Regulation and “Mark to Market” Accounting Rules

The odd thing is that nobody seems to understand that it is not the markets that caused the current credit crisis, but rather accounting rules (some of which were enacted after Enron) that require firms to value their assets according to market value rather than according to performance, with some measure of risk that is realistically heavy tailed.
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Regulation and “Mark to Market” Accounting Rules

Few people realize how much of the present damage to markets is caused by the new regulations imposed by Sabannes Oxley and the “mark to market” rules imposed by FASB. How do you mark to market when there is no market? The market for troubled loans has dissolved for two reasons: no one knows what they are worth, and if an investment bank takes the loans into its portfolio it must mark them at the market price. The market is illiquid and facing not mere risk. They are facing uncertainty. No one knows what the values are or what the probabilities are.

My friend Axel Leijhonhufvud once told me a story about inflation in Latin America. No one knew what a dollar was going to be worth in a few hours. A day was a lifetime for the currency. So, when he tried to buy something a shop owner had in the window, the owner said “It is not for sale.” “Why,” asked Axel. The shop owner replied, “If I name a price and you buy it, I will feel like a fool and that I sold it for too little.” That is the situation investors face with sub prime mortgages (the equivalent of “junk” bonds). Right now only the US Treasury or the Mortgage Trust soon to be set up will buy them. But, the problem remains: how much are they worth? No one knows. They are worth more than the “mark to market” rule implies because they can be held and sold later when the market regains its liquidity.

But, the fact remains that most of these investment banks would not be bankrupt if they could price their mortgage portfolios according to a more realistic standard. Regulation seems to be forcing the bankruptcies.

Dr. Rimmer has a few salient observations to make on the current frenzy to regulate financial markets.

Nobody alive can remember as much regulation of financial markets in the U.S. as what is being proposed to Congress next week. The job will be rushed through, by the most inept Congress in recent memory. The players proposing the rules also have very little understanding of how markets work. The best we can hope for is that some of them have read Nassim’s book. For every new regulation enacted, there will be thousands of people immediatly set to work figuring out how to profit from the regulation, and the seeds for the next disaster will sprout. The odd thing is that nobody seems to understand that it is not the markets that caused the current credit crisis, but rather accounting rules (some of which were enacted after Enron) that require firms to value their assets according to market value rather than according to performance, with some measure of risk that is realistically heavy tailed. Current markets are in fact less volatile than markets ten years ago. This graph illustrates that point.

Auction markets are cruel and predatory. When hardly anybody wants an asset, the market value can quickly become close to zero, at which point someone who has lots of capital will snap it up for huge profit. The problem is not the market, but that many people were encouraged to speculate with extreme leverage, without understanding the risk. How many bank CEOs know enough math to understand stable distributions? Probably none. Does Paulson, unlikely. Does Bernanke, we would hope so, but we can’t be too sure.

Anybody who has mastered seventh grade arithmetic can figure out that no bank or money market can sustain a run. In order to earn a return, liquid assets must be invested in assets that cannot immediately be liquidated, and if many similar assets are liquidated simultaneously in a market the value will fall precipitously. Yet no one ever proposes that bank depositors or money market depositors shouldn’t all have immediate access to all of their deposits, why? How can the government guarantee money market and bank deposits through the FDIC or other agency without creating enormous “moral hazard?”

No regulation of markets will ever overcome such moral hazaard, we should be regulating depositors rather than the market. Depositors should have the expectation that they can receive some portion of their deposit immediately, but if they ask for it all they will have to wait some period of time, that increases proportionately to the size of the amount they want to withdraw AND the number of current withdrawal requests.

This will never happen. Instead we will have recurrent bail outs. The interesting thing is the false concept that the tax payer ultimately foots the bill for these things. That is not true, it is the government bond holder who first pays; he in turn demands higher rates (getting his money back), forcing inflation which pays the interest with inflated dollars. The inflation is paid for mostly by people who are not taxed; it is the ultimate tax the poor scheme — even illegal immigrants pay. I guess this will go on as long as most people cannot understand arithmetic. And the Teacher’s Union makes sure that will never happen.