Posted
Sep 17 2008, 11:41 AM
by
Vinny Catalano, CFA
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 option via an equity sale?
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 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, 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 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 (not is) a return to regulatory and oversight environment that preceded
it. The danger is this 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.