Perfect storm of unintended consequences?
As I write this the NYSE is off almost 300 points - the market fretting about spreading "contagion" and the wait for Congress to pass the "Emergency Economic Stabilization Act of 2008" – formerly known as the "Bailout".
While the current Black Swan event continues to unfold I, like many others, struggle to try and understand how this happened – consistent with Nicholas Taleb's definition of a Black Swan event where human nature compels us to ascribe rationale and predictability to unforeseen events.
I suspect that when the dust settles we will find ourselves in the aftermath of a perfect storm of unintended consequences:
- A desire to extend home ownership
- Declining interest rates as 9/11 and the dot com collapse wrought prior havoc on the economy
- Changes in the accounting standards (FAS 157) to provide "better transparency" into asset valuations
Late Friday afternoon, Michael Arrington of TechCrunch offered "How the US Government Engineered the Current Economic Crisis" as he highlighted an article in the NY Times from 1999 where Fannie Mae was under pressure to extend loans to "borrowers whose incomes, credit ratings and savings are not good enough to qualify for conventional loans".
From the graph in the TechCrunch article you can see how US Residential debt grew rapidly, fanned by declining interest rates.
The masked villain in this plot begins to look like FAS 157 – today's newspapers are full of analysis of the "bailout" but there's little mention of sections 132 (Authority to Suspend mark-to-market accounting) or 133 (Study on mark-to-market accounting) – both buried in the 110 page draft of the bailout bill – you can find the full text here.
The Federal Accounting Standards Board (FASB) issues a series of statements that define the framework for GAAP (generally accepted accounting principles) – these in turn are used by accountants and auditors in preparing financial statements. Statement 157 defines how to establish the value of certain assets using so called "mark-to-market" valuations.
Here's a critical element of FAS 157:
"This Statement clarifies that the exchange price is the price in an orderly transaction between market participants to sell the asset or transfer the liability in the market in which the reporting entity would transact for the asset or liability, that is, the principal or most advantageous market for the asset or liability. The transaction to sell the asset or transfer the liability is a hypothetical transaction at the measurement date, considered from the perspective of a market participant that holds the asset or owes the liability. Therefore, the definition focuses on the price that would be received to sell the asset or paid to transfer the liability (an exit price), not the price that would be paid to acquire the asset or received to assume the liability (an entry price)."
I highlight the issue that may be the masked villain. FAS 157 works fine until you have to contend with an illiquid asset such as a private company stock or (as in the current crisis) mortgage backed securities when the credit market dries up.
Pricing assets under these conditions is a lot like trying to catch a falling knife – you have to keep reducing the price to fire sale valuations. The underlying asset may not be impaired but FAS 157 requires you to reduce the valuation to the price you would hypothetically receive in an open market transaction.
If you read the article on briefing.com that I linked to in my last post, FAS 157 is the reason why these assets are being held at heavily discounted values – the institutions holding these assets have had to report an accounting loss as a result. The knife started to fall as the credit market dried up and buyers became concerned (panicked!) about the risk of massive mortgage defaults thus driving prices down.
It's interesting that the proposed bill gives the SEC the power to suspend FAS 157 and also calls for a study to examine the role FAS 157 may have played in the meltdown.
When the dust settles, will anyone have the courage to call the crisis a result of unintended consequences of otherwise good intentions? Somehow I doubt it – Main Street, so poorly informed by the media about the issues behind this crisis is howling for blood… and in an election year, they will surely get it.