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Sunday, September 21, 2008

Analyzing Forbes' Solutions to the Financial Crisis

According to Steve Forbes, there are three things that the Federal Government can do to end this financial crisis. In fact, Forbes goes so far as to call this crisis artificial.

1) Strengthen the Dollar.

If you have been following the work of Steve Forbes, then you know that his answer to every crisis financial and even national security is to strengthen the Dollar. He believes that the weak Dollar caused the spike in gas and food prices. What I don't see though is how a stronger Dollar would help in this crisis.

2) End Marked to Market

He is referring to FASB rule 157. Here is what the rule, instituted at end of 2007, said.

A Federal Accounting Standards Board (FASB) Statement that requires all publicly-traded companies in the U.S. to classify their assets based on the certainty with which fair values can be calculated. This statement created three asset categories: Level 1, Level 2 and Level 3. Level 1 assets are the easiest to value accurately based on standard market-based prices and Level 3 are the most difficult

Here is the net effect of this rule.

FASB 157 was passed to help investors and regulators understand how accurate a given company's asset estimates truly were. Many firms (including some of the largest in terms of assets) had to write down billions of dollars in hard-to-value Level 3 assets following the subprime meltdown and related credit crisis, which began in late 2006. By making companies report to investors the breakdown of assets, they allow investors to potentially see what percentage of the balance sheet could be open to revaluation or susceptible to sudden write-downs.


Here is how Forbes himself described the corrossive effect of FASB 157.

Think of the mark-to-market madness this way: You buy a house for $350,000 and take out a $250,000 30-year fixed-rate mortgage. Your income is more than adequate to make the monthly payments. But under mark-to-market rules the bank could call up and say that if your house had to be sold immediately, it would fetch maybe $200,000 in such a distressed sale. The bank would then tell you that you owe $250,000 on a house worth only $200,000 and to please fork over the $50,000 immediately or else lose the house.

Now many of these Mortgage Backed Securities and other financial vehicles derived from bad mortgages, would be classified into these level 3 assets. These assets had to be "marked to market" and thus market to some depressed price. Here is how one of my readers described the effect.

When portfolio managers discovered they were holding assets that would suffer from an unnecessarily harsh valuation according to this new rule, they all tried to sell them, and very quickly there was nobody to buy them. Thus, we began the Great Asset Contraction that helped to trigger the present crisis

As such, panicked selling happened at the worst time for no good reason besides a new accounting rule.

3) End so called naked short selling on financial services stocks.

Here is what naked short selling is.

Naked short selling, or naked shorting, is the practice of selling a stock short without first borrowing the shares or ensuring that the shares can be borrowed as is done in a conventional short sale. When the seller does not then obtain the shares within the required time frame, the result is known as a "fail to deliver."

A short sale is a speculator's tool used when you believe the value of a stock will go down. You sell the stock first and buy it back later. Normally in a short sale, the stock is borrowed, normally from the account of the broker you are using, before you sell it. With a naked short sale, even that doesn't happen. Because speculators have taken advantage of the financial mess to short sell every financial company in sight, this practice has perpetuated the problem. By ending this practice, even for a limited time as Forbes suggests, this would curb the practice of short selling. Limiting the ability of speculators to drive already beaten down stocks even further.

1 comment:

Anonymous said...

Hi Mike,

I've been railing about mark to market like forever. Don't know if you've seen it yet, but WSJ has the actual proposed legislation. Don't know what I think about it yet. (Warning: The legislation is 2 pages - the comments are 77!)

http://blogs.wsj.com/economics/2008/09/20/treasurys-financial-bailout-proposal-to-congress/

wahibicorridor