downs add to volatility. Higher volatility leads to very low extremes, and it is, basically, these worst case extreme values that are used to assess the adequacy of a bank s capital for lending. F. Hill 9/25/2008 2

3 As currently structured, mark-to-market banking has led to manic-depressive markets. Ex Fed Chairman William McChesney Martin stated the regulation of mania with his famous quote, "The Federal Reserve's job is to take away the punch bowl just when the party gets going." More generally, he said, "Our purpose is to lean against the winds of deflation or inflation, whichever way they are blowing, but we do not make those winds." Winds of depression are beginning to blow. If the current situation is to settle down, time is needed. The Fed and Treasury are attempting to buy this time by acquiring depressed assets. Really what they are doing is putting depressed assets on the only large balance sheets in the U.S. that are not subject to mark-to-market accounting. The reason is that Government Accounting Standards are where private standards were in the 1970 s. Basically, government accounting rules exist for Government-issued financial claims and trade credit, but not for other financial claims such as equity, mortgages, insurance, and the associated derivatives. While credit reporting and default requirements exist, no Government mark-to-market requirements exist. As in the case of most financial problems, including Enron, we have assets being, effectively, parked somewhere out of sight, and maybe, for awhile, out of mind at the Treasury and the Fed. Adding to the complexity of our situation, the U.S. governments borrowing may soon hit its limit. By slipping an $800 billion increase into the July housing bill (H.R.3221, sec. 3083) and breaking the $10 trillion debt level, Congress finessed an act that had, generally, made front page news. Effectively, the proposed $700 billion bail out package and associated support for JPMorgan s Bear Stearns acquisition, Treasury loans to Fannie Mae and Freddie Mac, and Fed support for AIG will spend the $800 billion. Minimally, $350 billion will be made immediately available to the Treasury Secretary. In mid-july, Congressman Barney Frank stated that the costs of any Fannie Mae and/or Freddie Mac clean up would be counted against the current federal debt limit. They were, but what will the Honorable Barney Frank propose going forward? Probably, he and we overestimated ourselves. However, it s natual after a failure to underestimate as well. In all matters, it is good to average. Though in the long-run, we are all dead; on average and regularly, we lead long and fruitful lives. As stated by Mr. Martin, you can't spend yourself prosperous, and ''perpetual deficit is the road to undermining any currency. F. Hill 9/25/2008 3

4 To get back on track, we need regulated policies and practice. Should the deficit capacity be expanded, it should be done with true requirements that the debt level be brought back down. Corporations receiving government support should pay rent for their asset parking places. The government should hold itself to a workout plan, just as it imposed on individuals in bankruptcy. We must remember that there are alternatives to U.S. Treasury securities, the U.S. dollar, and U.S. financial markets. Looking further ahead, business cannot continue to reward the appearance of significant value without recognizing that cash flows earned from a new high value enterprise may take years to, well, accrue. Unless, an asset is sold to market without recourse, it is illusory to assume that a current market price for a similar transaction of far less value indicates fair market value. It is very useful to know these market benchmark values, but they should not be used as the sole basis for compensation or assessments of longterm financial health. Analogously, medium and long-term losses are, on average, likely to be over estimated with current depressed market values. Instead, the relative correctness of market value benchmarks only becomes clear over the life of any endeavor. For that reason and, particularly, due to the structure of banking regulation, it seems prudent to return to some form of accrual and amortisement in assessing levels of regulatory/regulated bank captial. This change could be accomplished by changes in either bank or related accounting rules. Though this suggestion may appear like a return to the past and its associated problems, it should not, because moderate extensions of current market value concepts also provide expected life estimates. Unlike contracted maturities, which are unrelated to change without default, expected life measures are adaptive to changes in the financial environment. Amortizing differences between fair market value and last regulated book value over expected life should smooth capital changes both in rising and falling markets. Potentially, smoothing capital changes would lead to smoother market values. A simple implementation is to set statutory capital off an average of years. For a start, why not three? The guess is that the last three years now include a fair representation of what were, for the mortgage markets, the end of a best of times and the beginning of what looks like a worst of times. Subsequently, this maturity would be adjusted for expected life or another reasonable metric. Alternative solutions to the current problem that have been initiated or proposed are all very jumpy, they are not smooth. Get Shorty, Goodwill hunting, pulling a TARP over the already soaked financial infield, and other recent proposals only increase volatility and F. Hill 9/25/2008 4

5 disruption. Troubled assets should stay with the trouble-makers, natural consequences. We, the people, can forgive and help, but we can not just jump in and fix problems of this magnitude and complexity. How large is the problem? Significant value was recovered from the depressed assets of the 1980 s., a recovery rate of 70% was estimated in a retrospective FDIC study of the Resolution Trust Corp. In the NY Fed organized-private work out of Long-Term Capital Management s $3.6 billion in assets, a modest profit resulted. In the current environment, estimates begin with the 22 cents on a dollar that Merrill received for its mortgage-related assets. The estimates of the 1980 s RTC cost were $160 billion, and the final public and private cost was estimated by the FDIC to be $153 billion. The history of the RTC was never smooth. Congress consistently held back incremental funding for the endeavor and postured before grudingly passing each new allocation. The Lehman Brothers UK liquidation process could have provided prompt information on potential value. But Lehman s massive value transfer to its U.S. operation has hamstrung the usually prompt British bankruptcy exercise in valuation and restitution. Probably, it s safest to assume that the depressed asset debacle will cost at least $700 billion. Without some immediate changes to smooth mark-to-market regulations, standards, and the transparency of markets, further additions to Treasury and Fed ownership and regulatory burdens will continue. It is unavoidable that further bad credit decisions will be made. The current depression and contraction in the banking system is certainly ensuring that good credit decisions are also not being made. Relative to the alternative of adding more depressed assets to the balance sheets of over stretched Regulators, a simple time-averaged bank capital regulatory rule will reestatblish a lending base. Furthermore, this rule still requires relatively prompt action to fully restore bank profitability and capital. There are two decent years in the three year average, and one bad one. Unless things are worked out with dispatch over the coming year, one good year will be replaced with a worse one, and the credit base will, again, shrink. There shouldn t be any free lunch in for the perpetrators of this mess. F. Hill 9/25/2008 5

6 Business hasn t run on cash in a century. Loans are granted, and it was reasonably assumed that they would rollover. Companies that lived for a century have been destroyed by relatively small groups of mortgage and credit traders. In fairness to these traders, the feedback they got was that they were doing great. These individuals rolled their positions up and over until they pushed normal business out of bed. Hopefully, something will reverse the fall before the Little One says Good Night! Not the change most thought we d be talking about. F. Hill 9/25/2008 6