18 April 2008

Why We Are Screwed

I'm not sure that there is a real "vision" for my blog, except to provide for the 5-6% of personal posts that I want to put in my eponymous newsletter.

That being said, I think that my most consistent vision, after being a fighting liberal, is that I am an economic bear, and a pro-regulation one at that.

Martin Hutchinson, writing in the Asia Times, manages to distill much of what is going on right now. He calls it The degradation of accounting.

Basically, it comes down to the fact that any number of people have a vested interest, at least in the short term, of not using accounting that reflects the situation out in meat space.

THE BEAR'S LAIR
The degradation of accounting
By Martin Hutchinson

Fair value accounting, by which debt and equity securities on a company's balance sheet are "marked to market" - written up or down to their market price - has been hyped by accountants and regulators as the epitome of modern financial reporting, enabling investors to gain a completely true picture of their investment's financial position.

Indeed, Gerald White of the Chartered Financial Analyst Institute, speaking at an American Enterprise Institute conference on Tuesday, believes it should be applied to all items on the balance sheet, not just financial instruments. There is just one problem: in the turbulence of the past nine months, it has completely failed to
work and has indeed shown itself to be pro-cyclical, encouraging economically foolish behavior in both up and down cycles.
He notes that this is a change from when he was in B-School in the 1970s, when frequently assets such as real estate were on the balance sheet at a value close to what they were in the 1920s.

While having undervalued assets on a balance sheet is an issue in the old system, it's also clear that the current system of accounting is less accurate, and it is less accurate in a potentially catestrophic way:
The new accounting standard FAS157, propounded in September 2006 and coming into effect for fiscal years beginning in 2008, codifies this trend but does not materially alter it. Its most startling feature for a layman is that it allows companies to mark-to-market assets for which there is no market. Financial assets are divided into three "levels" according to their degree of marketability. Level 1 assets are those for which a ready market exists, Level 2 assets are those for which a market exists for comparable securities and Level 3 assets are those for which no market exists, which are to be valued by use of mathematical models.
(emphasis mine)

He makes the note that this is why we have an insolvency crisis, not just a liquidity crisis.

It will take 5 minutes to read, and you should send it to every financial regulator you know.

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