by Calculated Risk on 9/14/2009 08:44:00 AM

Fed Governor Elizabeth Duke presented some thoughts today on possible accounting changes: Regulatory Perspectives on the Changing Accounting Landscape

... I feel it is crucial that an accounting regime directly link reported financial condition and performance with the business model and economic purpose of the firm. It is difficult for me to comprehend the value of an accounting regime that doesn't make that link.

As a regulator, I focus on the viability of individual financial institutions and the financial system as a whole. To be frank, it has been frustrating to try to assess that viability when the value of an asset is based on the nature of its acquisition rather than the way in which it is managed or the way in which its economic value is likely to be realized.
...
If the business model is predicated on the trading of financial instruments for the realization of value, or other strategies that essentially focus on short-term price movements, then fair value has relevance. In the trading business model, reporting fair value focuses risk management on short-term price movements and in most cases incentivizes management to define the organization's risk appetite and to mitigate risk through hedging or other means. Fair value also incentivizes the entity to raise and maintain capital at a level sufficient to cover the price volatility of its assets. For example, if the business model is an originate-to-distribute model, then fair value has relevance.

In contrast, if the business model is predicated on the realization of value through the return of principal and yield over the life of the financial instrument, then fair value is less relevant. Consider, for example, a bank that finances the operations of a commercial enterprise. The realization of value will come from the repayment of cash flows. Risk management is based on an assessment of the borrower's creditworthiness and the entity's ability to fund the loan to maturity. In this case, the accounting should incentivize the entity to maintain sufficient funding to hold the instrument to maturity and to hold a sufficient amount of capital to cover potential credit losses through the credit cycle, preferably in a designated reserve. Indeed, the use of fair value could create disincentives for lending to smaller businesses whose credit characteristics are not easily evaluated by the marketplace.

Admittedly, some have used the business model argument to manipulate accounting results. But the actions of those entities do not diminish the relevance of the business model to the measurement principle. Indeed, over time if the valuation model is not relevant to the business model, the business model itself is likely to change. Rather, the lesson to be learned from such manipulation is that we--preparers, users and auditors of financial statements--need to be vigilant in evaluating actual business practice, and restrict the use of particular measurement principles to the relevant business models.

To this end, safeguards should be implemented to eliminate a firm's ability to overstate gains or understate losses by switching back and forth between business models or by reclassifying assets from one business segment to another. For example, from a regulatory perspective, assets in a financial institution's liquidity reserve, by their nature, imply utility through sale and, therefore, should be valued at market price.

Take a mortgage loan. If the business model is to hold the loan to maturity, Duke believes the loan should be valued based on future cash flow (considering the creditworthiness and capacity of the borrower). However if the business model is based on trading mortgage loans, then she believes the loan should be valued based on fair market prices.

Duke goes on an discusses the Stress Test accounting and current FASB and IASB discussions.

by Calculated Risk on 9/13/2009 11:22:00 PM

Stephen Mihm at the Boston Globe looks at Hyman Minsky: Why capitalism fails

Amid the hand-wringing ... a few ... commentators started to speak about the arrival of a “Minsky moment,” ... shorthand for Hyman Minsky, a hitherto obscure macroeconomist who died over a decade ago.
...
In recent months Minsky’s star has only risen. Nobel Prize-winning economists talk about incorporating his insights, and copies of his books are back in print and selling well. He’s gone from being a nearly forgotten figure to a key player in the debate over how to fix the financial system.

But if Minsky was as right as he seems to have been, the news is not exactly encouraging. He believed in capitalism, but also believed it had almost a genetic weakness. Modern finance, he argued, was far from the stabilizing force that mainstream economics portrayed: rather, it was a system that created the illusion of stability while simultaneously creating the conditions for an inevitable and dramatic collapse.

In other words, the one person who foresaw the crisis also believed that our whole financial system contains the seeds of its own destruction. “Instability,” he wrote, “is an inherent and inescapable flaw of capitalism.”

Minsky’s vision might have been dark, but he was not a fatalist; he believed it was possible to craft policies that could blunt the collateral damage caused by financial crises. But with a growing number of economists eager to declare the recession over, and the crisis itself apparently behind us, these policies may prove as discomforting as the theories that prompted them in the first place. Indeed, as economists re-embrace Minsky’s prophetic insights, it is far from clear that they’re ready to reckon with the full implications of what he saw.

An interesting overview of Minsky. And this sure sounds like the recent credit bubble:

As people forget that failure is a possibility, a “euphoric economy” eventually develops, fueled by the rise of far riskier borrowers - what [Minsky] called speculative borrowers, those whose income would cover interest payments but not the principal; and those he called “Ponzi borrowers,” those whose income could cover neither, and could only pay their bills by borrowing still further. As these latter categories grew, the overall economy would shift from a conservative but profitable environment to a much more freewheeling system dominated by players whose survival depended not on sound business plans, but on borrowed money and freely available credit.

And since the failure of many economists to see the coming crisis is being widely discussed, here is a quote from Minsky on macroeconomics:

“There is nothing wrong with macroeconomics that another depression [won’t] cure."

by Calculated Risk on 9/13/2009 06:49:00 PM

From Bloomberg: Stiglitz Says Banking Problems Are Now Bigger Than Pre-Lehman (ht Ron Wallstreetpit)

... “In the U.S. and many other countries, the too-big-to-fail banks have become even bigger,” [Joseph] Stiglitz said in an interview today in Paris. “The problems are worse than they were in 2007 before the crisis.”
...
“It’s an outrage,” especially “in the U.S. where we poured so much money into the banks,” Stiglitz said. “The administration seems very reluctant to do what is necessary. Yes they’ll do something, the question is: Will they do as much as required?”

And on the economy:

"We’re going into an extended period of weak economy, of economic malaise,” Stiglitz said. The U.S. will “grow but not enough to offset the increase in the population,” he said, adding that “if workers do not have income, it’s very hard to see how the U.S. will generate the demand that the world economy needs.”

The Federal Reserve faces a “quandary” in ending its monetary stimulus programs because doing so may drive up the cost of borrowing for the U.S. government, he said.

“The question then is who is going to finance the U.S. government,” Stiglitz said.

Stiglitz also wrote a comment in the Financial Times: Towards a better measure of well-being and I think this comment is very important:

Too often, we confuse ends with means. ... a financial sector is a means to a more productive economy, not an end in itself.
excerpted with permission

by Calculated Risk on 9/13/2009 01:11:00 PM

Kenneth Harney discusses the credit impact of various mortgage choices: Mortgage problems are walloping Americans' credit scores

For example, loan modifications that roll late payments and penalties into the principal debt owed on the house can actually increase borrowers' scores modestly. Refinancings of underwater, negative-equity mortgages ... may have little or no negative effect on scores ...

However:

... short sales can trigger big drops in credit scores. ... strategic defaults [lead to even larger credit hits] "plus negative marks on their credit bureau files for as long as seven years." ... People who file for bankruptcy protection covering all their debts (mortgage, credit cards, auto loans, etc.) will get hit [the hardest]. Bankruptcies remain on borrowers' credit bureau files for 10 years.

Harney has some data on the sharp overall decline in credit scores.

Most of these changes -- fewer people with excellent credit, more people in the lowest brackets -- have been caused by late payments on home mortgages, serious delinquencies, short sales and foreclosures ...

One of the tragedies of the housing / credit bubble was that many people bought homes before they were financially ready - or bought homes they could not afford. Now many of these people will be soured on the home buying experience, and their credit scarred for years.

And there will also be another group of people who make their payments, and keep their "excellent" credit scores, but will be stuck with their underwater homes for years.

by Calculated Risk on 9/13/2009 10:30:00 AM

The "everyone was doing it" excuse ...

“Yes, we spent too much money. Of course we made mistakes. We made the same mistakes that everyone else has made across the country,’’
Roland Fahnbulleh Jr., [a Pequot tribal member].

From the Boston Globe: The wonder, and the fall (ht Lisa)

... casinos rode the wave of easy credit to success in the years leading up to the recession, and Foxwoods was no exception. The Pequots, who had to go to Malaysia to fund the initial $60 million casino because no one else would lend to them, soon had banks lining up with loan offers as Foxwoods raked in customers - and their cash. The tribe quickly expanded the resort, adding hotels, restaurants, and shops to the complex, which now stands at 4.7 million square feet, nearly 20 times its original size. The Pequots also spent big to acquire nearby businesses and invest in other industries, such as shipbuilding -an expensive effort that later flopped.
...
But by the time the MGM Grand at Foxwoods debuted in May 2008, the recession was well underway, and gambling receipts were dipping sharply nationwide. ... Now, the shimmering tower stands as a symbol of excess, with unbooked rooms, empty stores, and a sparsely populated gaming floor.

This has some interesting twists because many of the employees are members of the tribe and have lost their jobs. Plus there are payouts to the tribe members ... but the rapid expansion, with too much debt, are common stories.