[Rhodes22-list] Accounting

[Brad Haslett]

Wally,

This article from a tax blog just showed-up on the scan and supports
some of your points (note to self - Brad, get a life, leave the house,
go to the hangar, go sailing).

-----------------------------

September 30, 2008
7 The Financial Crisis: What Went Wrong?

The ongoing turmoil in the financial markets has diverted me from my
usual tax academic pursuits, including this blog, for which I
apologize. This post explores the causes of that turmoil. My next post
will explore solutions currently under consideration, including
aspects of the so-called "$700 billion bailout."

The current financial crisis has many causes, some long-term and
structural. I focus here, however, on three immediate aspects of the
crisis: the trigger, how problems generated by that trigger spread
through the markets, and how this produced the liquidity freeze that
persuaded Mr. Paulson and Mr. Bush to act (unsuccessfully thus far).

The Trigger: Teaser-Rate Mortgages

The media talks about "sub prime mortgages" – by which it means
mortgage loans to borrowers with less than stellar credit. The real
problem, however, was the advent and widespread use of teaser-rate
mortgages in both the prime and sub prime markets. A teaser-rate
mortgage allows a borrower to make relatively small payments for
several years. At some point, the rate jumps dramatically, and the
borrower faces much higher monthly payment obligations.

Not surprisingly, borrowers loved this innovation. Teaser-rate loans
allowed folks who otherwise could never have afforded to own a home to
buy one, at least until the rate reset. But it wasn't just sub prime
borrowers who liked teasers. Teasers sold like hotcakes; loan
originators made correspondingly fabulous profits.

(Some have tried to blame teaser-rates on the Community Reinvestment
Act of 1977, which encouraged lending to minorities and lower income
Americans. But that act only applied to commercial banks. A majority
of this crisis's teaser-rate loans were made by unregulated
originators not subject to the act. More fundamentally, there is no
evidence the present crisis started in 1977. Teaser-rate mortgages
first became widespread after Mr. Bush took office in 2001.)

In any event, it's not hard to predict what happens when rates reset.
All of a sudden, buyers who have been paying $1,000 per month face
monthly payments of $4,000. Many, perhaps most, go into default.

The possibility that this would become a major problem became apparent
as early as 2005. (I actually wrote that fall predicting the current
crash.) Mortgage economists began publishing reset schedules –
schedules of how many billions or trillions of dollars of mortgages
would reset and when. In effect, those tables offered a rough schedule
of how many mortgages would go into default and when.

As defaults increased in number, lenders ended up holding large
amounts of foreclosed property. When they tried to convert the
property into cash, they put downward pressure on housing prices. And
this, in turn, made financing and refinancing more difficult and
further defaults more likely – even of non-teaser loans. (A perfect
vicious cycle, and we're not remotely near the end of it. In parts of
the country, more half the homes offered for sale are now
foreclosures. Banks are desperate to get those homes off their balance
sheets and are dumping them much faster than the market can absorb
them.)

The Spread: Securitization and Debt Chains

But why did Lehman Brothers and AIG go under? After all, they don't
make mortgage loans. I turn next to how the problem spread.

Assume that A borrows from B to buy a home, giving a mortgage on the
home to secure her debt. B then borrows from C, using A's mortgage as
security. C in turn borrows from D, using B's obligation as security.
And so on.

Now assume that A's mortgage goes bad. What happens to B, C, and D?
Answer: all the loans up the chain go bad as well.

And this isn't all. If the loan is secured (as mortgages and many
other links in debt chains are), the lender is typically less
interested in the creditworthiness of the borrower. The lender relies
primarily on the collateral, not the borrower, for assurance of
repayment.

As a result, each financial intermediary can be thinly capitalized. So
a company with $10.1 billion in assets and $10 billion in debt may
have a small amount of net equity. Indeed, the more thinly capitalized
a company, the higher the return it can make on its capital.

Unfortunately, what this means is that when A's mortgage goes bad,
it's not just the loans up the chain that go bad – financial
intermediaries in the chain often go bust as well. A thinly
capitalized intermediary cannot absorb many losses. And that is why
teaser-rate mortgage defaults triggered and are still triggering
defaults and failures across the entire financial sector. Almost
everyone was in the debt-chain business and extended themselves to the
max to take advantage of the extraordinary profit opportunities of
that business.

I've explained the transmission mechanism in terms of debt because
readers have an intuitive understanding of how debt works. In fact,
however, many of the most important links in the chain were not
technically "debt." Some were shares in "mortgage pools"; some,
"derivatives"; some, "credit default swaps." What they all had in
common was that each transferred some risk of default up the chain to
someone else. Wall Street sometimes calls links in such debt chains
"toxic waste," because today no one wants them.

AIG, for example, held about $500 billion in "notional exposure" on
credit default swaps. In English, it was at risk to the tune of about
$500 billion if mortgages down the chain went bad. When mortgages
began to go bad in large numbers, the market realized that AIG might
not be able to cover its obligations and began to sell AIG stock
seriously short. Lenders stopped lending. End of story.

What made this more than just a corporate problem was that AIG was a
domino at the head of many long chains of dominoes. If AIG had gone,
some believed the world would have faced immediate economic collapse.
So the US government bought an 80% stake in AIG in exchange for enough
money to allow AIG to dissolve gracefully – over a couple of years –
instead of imploding overnight.

The Crisis: Liquidity Freeze

None of this, however, would by itself have led a free-market US
administration to propose a $700 billion general "bail-out." Real
estate is important, yes, but there are many parts of the economy not
dependent on the market for home mortgages. What happened?

In ordinary times, most businesses borrow on a short term basis to
fund payroll, inventory, and other operating needs. There are two
principal sources of short-term money: banks and money-market funds.
In the past several weeks, each of these has substantially reduced the
amounts they are willing to lend. This is what's called a liquidity or
credit freeze.

Why did banks and money-market funds stop lending?

Let's start with money-market funds. Investors put money into
money-market funds when they want absolute safety and the ability to
pull their money out at will. Put in a dollar, get out a dollar,
whenever you want. In return, they accept a very low return. What
happened was that The Reserve, the oldest and most highly regarded
money-market fund sponsor, "broke a buck" – which means it paid back
only 97 cents for every dollar investors put in.

The reason was simple: The Reserve had loaned short-term money to
Lehman Brothers, a major participant in the debt chain business.
Lehman Brothers went belly up, and The Reserve's short-term loans to
Lehman became uncollectible. (Remember that the Treasury and the
Federal Reserve Bank, having bailed out Bear Stearns, decided to let
Lehman Brothers go bankrupt to teach the market a lesson. In
retrospect, this was probably a mistake.)

As a result, investor confidence in money-market funds plummeted.
Fortunately or unfortunately, investors always have a secure place to
park money, Treasury bills – short term obligations issued by the U.S.
government. When The Reserve broke a buck, everyone moved their money
into Treasuries. Money-market funds dried up. And that was the end of
one major source of business working capital.

Another major source is the banking system. Unfortunately, banks and
other financial intermediaries became reluctant to loan to each other.
As a result, money in one part of the banking system stopped flowing
to where it was most needed.

Why did banks stop loaning money to each other? When lenders lend,
they generally look at borrowers' financial sheets to determine how
creditworthy they are before giving out money. Unfortunately, most
banks and other financial intermediaries have large amounts of toxic
waste on their books.

In situations like this, accounting rules require companies to "mark
assets to market." If an asset with a face value of $100 appears to
have a market value of $40, the company is supposed to record a loss
of $60 immediately, even before the asset is sold, and to carry that
asset on its books at a value of $40. So banks and other financial
intermediaries began reporting enormous losses on the toxic waste they
held, and their balance sheets crumbled. (The head of the Securities
and Exchange Commission was pressured to waive this rule, but refused.
It was for this reason that Sen. John McCain demanded that he be
fired.)

But recognizing market losses isn't the most serious problem. If a
lender can be confident that the asset in question really has a value
of $40, it may still conclude that the prospective borrower is likely
to repay the loan – notwithstanding the reported loss. If no one knows
how much the toxic waste is actually worth, however, lenders can't
assess the creditworthiness of any prospective borrower with
significant amounts of toxic waste on its books. Almost all banks hold
toxic waste. So banks stopped lending to other banks. (Waiving the
mark-to-market rule would not have solved this problem; it would
simply have hidden the accrued losses. Banks are sophisticated enough
to worry when accounting rules do not correctly reflect what's going
on in the market.)

But why is the unavailability of short-term money so bad?

Remember what businesses use short-term money for – to meet payroll
and put inventory on their shelves. When businesses lose access to
working capital, they stop operating, not because there is anything
fundamentally wrong with their products or markets or business plans,
but simply because they can't get the cash they need on a daily basis.

You might think of short-term money as the lubricant that keeps the
world's economic engine turning over smoothly. If there's no
lubricant, the engine freezes. No paydays, no goods on the shelves.
Seriously.

This was the possibility that persuaded Mr. Bush and Mr. Paulson to
change course and support a general "bail-out." And it remains a very
real possibility.

The $700 Billion Bailout

I will discuss the details of possible solutions in my next post.

What is important to emphasize here is that current proposals are
primarily intended to solve the liquidity freeze part of the problem –
to prevent the world's economic engine from seizing up.

Mr. Paulson's original proposal hoped to accomplish this in two ways.
First, by buying up toxic waste at fair market value, Mr. Paulson
could take toxic waste off financial intermediaries' balance sheets.
This would allow lenders to assess borrowers' creditworthiness with
greater confidence and, hopefully, get banks to start lending to each
other again.

Equally importantly, however, Mr. Paulson requested authority to buy
up that waste at whatever price he thought best. By buying toxic waste
at higher prices than private buyers were willing to pay, he hoped to
bolster the financial intermediaries' balance sheets – to make them
more creditworthy.

This aspect of the proposal was what made it a "bail-out." And this
was part of what led to its defeat in the House.

Note that Mr. Paulson's proposal was not intended to solve the
teaser-rate mortgage problem, either now or in the future. In the
transactions that created the teaser-rate mortgages in the first
place, both parties made bad decisions – the lender and the borrower.
Mr. Paulson's proposal was not intended to help either. One of its
unavoidable side effects, however, was to relieve lenders of the
consequences of their bad decisions, while leaving borrowers to suffer
the consequences of theirs. This made it politically less palatable.

In addition, at least $500 billion more of teaser-rate mortgages are
scheduled to reset over the next several years. In all likelihood,
they too will go into default and become toxic waste. Nothing in Mr.
Paulson's original proposal was intended to do anything about this
next $500 billion installment – or, indeed, to prevent lenders from
making more teaser-rate mortgages in the future.

Similarly, Mr. Paulson's proposal was not intended as a general Wall
Street bail-out, although to some extent it would have had that
effect. Note that the outstanding overhang of credit default swaps
alone is estimated to be between $45 and $60 trillion – three to four
times the size of our annual gross domestic product. The requested
$700 billion, although the single biggest appropriation request in
U.S. history, was miniscule when compared with the toxic waste problem
as a whole. Mr. Paulson's proposed solution was to cost just 1% of the
size of the problem and was aimed only at a small part of that
problem. (It is unnerving to realize that the U.S. government – the
"beast" we have been starving for so long – may now lack the borrowing
capacity to solve the problem as a whole. We need to get our financial
house in order.)

All Mr. Paulson's proposal aimed to do was to put lubricant back into
the engine, to get short-term money flowing again to prevent our
economic engine from freezing up. Now that the proposal has gone down
to defeat, we can only hope that Mr. Paulson was wrong.


On Wed, Oct 1, 2008 at 8:10 AM, TN Rhodey <tnrhodey at gmail.com> wrote:
> "A sharp CPA could design a believable computer
> model that could make the value come out wherever his boss wanted it
> to be. He could also convince outside auditors and regulators of the
> soundness of his model. "
>
> Brad, I am with you but wondering how they determine new (long term) value
> for this big pile of crap?  One thing the article mentions that often gets
> lost. Most people are paying their mortgages. The properties that are
> bundled in these securities are not worthless. At some point they all will
> be worth something to somebody.... but when?
>
> Are there computer models that accountants trust? Not poking a stick I have
> no idea. I can see how it would ease credit. I also see how it led to past
> problems.
>
>  I thought we were rushing into the bail out. I am all for any plain that
> reduces government intervention.
>
> Wally
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