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How can a component of the
Dow Jones Industrial Average
teeter on the edge of bankruptcy? The
story involves more than first meets the eye.
There is a wide disparity between what is happening and the general public's understanding. Most media accounts emphasize the federal intervention, the potential cost of a bailout, the moral hazard arguments, and the fact that taxpayers may be on the hook for losses. These are all valid public-policy issues and worthy of discussion.
Many of the accounts emphasize the rapidly rising total of capital requirements with little explanation of why these took place. (Ratings downgrades requiring more collateral for AIG.)
Meanwhile, there is an increasing chorus of support for one key factor behind the problem: last year's implementation of FAS 157. This well-intentioned measure, introduced by accountants to avoid a Japan-like situation where institutions maintained assets on the books at unreasonable prices, instituted a procedure for mark-to-market evaluation.
It is a good idea, implemented at the wrong time in the wrong way.
Why This Is Important
FAS 157 rules have (at least) two negative effects:
Requiring asset evaluations based upon the fire-sale prices of other firms. These forced sales into illiquid markets are unlikely to reflect the true value of the underlying assets.
Requiring potential buyers to assume assets that are immediately marked down, placing additional stress on their capital.
The mainstream media have covered only one side of this debate. It is easy to champion free-market pricing and point to the hazards of Japan. It is more difficult to draw a distinction between normal trading and distressed and illiquid markets. The result is that
, when we pointed out the dangers in letting accountants -- unelected and with little oversight -- form our public policy.
David Malpass puts the problem quite well in a paper on RealClearMarkets (revised today on
The new mark-to-market rules are creating capital shortages by valuing assets as cautiously (meaning low) as possible, without a reasonableness test. The mark-to-market rules discourage takeovers (the bane of short-sellers) by forcing prices for post-merger assets to be lowered overnight (when reasonableness would argue that their value would increase due to the deeper pockets of the acquirer).
The astute bank analyst Robert Albertson, featured on yesterday's
Kudlow & Company
, has a great summary:
The combination of rating agencies and mark-to-market accounting is proving to be a very dangerous cocktail that is pushing arguably solvent companies into insolvency. The problem is that they are financial companies that provide liquidity to the economy. So while we may be solving some issues in the short term for that, I think we are threatening ... the liquidity of the economy.
Albertson again, replying to a Kudlow question about "fair value" and mark-to-market accounting:
It is a big issue, because everyone is trying to be precisely wrong.
Indeed! What good is it to have a precise measurement of the wrong thing?
Ned Riley, founder and CEO of Riley Asset Management, also weighed in on
The 157 rule should be suspended. It was developed during a calm period. It was not developed during a period when fire sales were going on and assets were being marked down to an unrealistic price. We forget that some of this stuff is worth more than what they are going to pay for.
These are only the latest analysts to recognize the FAS 157 rule as an important contributor to the problem.
AIG did not get the time to shop around its valuable business lines. How long does it take to get some reasonable bids for something like an airline leasing business?
Rules made by independent groups like FASB have important public policy implications. Accountability in a democratic society requires oversight of these boards. It is especially important in times of stress.
Government intervention might not be necessary if private entities were not punished for stepping in.
The government actions will probably not result in massive losses for taxpayers, despite the hype. There may even be gains.
Observers should balance costs with public purposes and systemic consequences when evaluating government intervention.
And finally, the FAS 157 rule did not cause the credit market problems. The causes -- opaque instruments and flawed rating systems -- are well documented. Having said this, the rule is a hindrance to the effective use of private markets to resolve the problem. It should be suspended, at least for a time. The U.S. will probably join the rest of the world in abandoning it entirely as part of the move to international accounting standards, so why punish ourselves now?
If the groundswell of opinion gets more traction, it would be a bullish event for investors. One important step would be more balanced treatment by the loud and powerful voices in the investment media.
The problem is that one side of the case is easy and popular. The other is more technical and runs against the grain for all of us who mark our positions every day.
At the time of publication, Miller had no positions in the stocks mentioned, although positions may change at any time. Jeffrey Miller is president and CEO of NewArc Investments, a registered investment adviser, and Capital Markets Research.
Miller writes about the market, interpreting data, and finding the right expert at his blog, "
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Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Miller appreciates your feedback;
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