Tuesday, February 24, 2009

The Damage Has Been Done

Thank you, FASB. Thank you for the turning what would have been a bad, deleveraging-driven economic downturn into the borderline depression here in the US. Oh, and let’s not forget to thank your efficient market cohorts who have chosen to ignore decades of behavioral science and stick to the dogma of market efficiencies, including illiquid assets depressed by panic driven redemptions and forced liquidations.

Thank you for not appreciating the power of reflexivity and the feedback loop from the financial to the real economy with its negative wealth effect. For that is where things stand these so many months into the relentless graveyard spiral of bank assets writedowns, with its unchecked inevitability of creating the very real economy conditions that justify the depressed prices. At this lovely moment, the efficient market advocates are certain to proclaim the “wisdom” of the market in forecasting where the fair value of the depressed assets truly belonged (of course ignoring how reflexivity creates the very conditions it “predicts”. A self-fulfilling prophecy example if ever there was one.)

To be clear, I get the transparency argument put forth by FASB and certain groups advocating mark-to-market, such as the CFA Institute. However, it takes an intellectual leap backward to conclude that mark-to-market is the only asset valuation method worthy of consideration. In such a view and since markets are "efficient at all times and under all circumstances", only the last trade can be considered an acceptable data point to know what the “fair value” of an asset is. No reason to consider other valuation methodologies (such as mark to maturity), for such methods are fraught with potential senior management chicanery. In such a view.

Investment Strategy Implications

With all the talk of a Great Depression II, I have a recommendation. I recommend that FASB and the efficient market cohorts hire a spokesperson. A spokesperson with a trademark expression that exemplifies the economic situation we find ourselves in. I recommend Oliver Hardy, who said it best, “Well, here's another nice mess you've gotten me into."

The damage has been done. Repeal or modification of FAS 157 will now almost certainly have limited positive effects now that reflexivity has begun to work its magic. In fact, one could argue that repeal or modification of mark-to-market will actually inhibit, if not outright eliminate, the recognition of the capital appreciation potential in many of the panic driven depressed assets once fear recedes and balanced thinking returns. Under such conditions, one can only conclude that the winners will be those who scoop up the babies thrown out with the bath water. Tragically, those winners are not likely to be the entities who were forced to writedown all the "toxic" assets - the banks.

(By the way, I wonder if the history books will conclude that the adoption of FAS 157 is the equivalent of Smoot-Hawley: What the Smoot-Hawley act did for the Great Depression, FAS 157 does for the economic mess we are in today – turn a bad recession into a depression.)

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