No Runny Eggs

I’ve written several times about the idiocy of not modifying or eliminating the current interpretation of an accounting procedure known as Mark to Market.

In short, “mark to market” means that financial institutions need to recognize the market value of their investments as they change rather than waiting until they dispose of the asset and recognizing a gain or loss.   The purpose for “mark to market” is to reflect the estimated “value” change of the asset, real time, rather than having shareholders or mutual fund holders get surprised (up or down)  in one fell swoop. 

In a “normal” world, mark to market is a good tool.  However, for mark to market to work properly there needs to be a fairly active market for the asset being marked.  If the market for the asset has few trades (thinly traded), it has the possibility of causing “fire sale” pricing for assets that have actual, recoverable value that is much higher.  This latter situation is what is happening to various financial instruments that many of the banks and other financial institutions (Citicorp) hold.  Today, there are many reports that assets like the mortgage backed securities have been written down to as low as 30% of their face value.  This while the actual cash flow performance of those same assets are performing at a level that is close to 90% of face value.

Various government entities, including the FDIC, require that banks have capital of a certain ratio to the loans they have outstanding.  Part of the capital that a bank has is the value of assets that they invest in.  When the assets, like CDOs get written down in a dramatic fashion, the bank or financial institution’s capital is also reduced.  This is part of the reason that financial institutions have been chasing after capital infusions during this meltdown.  Part of the reason that the TARP plan exists is to infuse capital into financial institutions to replace the eroded capital from written down assets.  You can see from the previous paragraph that because of mark to market, it is possible that TARP is having to infuse 50% + more capital than they need to for the capital they are providing to support the CDOs.

Finally, FINALLY, after having first written about this nearly a year ago, it looks like the FASB is going to address and likely modify mark to market.  About dang time!

You may ask, “Shoebox, if this was so obvious, why did it take a whole year to address?”  Good question!  This is yet another example where government’s “good intentions” led to unintended consequences. 

Mark to market as we know it, was created by the Financial Accounting Standards Board (FASB) with FASB 157.  FASB 157 was a direct result of the Enron scandal.  Congress was so incensed by what happened at Enron that they basically told FASB and others that either they fixed the problem or Congress would.  FASB 157 is the result. 

The other result of Enron was that auditing firms became extremely conservative in interpreting FASB rules.  All you have to know is that Arthur Andersen, then one of the largest auditing firms in the world, ceased to exist as a result of Enron and you can see why auditing firms quit “interpreting” and merely “implemented” anything that FASB promulgates.

Let me make one caveat to my advocacy for a change in mark to market.  Many of complained that by eliminating M to M we will not have financial statements that fairly reflect the company’s status.  In some respects that’s accurate.  What I propose is going back to a mark to model for financial purposes but providing information in the financial statement notes that reflect the difference between mark to market and mark to model.  This will give both sides of the argument the information they want/need and will allow knowledgable investors the information they need to make assessments.

The sad part of all of this is that FASB, the FDIC or Congress could have acted on this long ago.  Had they done so, even if only doing so on the capital requirement calculations, some portion of the hullabaloo in the financial industry could have been avoided.  Additionally, some of the financial bailouts could have been avoided or at least mitigated and maybe, just maybe, President Obama would not have had the door thrown wide open to waltz into any company he now chooses and dictate how they should do business.

I hope that FASB does act on Thursday.  If they don’t, expect a nasty reaction from the stock market.  If they do act, as I expect them to, this could provide a significant boost to the viability of several financial institutions.  If that happens, we could see the end of the beginning of this financial downturn.

Senator Judd Gregg, says the US doesn’t have the economic where-with-all to even join the European Union:

“We won’t even be able to get into the EU if we wanted to,” Gregg said this morning on MSNBC, “because our government is so large and so huge.”

The European Union’s Stability and Growth Pact (SGP) adopted in 1997 requires a budget deficit to be less than three percent, and requires a national debt beneath 60 percent of Gross Domestic Product (GDP).

As Gregg further points out, we’re getting dressed down by the French:

“We’ve been lectured by France on the fact that we’re not fiscally responsible right now,” Gregg, the would-be commerce secretary, noted with incredulity.

We’ve also been lectured by the Russians and the Chinese about our excessive borrowing and spending.

With the size of the deficits and borrowing that President Obama is proposing, it’s obvious that we will no longer be an economic super power.  The EU is saying we couldn’t even join a club that includes Western versions of Socialism.  If we can’t join their club, where does it leave us?  I hear Mugabe, Chavez, Castro and Kim Jong-ll are looking for members!

Treasury’s Top Candidate to Run TARP Drops Out .

Damn, is there anyone who wants a Treasury job?

WASHINGTON — The leading candidate to run the Treasury Department’s $700 billion bailout program has withdrawn his name from consideration, according to people familiar with the matter.

Frank Brosens, a hedge-fund manager and big Democratic donor, was considered the top contender to run the Treasury’s Troubled Asset Relief Program. Treasury Secretary Timothy Geithner is now considering several other candidates, including Herb Allison, who currently heads mortgage titan Fannie Mae.

Oh yeah, let’s get the Fannie Mae folks, they’ll do anything!

Mr. Brosens, who campaigned for Mr. Obama, said he withdrew his name for personal reasons, including wanting to remain at his hedge fund, Taconic Capital Advisors. “I very much wanted to find a way to serve,” he said. Among the reasons he cited for withdrawing was the need to commute between Washington and New York, where his son is in school.

Uh huh.  Did he just find out that his son is in school?

Just so you know, if nominated, I will not run.  If elected, I will not serve….just if you were wondering.

What would this article be without the obligatory and obvious video?

During his press conference last evening, when question about the dramatic increases in debt and deficit that his budget shows, President Obama again lashed out with, “I inherited this mess.”

The Washington Post has put together a graph showing deficits under Bush and the proposed deficits under Obama.  As they say, a picture is worth a thousand words:

I think it’s fair to cut Obama some slack on ’09. The deficit in this year was started by President Bush. That said, there was not one decision on the extraordinary monies spend that Obama was not involved with either through direct consultation or via his vote as a Senator. That said, there’s no question that every dollar past ’09 is all Obama, all the time. There is also not doubt that every year of Obama’s projected budget has a higher deficit than ANYTHING President Bush had.

Before you get into “this is a true comparison” or “Bush didn’t show Iraq”, go read the Heritage.org piece. As they say in the commercial, “Prego, it’s all in there!”

This morning, Treasury Secretary Timothy Geithner released his plan for Toxic assets.  Geithner’s latest attempt to solve this problem is called the , Public Private Partnership Investment Program. 

In its simplest form, Geithner’s plan would have the FDIC front a program where investment companies could place their “toxic assets” up for sale in an auction process.  Private entities would be able to bid on the toxic assets and via FDIC guarantees, be able to leverage their money 6:1.  The equity investment required to purchase the assets would be shared equally between the government and the private entity purchasing the toxic asset.  Perhaps this example from Geithner’s document will help clarify how this will work:

Sample Investment Under the Legacy Loans Program

Step 1: If a bank has a pool of residential mortgages with $100 face value that it is seeking to divest, the bank would approach the FDIC.
Step 2: The FDIC would determine, according to the above process, that they would be willing to leverage the pool at a 6-to-1 debt-to-equity ratio.
Step 3: The pool would then be auctioned by the FDIC, with several private sector bidders submitting bids. The highest bid from the private sector – in this example, $84 – would be the winner and would form a Public-Private Investment Fund to purchase the pool of mortgages.
Step 4: Of this $84 purchase price, the FDIC would provide guarantees for $72 of financing, leaving $12 of equity.
Step 5: The Treasury would then provide 50% of the equity funding required on a side-by-side basis with the investor. In this example, Treasury would invest approximately $6, with the private investor contributing $6.
Step 6: The private investor would then manage the servicing of the asset pool and the timing of its disposition on an ongoing basis – using asset managers approved and subject to oversight by the FDIC.

Before I dissect the plan can I ask one question?  Is this it?  Is this what we waited two months for?  Is this the plan that Geithner was “uniquely qualified” for to put together?  How could this answer have taken more than about a partial weekend to come up with?

What’s not to like?  Plenty!

First, the FDIC and TARP are carrying nearly 93% of the risk of the asset program.  Obviously, if the assets are purchased at the “right” price, there is upside for these “investments.  However, with the private equity folks having to only pony up 7% and having significant return possibilities with minimal downside, isn’t it more likely that the assets get over priced in the auction rather than under priced?  Isn’t this the same kind of a scenario that lead to the toxic assets in the first place?

Second, I question how much of the debt will be placed up for auction.  Yes, the folks holding them would like to clear their books of them.  However, an auction can get you both less than you have the asset marked at as well as more than the asset is marked at.  This market is still very very thin.  Couple that with the uncertain economic environment and it would seem that there will be few players able and willing to bid on these assets.  Auctions work best when there are lots of bidders and the items being bid on have great transparency as to what’s being bid on.  I don’t see either of those situations occurring with these auctions.

Third, and perhaps most important, as it title states, this program is based on private participation.  OK, admittedly, the private participation is not much more than a way for Geithner to attempt to legitimize the government guaranteeing/buying these assets, but private companies are still required.  If the AIG kerfuffle showed nothing else, it showed that the Democrats have nothing but disdain and contempt for anyone who has made out better than whatever they think is “fair.”  The Democrats have also put private enterprise on notice that whoever uses government money is subject to retroactive “adjustments” if the Democrats think you did better than you ought to have done. 

Geithner’s new program would have private investors leveraging government funds to purchase these assets.  Isn’t that what AIG is/was doing?  If the private investors are able to drive significant returns on the toxic asset program what guarantee is there that Congress, specifically the Democrats, won’t come back afterwords and say “we want more!”  With this as the backdrop, how many private investors do you think will be willing to put their money at risk in another government supported effort?

I’ll say right now that I may be completely wrong about this program.  As I write this, the DOW is up 260+ points on the anticipation of this program.  I suspect however, that this may look a lot like last week’s announcement by the Fed to expand it’s balance sheet by over a trillion dollars, the DOW ran up on the anticipation but sold off the following two days as investors digested the implications and reality of what the Fed had done.

My take?  This is another “swing and a miss” by Geithner.  That makes a strike out on my stat sheet.

Update 3/23 10:44 AM – and if you think the disincentive of working with the government is limited only to AIG because Congress so “carefully crafted” the legislation not to have any unintended consequences, think again!  Read this about what is happening at another “failing bank.”  You can bet most of the other “failing banks” are impacted by the unintended consequences of the AIG bill as well!