When genius (finally) gets wise

August 19, 2009

The people who brought you the Long-Term Capital Management debacle want banks to get serious about cutting their own leverage, applying fair value accounting to a wider range of assets.

Writing with two colleagues in the Financial Times on Tuesday, Nobel Laureate Robert Merton said banks, their regulators and legislators are conspiring to conceal depressed asset prices in order to avoid dealing with the consequences of insolvency. He wants wider adoption of fair value accounting to force banks to fess up to losses and raise more capital.

Speaking on Bloomberg radio, Merton’s long-time associate and fellow laureate, Myron Scholes, concurred.

This is very refreshing, an honest appraisal of the disease still infecting the financial system—leverage—from two prominent economists who learned the hard way that leverage kills.

These days it’s de rigueur to declare that the worst of the recession has passed, that we’re on our way to “recovery.” Never mind that big banks remain insolvent. Take away the government guarantees that provide them cheap financing and protect the value of their assets and many would be at risk of collapse.

As I argued earlier this week, the fall in real estate prices implies huge losses for bank loan portfolios, losses that could wipe out what’s left of their meager capital.  We got another reminder on Monday of just how bad the losses might be. BB&T said it marked down loans acquired from failed Colonial Bank by 37 percent.

A loss rate half again as large, if applied to Citigroup, Bank of America and Wells Fargo, would wash away what’s left of their equity capital. In other words, despite recent capital raises, their leverage remains way too high.

Merton and Scholes know about the risk of leverage. Their hedge fund,Long Term Capital Management, was levered 25 to 1 before losses wiped out capital, pushing leverage to 100 to 1. It took a bailout from Wall Street firms to make up LTCM’s capital deficit and prevent a systemic collapse.

Even after the stress test, big banks are still levered more than  20 to 1. Far higher when you consider losses they are hiding and off balance sheet assets they have not recognized.  FASB has already instructed them to recognize off balance sheet assets beginning next year and their fair value proposals would, if adopted, kick in a year later.

True, it won’t be easy to put into effect. Banks’ existing fair value estimates are highly questionable. It’s not clear what assumptions they’re plugging into internal models in order to arrive at them. That’s why Merton argues estimates should be “independently validated by external auditors.” If that’s expensive or difficult –  well, then that’s a price banks should bear for investing in hard-to-value assets.

One legitimate criticism with fair-value accounting is its procyclicality. Marking assets to market can inflate capital during bull markets and deflate it during bear markets, exacerbating market swings.

But not if regulators respond dynamically to market conditions. As bubbles inflate, regulators should increase capital requirements so that leverage doesn’t get out of hand. That way when markets turn south, banks will be well-capitalized to handle them.

Unfortunately, regulators don’t have the flexibility to be forgiving right now. Banks didn’t build up reserves during the fat years, so regulators must force them to do so during lean ones.

The first step in solving a problem is admitting you have one. Fair value accounting would force banks to admit they still have a leverage problem and, hopefully, inspire regulators to jack up their capital requirements.

9 comments

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This will only happen once unemployment explodes among Americans who have a Bachelors degree or higher. They run the U.S., they’re suburbia, and their unemployment rate currently is only 7.4%.So they’re not really feeling the recession. They will during the next six months, then it will really be academic whether you make the banks do mark-to-market or not. The economy will have collapsed.By the way, this statement of yours is not logical:”One legitimate criticism with fair-value accounting is its procyclicality. Marking assets to market can inflate capital during bull markets and deflate it during bear markets, exacerbating market swings.”Your definition of fair-value includes “procyclicity.” So either you are in favor of inflated stocks, or your solution, increasing capital requirements, makes no sense.In short, you are mired in the same mixture of ideology, corruption and bad logic, as is the political system.Congratulations.

Posted by John Ryskamp | Report as abusive

The banks and non-banks had no problem invented endless ‘innovations’ to leverage to 40 or higher on the way up to bubbleland.So now you are talking the need for ‘flexibility’, relaxation of accounting rule, convenient disregard of market reality, to make life easier for the same gang of busted banks on the way down. To save their skins. Are you their crybaby?How about this: those guys made, like, $200b in bonus over the past 6 years on the way up to their fantasyland. With each little change of accounting rule on the way down, a little ‘flexibility’, they will pay $20b back to society. Their bonus will buy 10 changes. That’s a very good deal compared to bankruptcy.Ban all derivatives that leverage beyond 12. Now.Let’s see how these geniuses make a living.

Posted by The Real Deal | Report as abusive

The Real Deal….that’s not what I said. In the penultimate paragraph, I argye regulators SHOULDN’T be flexibile right now. If they’d forced banks to raise capital as the bubble expanded, first of all, it wouldn’t have expanded nearly as much. Second, banks would now have more cushion to protect themselves, giving regulators more flexibility to be forgiving.What needs to happen right now is regulators need to force banks to raise more capital so that government guarantees can be removed without crashing the system.Hopefully in the future, after banks have been broken apart and properly recapitalized, regulators will have the luxury to be flexible during downturns.

Posted by Rolfe Winkler | Report as abusive

It is only fitting that we recently celebrated the 40th anniversary of Woodstock and how the headlines are questioning whether baby boomers are still getting high (Reuters).All one needs to see is the state of our financial system and how we seem to have ‘bent’ GAAP to our will.The entire investment community must be so high that they’ve lost their collective memory. What else explains how the ‘baby boom’ generation could send up in smoke the financial discipline and sacrifice of their parents.

Posted by csodak | Report as abusive

Some of the “geniuses” read Ayn Rand’s novels “Atlas Shrugged” and “The Fountainhead” but thought they were brilliant economics tracts. Financial deregulation began with Ronald Reagan’s deregulation of the savings and loan industry and may have reached its apex with the repeal of the Glass-Steagall Act. The Congress and Administration elected by The People pressured the regulators to do little, and passed laws in that regard, and the regulators cooperated massively. And now Robert Merton and colleagues think that fair-value accounting is our savior? Pardon me if I laugh loudly but sadly.

Posted by Steve Numero Uno | Report as abusive

I feel that there are two forces that are holding up any chance of real recovery: the stock market and the government. The government feels that the positive sentiment coming from a bubblicious stock market rising will fix all the ills that have beset us. That’s their solution – prop up enough companies and let the rules slide enough so that everything looks good on paper and ‘growth’ can continue. The public is happy b/c the market is up, companies taken on the ride are happy b/c the don’t have to face an ugly balance sheet. Until people stop forming sentiment based on what the Dow30 or S&P500 is doing, we will continue this run of bubble chasing and will find a hollowed out economy in the end.

Posted by the Shah | Report as abusive

O what a tangled web we weave, when first we practice to bail out banks with 0% money. Allan Sloan in Fortune has a great article on the cash flow problems of Social Security. How is this pertinent? Well, continued artificially low interest rates are going to cause a great deal of problems for state and private pension funds (e.g., CALPERS), as well as insurance companies and any institutions that depend on bond income.

Posted by fresno dan | Report as abusive

I suspect the clue in the words “regulators” and “legislators” might hold part of the answer to beginning to emerge from the current quagmire. “Regulators” should make sure their regulations are fit for purpose, as the de-regulation; for which Bill Clinton and George Bush and the Tony Blair/Gordon Brown dynamic duo should stand-up and take much of the credit for; has so patently failed. The “legislators” should make sure “regulations” are complied with, even if the digression is done by an organisation that is “too big to fail”. Getting people to confess to their flawed “leverage” game over the last decade or two might not achieve anything useful.The reference to “cheap finance” in paragraph 5 hopefully doesn’t end up being more like expensive, long-standing debt dangling by a thread over the heads of a doomed modus operandi.

Posted by Peter H | Report as abusive

Hi Rolfe,Interesting, but a bit late. Removal of mark to market allowed more ‘willful unconsciousness’ of the insolvency of banking and the tsunami to come.As I’ve posted before, I’m a forensic loan auditor. I evaluate residential mortgage loans for violations of federal Truth in Lending laws, among others. Presently, I’m working on audits for commercial loans, and what I’m finding is quite revealing.I’ve known that banks use ‘debt’ and somehow ‘convert’ them to ‘assets’–but I didn’t know *how* they did it. I’ve found the law in the UCC that allows them to do that–though it is tricky and involves other factors.Suffice it to say that banks are woefully underfunded–and it isn’t just the naughty ones dabbling in risky exotic instruments. It’s all of them, domino tipped by the bad boys, and the result will be felt everywhere.CiaoLisa