Wednesday, September 17, 2008

From Chaos to Sanity: The Imperative of Logic

Rules Matter.

If the NFL changes its rules of play, does that not have an effect on the game? So, why would a rule change by the FASB or the SEC or a law by Congress not have the same game changing effect?

When the FASB said that illiquid and opaque assets should be valued at their last sale (or whatever could be approximated as such), were they cognizant of the impact it would have on financial institutions with their capital requirements?

When the SEC eliminated the uptick rule and looked the other way on naked short selling, were they cognizant of the impact it would have in facilitating the bear raids from short sellers? And were they aware that such bear raids would virtually take off the table any capital raising options via an equity sale for financial stressed institutions?

When Congress let the financial innovation genie out of the bottle via various laws (mostly in the area of deregulation) and lax oversight, were they cognizant of the impact it would have on the financial engineers on Wall Street?

The answer to all of the above is apparently not.

Let me clear – the problems of excess amounts of leverage, animal spirits, and bad business decision-making are at the core of the credit crisis. There is no doubt that this is where the blame must lie. Be it no-doc, no-income mortgages, or homes purchased with the intent of flipping them in six months, or credit cards to teenagers in high school, or junk bonds with very generous covenants, the list is very, very long. However, the circumstances produced by such bad behavior are not the only culprits. For when coupled with virtually no oversight and the above noted rule, legislative, and regulatory changes, the bubbles that were blown are what the financial system is now struggling to unwind. Which brings us right to the single most important aspect of the crisis – will the unwinding of the excess amounts of leverage (the deleveraging process) be an orderly or disorderly one?

If left unchanged, the answer is what you see on your screens everyday. Firemen Hank and Ben rushing about to put out one financial wildfire after another.

But it need not be this way.

No doubt, there are many ways to achieve the same end result – a more orderly transition of the deleveraging process – but we’ve got to get beyond the reactive mode and become more proactive to begin to move from chaos to sanity. So, let me humbly offer a few immediate solutions to the credit crisis:

1 - Modify FAS 157

Change the rule from the insanely destructive and academically illogical mark-to-market to mark-to-moving average. By shifting the “fair value” reading from the last sale to the average of the past six months, you will get the closest thing to a reasonable compromise between the market fundamentalist ideologues (with their quaint notion that markets are always efficient) and the realists who know that in the short term investors can be anything but rational, especially when it involves illiquid, opaque assets.

2 – Require more transparency in illiquid assets

The FASB’s recent rule change for FAS 133 appears to be one such solid step in the right direction. More needs to be done.

3 – Begin the process of creating standards for derivatives

Financial innovation is not going away. And when conducting properly, financial innovation can be a very positive force for the real economy. However, when so much is constructed in the dark, in times of stress it becomes impossible to determine where the bodies are buried.

4 – Restore the uptick rule

Since the SEC has finally woken up and instituted sanity into the naked short selling arena, they now need to revisit their laissez-faire, market fundamentalist ideology and restore the uptick rule. By doing so, it will significantly reduce the incentive for the pre-Depression era bear raids that are wrecking such havoc.

5 – Move with a sense of urgency

I began this commentary with a reference to football, so let me return to that metaphor.

In a football game, there often comes a point where time is of the essence. And those teams that are prepared for such times act with clarity and a strong sense of urgency. They may not always succeed but the process is the correct one. The current crisis requires such a sense of urgency. If left unchecked, however, the bear forces at work will continue their bear raids (on equity and debt) until the threat to the system becomes more than it can withstand. Frankly, financial Armageddon is not too strong of a phrase.

Investment Strategy Implications

The impact on the economy has now become so significant that lives are being impacted, most dramatically within the companies that are being driven out of business or into the arms of the US Government and for why? Because rule changes have altered the game.

The laissez-faire, market fundamentalism Reagan doctrine is dead. Over. Finished. Kaput. In its place will be a return to the regulatory and oversight environment that preceded it. The danger is if the pendulum swings too far the other way and restrictions are imposed that severely limits the US’s ability to compete. Given the populist rant of the two presidential candidates, such a move to overregulation is not out of the question.

As I noted yesterday and Mr. El-Erian stated in his interview, transitions can be very messy. Let’s hope that some degree of clear thinking will produce the kind of results needed.


Valueman said...

Vinny, Investors should be able to bet that a stock is going to go up or go down as long as they have something at risk, no matter what the last tick was. Buyers going long are buying from someone who thinks the stock is going down, so following your logic, sellers providing the liquidity in the shares should be prevented from selling before there is a down tick. Equally silly.
If some companies chose to invest in complex and sometimes risky and volatile financial instruments, how is an investor supposed to know the latest value of the assets of the company when making an investment decision, other than there being a mark-to-market? Maybe the problem is with the rules that trigger the periodic need to raise more capital if things move away from the company's vision of its investment strategies.
This crisis wasn't started by the SEC or FASB for the transgressions you list. It wasn't started by mortgage brokers, originators of loans. It was started by the innovation of those who securitized these loans into tranches, those who gave them ratings and covered them with insurance... and finally those who bought them not understanding the true risks when the insurance didn't pay, the rating agencies said they were sorry, and the underlying assets began to see increases in non-performing loans. These were all (sellers and buyers) financial pros operating legally. If you want to blame the regulators, blame them for the right things.

Regis said...

Picking up on your last comment about urgency: we have seen how events are speeding up and everything is moving faster and faster. There is less and less time to stop and think about it: more weekend meetings of top players to decide on Monday morning strategies. Why? Globalization and information availability as well as global trading platforms. It's not going to get slower, its going to get accelerate, and not at an even speed. Too much time and comment has been spent looking in the rearview mirror. We need to look ahead: what will finance and markets look like tomorrow?
1. More innovation, but with greater transparency.
2. More interconnectedness fosters mutually assured survival (MAS as opposed to MAD--are you listening Mr. Putin?)
3. More "win-win" and less "I win, you lose." destructive competition--read Jack Welch's comments on "stickability" as a corporate strategy.
4. More volitility--this is the new "normal" and it presents great profit opportunity for those who can surf it.