Politicians + Banking Reform = Financial Disaster

Anyone who doesn't harbor some degree of animosity for the bankers who, through a combination of stupidity, short-sightedness and avarice, caused the global financial crisis is a better person than I am.  That said, financial reform should not be tantamount to financial dismemberment.  And there's a little known accounting rule winding its way through financial reform that may be just that.
My writer husband and I often discuss our finances.  He is a brilliant man, one whose brilliance is primarily that of adept observations and the facility with which he uses language to share them.  His writer friends, many of whom are dear to me, share a trait with him:  they hate math.
Consequently, when the business channel drones on about FASB's consideration of mark-to-market accounting for mortgages held by banks, his eyes glaze over like a weary parent listening to his two-year-old blathering unending baby talk.  I imagine many others do as well.
This bill, however, is important.  And I believe that a combination of me speaking English and you being smart will result in your understanding that this is a big deal, and something you should tell your Congressional representatives to stop.
Here goes.
Let's pretend you lend money in the form of buying a bond from the ABC company.  They pay you interest and agree to repay you on a certain date.  Let's say your bond is worth $10,000 (the amount you lend them), your interest rate is 3% and the bond is due (repayable to you in full) on June 1, 2013.  Unless ABC company files for bankruptcy protection before your loan is due, you can expect to be paid $150 twice each year (3% on $10,000), and the full amount you lent them, $10,000, in three years.
Now let's say interest rates go up this Summer.  Now companies like ABC have to pay 4% for borrowed money, 1% more than the amount they're paying you.  If you sell your bond to someone else after rates go up, it will now be worth less than the $10,000 you paid for it, because anyone can now get 4% for their money, and your bond only pays 3%.  If you mark your bond's value to the current market price (mark-to-market), your bond will be worth less after rates go up than it was what you bought it.
But, what if you don't sell it?  What if you hold your bond until June 1, 2013, collect your 3% per year, and get all your money back?
While you hold your bond from now until 2013, what is it worth?

• Is it worth what you could sell it for after rates go up?
• Is it worth what you know you'll receive what the bond is due?

With that in mind, let's pretend you're a bank.  You are now lending money to people to buy houses.  You don't sell your mortgages to investors.  You keep the loans, collect the payments and keep the interest your customers pay.  When rates go up, are these mortgages worth less?  When rates go down, are they worth more?
Yes, according to this new rule.  Why should you care?
If banks have no intention of selling their mortgages, then they probably will be very careful how they lend money.  Why?  If they keep the mortgages, they keep the risk that if borrowers don't pay them back, they'll take the loss.  They won't make crazy loans to people and sell them to investors.  That's good.
But, when rates go up (as they are sure to do), these loans will be worth less.  Then, the banks have to put more money aside for them, and will have less to loan to you.
Seems crazy, doesn't it?  Banks will be penalized for NOT selling their loans to investors, and you'll have a harder time getting a loan.
So, here's the English translation of what's going on.  FASB  (pronounced FAS-bee), is the Financial Accounting Standards Board.  They're considering marking-to-market (immediate sale to investors value, not repayment value) all mortgages that banks intend to keep.
FDIC Chair Ms. Bair is against it, as is former Chair Mr. Isaac.  So am I.  So should you, if you intend to borrow money from a bank who makes mortgages and doesn't sell them to investors.
Contact your Congressional Representatives if you agree, and tell them that you are against FASB Topic 220, 825 and 815.

Who's Most Guilty of Financial Malfeasance?

You may have heard Warren Buffett has said that he has no problem with the Goldman Sachs deal that has resulted in charges of client misrepresentation by the Security and Exchange Commission (and is being considered for criminal charges by the Justice Department).  As discussed in a previous article, I agree.  If not the banks, than who is most responsible for the financial meltdown?
1.  The Players  
The Quants
First, there were the "Quants," the quantitative analysts, fresh from Ivy League graduate schools, who prepared studies showing the extreme unlikelihood of all regions of the US housing market dropping in value at the same time.  As these were academically gifted young people with virtually no practical experience, I hesitate to lay blame here.
The Quants' Bosses
It started at JP Morgan.  The bosses, seasoned professionals, read the analysis, looked at the commercial banks' and thrifts' mortgage profits, and decided to get into the business.  The big question is, "Did they understand that the increase in demand that would result from broadening the real estate market would result in a crash?"  While the answer to this question is unknowable, there are two issues that may point to the truth.
The first, is the recent "Internet bubble."  Anyone could have seen that the amount of money that was invested in Internet stocks would have pushed their valuation to ridiculous levels.  Surely, an analogous investment in the real estate market would do the same.
The second, is the fact that the risk to increasing the number of real estate owners was mitigated by selling that risk to investors, instead of holding those investments on their books.
The Banks
Once JP Morgan entered the real estate business, it had to offer terms that would be more attractive to borrowers than commercial banks and thrifts.  So, underwriting standards were decreased.  So what if you didn't technically qualify for a mortgage?  A rising real estate market would allow you to sell your property at a profit, and a low "teaser" rate would result in low initial payments.  After five years, you'd be making more money at your job, wouldn't you?  Then you could afford the payments.
For banks and thrifts to compete, they, too, must lower their underwriting standards, or risk losing their loan portfolios to those banks that offered better refinancing opportunities.
So, we're off to the races.
The Borrowers 
The fact that borrowers were not required to prove their income did not force them to lie on applications.  Even if the borrowing terms were difficult to understand, people who earned $50,000 knew they could not afford a $500,000 house.
A lie is a lie.  Lies have consequences, and I am not in the camp that says, "Poor little borrowers didn't know what they were doing."
I don't think people are that stupid.
The Rating Agencies
Rating agencies are paid by the companies that generate the securities that they rate.  That is inherently insane.
If I have a security I want to sell to the general public and it's inherently risky, it is the job of the rating agencies to say "That is risky."
The problem is, if one agency declined to rate the security as "not risky," all the issuer had to do is take it to another and say, "Here's my fee.  See if you can rate this as 'not risky'."  And they did.
Packages of loans, geographically diversified in the US were sold to the general public as AAA - the same rating given to ultra-safe US Treasuries.  "Widows and orphans" could safely buy them.  Why?  Because, even if the underwriting standards were lax, there was good evidence provided by the Quants, verified by the Quants' Bosses (who paid big, fat fees for safe ratings), that a majority of the loans would be good, even if there were regional difficulties at times.
2.  Common Thread
If the Quants hadn't come up with the studies about the general safety of the US mortgage market, someone would have figured it out.  Maybe the Quants' bosses would have done it themselves, as they saw quarter after quarter of real estate lenders' profits.
Some percentage of borrowers have always lied on mortgage applications.  Underwriters catch some, but not all of them, but the number that squeak through the system were never significant.
But, this bubble could never have grown unless the issuers of laxly underwritten mortgages could have sold them to a "greater fool."  If they'd kept these mortgages on their books, the banks who lent the money would have had to acknowledge the losses.
That leaves the rating agencies.
3.  The Rating Agency Issue
There is no excuse for the ratings agencies giving AAA rating to risky securities.  Taking money to do so is effectively the same as taking a bribe.
Ratings agencies are charged with the responsibility of analyzing underlying securities and giving the public an easily understood way to know the level of risk they have.  This is the one place where, "I didn't know" isn't an excuse.  Maybe the Quants didn't know.  Maybe the Quants' Bosses didn't know.  Maybe the banks didn't know.
But the ratings agencies can't claim stupidity.  Rating securities is their reason for existing.  If they can't do that, they don't deserve to exist.
4.  Blame
Maybe the Quants should have known.  Probably the Quants bosses should have known.  Likely the banks should have know.  The borrowers should not have lied.  But, most definitely, the ratings agencies should have known.
So, the next time you hear that a security is rated AAA, what will you think?
It's time to hold the ratings agencies' feet to the fire.  Either rate securities by using generally accepted accounting principals or rename yourselves as, "Bribe Takers."
Perhaps a little something in this regard should be passed in Financial Regulatory Reform.  And, if it isn't, I wonder. 
Will it be because someone has been paid to ignore it?

The Case Against Goldman Sachs

There is no doubt that the sentiment toward big banks is negative.  Many resent that these banks were bailed out during the financial crisis, when the individual citizen who suffered as a result of irresponsible lending practices, misrepresentation of the safety of securities backed by those loans and resulting falling home prices, paid for the bail outs with their tax dollars.  When, added to that, historic profits are earned by those very banks, and enormous bonuses are paid to their employees, while ordinary citizens battle near double-digit unemployment, that anger is understandably exacerbated.
Few news reports give details of this charge, describing it as "complicated, difficult to explain, and hard to understand."  I disagree.  I think that, when explained properly, this is very understandable. 
It's easy to vilify Goldman for bad  behavior.  Let's take a look at this case, and decide for ourselves.
In plain English, Goldman is accused of selling derivative securities to their clients in April, 2007.  Derivative securities are securities that derive their price from another asset. The assets on which the price of these securities was derived, were residential mortgages, which were rated BBB-, the lowest "investment grade" rating available, by ACA Management, LLC, a company with experience rating securities like these. 
A Goldman employee, Fabrice Tourre, allegedly led ACA to believe that a hedge fund, Paulson & Co., Inc., was investing in these securities, when in fact, Paulson was investing in the other side of the transaction, i.e., a "short" position, or an interest in the securities losing value.  The securities that ACA approved as investment grade were chosen from a list that Paulson had chosen to invest against.
The approved securities were described as "Selected by ACA Management" and were marketed, not to individual investors, but to "sophisticated investors,” like banks and pension funds.
When explaining the difference between what must be disclosed to such sophisticated investors, former SEC lawyer Jacob Frenkel, explains,“Materiality is a lot like a continuum.  The amount of information that needs to be disclosed to institutional investors at the highest level, where they’re doing their own research and analysis, is less. Their criteria for the investment decisions tend to be far more sophisticated than the individual investor’s.”
So, the case is this.  A hedge fund wants to bet against sub-prime mortgages, and brings a list of the mortgages it feels will go down to Goldman.  Goldman takes the list to a rating agency, does not tell that rating agency that it received the list from a hedge fund that thinks the securities will go down, and gets an investment grade rating for most of those securities from that rating agency.  It sold those securities to banks and pension funds without telling them that a hedge fund was betting against them.  The banks and pension funds lost money.  So did Goldman, by the way.  They received $15 million for structuring this deal, but they lost $90 million investing in it.
The SEC alleges that Goldman should have told ACA and its investors that Paulson was investing on the other side.
Here are some questions that may help you decide how you feel:
1.  Should rating agencies rate securities on their own merit (not by considering who may or may not be investing in them)?
2.  Since ACA chose the securities in this investment from a list given to them by Goldman (from a Paulson list), was it a misstatement that ACA was "Portfolio Selection Agent?"
3.  Since banks and pension funds are defined as "sophisticated" investors, should they analyze the investments they are considering on their own merit (not by considering who may or may not be investing in them)?
I understand the anger many people feel toward investment bankers.  That said, I also feel that the analysis of securities, particularly by those who buy them on behalf of institutions or pension fund participants, should be based on analytical evaluation, not by "who else is buying this?"
I believe this to be a fundamentally weak case, and cannot help but notice that it was made public during the Financial Regulatory Reform debate.
For the record, I am in favor of Financial Regulatory Reform.  While this case may increase the likelihood of the passage of such reform, I find it largely without merit.
I welcome your comments.

A Rose by Any Other Name

As our nation grinds to a halt under the failure of statesmanship, I refuse to take a side.  You may not characterize me with a word, when doing so will only give me the opportunity to give countless examples of when that word does not accurately describe my position. 
Democrat, Republican, Independent, Libertarian - or Capitalist
In my study of political structures, and which function best, I've concluded that capitalism is my preference.  I prefer that to Democrat, Republican, Independent, or Libertarian.  In societies where capitalism flourishes, there is likely

• Greater opportunity
• Tolerance of diversity
• Social mobility
• Commitment to fairness
• Dedication to democracy.

But, we must take care in how we define capitalism.  Unbridled free markets recently rocked global finance to its core, and financial reform is stalled in a gridlocked Congress over a year from barely skirting a depression.  Without requiring that capitalism be characterized as pursuit of a rising standard of living for the clear majority of citizens, it is reduced to a system that benefits the few.
Pursuit of a Rising Standard for All
With that definition in mind, it is interesting that the ratio of compensation of CEOs to workers was 30:1 in 1970 and 120:1 in 2000.  These data were provided by the Economic Policy Institute, a think tank dedicated to including the interests of low to middle income workers in economic policy.
The growth in CEO earnings virtually mirrors in the growth in the S and P 500 Index over that same period.  While workers are generally paid in the form of cash compensation, CEOs in non-financial firms earn over 70% of their compensation in the form of equity pay.  Therefore, the inequity appears to be based more in the performance of the price of their company stock options than any other factor.  If the CEO is ultimately responsible to her stockholders for the performance of the company, then this inequity is readily explained.
Further, during this period retirement savings changed from company-provided defined benefit pensions to  retirement programs where employees make contributions that are deducted from their income.  For example, a worker who contributes 15% of her $50,000 salary to a 401 (k) plan will show a taxable income of $42,500 after deducting the contribution.  Because the IRS limits the dollar amount of contributions, a $250,000 executive at that same firm would be limited to a $16,500 contribution.
The worker's salary in this example would be decreased by 15%, and the executive's by less than half that (6.6%), even though the executive contributed $9,000 more.  As you can see, workers contributing to these plans make their income appear proportionately less than CEOs.
Finally, because transfer (unemployment, welfare, disability and social security) payments are taxed, if at all, at a lesser percentage for lower income taxpayers, those amounts are not fully represented as income, based on tax return data.
A 2007 article by the Cato Institute demonstrates that many studies, including recent work from Paul Krugman, grossly overstate the disparity between CEO and worker income, and estimate, based on Congressional Budget Office figures, that the top 1% of earners in 2003 earn between 14:1 to 15:1 more than workers, up from about 9:1 in 1981.  
So, while the current climate is not one that shows capitalism in its finest light, we do appear to be in a rising tide that lifts most boats.  And, with that, I will add a codicil to my "Capitalist" title.
Barron's Byline Admission
One of my favorite economists is Gene Epstein, who is the Economics Editor of Barron's magazine.  I have often referenced his work when teaching Security Analysis at UCLA because of its data-orientation and lack of agenda.
Mr. Epstein recently gave a speech to young people that he was kind enough to share with me, wherein he described himself as a "bleeding heart capitalist."  It was at that moment that I adopted a party affiliation.
I am in favor of a system that is most likely to result in greater opportunity, tolerance of diversity, social mobility, commitment to fairness, and dedication to democracy.  I am, indeed, a capitalist.
But, I also demand that that system results in a rising standard of living for the clear majority of their citizens.  Rather than a "laissez faire" approach to free markets, I favor a properly regulated financial system that compels those who take extraordinary risk be subject to extraordinary loss - and be outside the realm of Federal insurance, either by mandate or by being "too big to fail."
I favor protection of the finest educational system in the world by protecting the free exchange of ideas in a meritocracy, encouraging participation with the world's greatest minds regardless of their country of birth, and funding their priceless contributions to our competitiveness in the global economy.
I, too, am a bleeding heart capitalist, and will support whichever political party that furthers these ideals.