Proposed Regulations, If Needed, Ought to Value Assets Better

August 19, 2009

Are the United States Treasury, along with the Executive and Legislative branches looking everywhere but at the causes of the financial crisis in a rush to reform our regulatory regime and generally cure the crisis?  Might the cure be worse in the long  run?

There many culprits behind the current financial crisis including, excessive leverage combined with opaque instruments, a lack of transparency, conflicts of interest, credit ratings agencies, and a systemic flaw in Wall Street’s own risk models and the assumptions underlying risk models.  However, it does not seem that the causes of the current crisis have yet been addressed in the hearings before the House or in the pronouncements of the Treasury Secretary.  Are we instead focusing on the twin red herrings of mark-to-market accounting rules and short selling?

The Financial Accounting Standards Board announced August 13, 2009 that it will expand fair-value accounting to loans.  Presently accounting rules only requires companies to value potential loan losses only when they are seen as probable-allowing the recognition of loan losses to be postponed.  It would seem that financial institutions, especially banks, ought to use mark-to-market accounting rules or alternatively list difficult to value securities on public exchanges.  Albeit in the case of highly customized agreements (OTC derivatives between private sophisticated parties), it may never be possible to list these transaction on an exchange.

The SEC recently entertained announcing proposals to permanently restrict traders from short selling.  This comes on the heels of recommendation by the House to suspend mark-to-market rules.  It is this lawyer’s humble opinion that the long-term solution to the current global financial crisis does not rest in piecemeal hasty legislation made under intense political lobbying pressure like the suspension of mark-to-market by the Financial Accounting Standards Board under possible pressure by large banks or short selling by the SEC.  Neither mark-to-market accounting rules nor short selling caused the current financial crisis.

Short selling is a useful tool for market participants as a source of liquidity, and a risk transfer and hedging mechanism.  It is an essential risk transfer mechanism that enables skeptical traders or the public to wager against publicly traded companies.  Short selling transfers the risk of failure without actually necessitating a failure.  It provides necessary liquidity to the financial markets.

Mark-to-market is more than an accounting rule; it is a principle that allows market participants to know the true value, the market value, of a financial instrument.  Marking to market fosters transparency.  As long as investors do not have the timely prices by which they can evaluate their decisions, as is often the case in the private OTC market, the market remains frozen.

Remember that the value of transparency in the marketplace is possibly best explained by its absence-opaqueness.  The lack of transparency is called opaqueness.  The environment that led to the current crisis was opaque.  In the current mortgage debacle, few of the players knew what the baskets of mortgages they were packaging, buying and selling were actually worth.  The participants in instruments that led to this current crisis operated in a very opaque if not downright murky environment.

Price is the single most relevant information provided in a transparent market. Eliminating the requirement that assets be marked to market will result in their being marked to model…or as Warren Buffett remarked, “market to myth.”

The regulated futures market, long a stepchild of the financial markets, is the most liquid and transparent market in the world.  It has been remarkably free from systemic financial crisis and there is a lesson there.

In my opinion, transparency, strict accounting rules and the ability to short sell are characteristics of the most efficient financial markets.  Easing accounting standards may set the stage for the opposite of transparency, that is financial obfuscation, and in the long run, the very real possibility of future financial crisis.*

R. Tamara de Silva