Sunday, February 22, 2009

How To Fix The Economy...(back to the future).

Clearly the banking crisis is complicated beyond anyone's capability to comprehend - its significance and outcome will only be known to us as it plays out (is this the end of free market capitalism or a crisis from which we will emerge, albeit battered)? That said, a little bit of knowledge can actually be a good thing when no one seems to have any good ideas - so here's an idea based on a little bit of knowledge:

Our giant banks and financial institutions have balance sheets and income statements that are so complex as to be impossible to understand. One result is that we do not really have a true and clear picture of the overall economy - are we in a death spiral or is the ship going to slowly turn around? We simply do not know with any degree of certainty what is what. (Footnote: The fact is that complexity has been used for years by corporate leaders to distort, exaggerate and "massage" their financial numbers. This is not hyperbole - the idea was that a rising tide raised all boats - you could borrow from next year to make this year look OK because next year the long term income we produced this year (but have not yet "realized") would emerge. (I am not making this up - that was the thinking process). This distortion was based on judgements and therefore within acceptable legal prerogative - my point is - the sinking tide (made worse by leverage) has now exposed the unreliability of the financial statements that have been the backbone of investor/lender and capital provider decision making). (Further footnote - if any of this seems far fetched take a look at how compensation systems worked over the last few years - many (most?) were based on NPV (net present value) - think about that - bonuses were set not on actual income produced but a guess as to what the present value of speculative profits in the the future would amount to - that is short term bank robbery (literally).

Over the last few years as regulators, rating agencies and auditors (who have been unconscious at the switch for the last 20 years) woke up to this wide spread institutionalized manipulation (examples - off balance sheet debt, special purpose vehicle financing, mark to make believe asset valuations, recognition of accelerated earnings and under reported true liability values) they tried to reign it in by enacting hastily conceived and enacted accounting rule changes. One of them was the Mark to Market Rules adopted in November of 2007 known as FASB 157 and FASB 105. By year end 2007 reporting season (March, 2008), this resulted in the beginning of massive write downs in market valuation of assets and has continued in an unabated downward slide since then. Now that there is virtually no market to mark to that system leaves accountants, corporate CFO's, rating agency analysts and auditors at sea - they are naked (embarrassed and exposed (legally and otherwise) in front of us as we see that they were gamblers - raking in money and fees for selling their ratings, their auditing services and their insurance and other derivative and leveraged bets they made assuming a system wide melt down would never happen while ignoring the true risks they were taking. (Footnote - ignoring risk is an epidemic in corporate America - the quality most rewarded in business is the ability to accept chance and act as if victory is at hand when the actual outcome is unclear and unknown - the result - a corporate upper class that makes decisions based on unrealistic assessments of the downside allowing rational thinking to get bent by the strength of the wish to see their desire translated into reality - it is seductive.)

So here's my proposed solution - lets go back to the old ways. We used to pretend that our financial statements were accurate - and until we changed the rules that illusion gave us confidence and continuity. I propose we repeal FASB 157 and 105 - the mark to market rules - and let corporations once again make up their financial results based on their best judgement on what the future value of their present day decisions will be. My guess is that the economy and our confidence in the future will return because things will seem to be getting better (based on increasing reported profits). People will start buying again, more production will be needed, employment will go up etc. What's the downside? If we do not recover we are no worse off than we are now - facing a situation where the government will have to step up and recapitalize the banks, the auto industry, the insurance industry, the health care industry etc. anyway. Why not at least give our corporate leaders a chance to see if what they do best can get us out of this mess - lying, distortion, manipulation, denial, self delusion - it all worked before - I say go back to the proven ways. There is every reason to believe that the economic cycle will turn and the very needed rising tide will do its thing... Repeal the Mark To Market rules now! (and then a few years from now when we can afford it - lets get real).

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