Stepping in the Same Pile

Close your eyes and guess which era I am referencing. If you guess correctly, you receive a lifetime supply of backslaps.

Interest rates are low as a result of easy monetary policy. Banks are free to operate with impunity, booking loans without regard for losses. Accounting rules are compliant, allowing balance sheets to be painted with the hand of an artist, not the rigors of an actuary. The stock markets soar.

Which era am I writing of? If you guessed 2005-2006, you were wrong. The era is now, and like it or not, I am fearful that we are stepping into the same pile of you-know-what that got us into this mess.

Yesterday’s repeal of mark-to-market accounting should go down as one of the darkest days of Corporate America. Accounting, above all else, is intended to be an absolute reflection of the state of a company’s finances. You know the expression “numbers don’t lie.” Well, they can and will now. Fair-value accounting is like gain-on-sale, only for investors. Consider this element of the guidelines approved yesterday:

Affirm that the objective of fair value when the market for an asset is not active is the price that would be received to sell the asset in an orderly transaction (that is, not a forced liquidation or distressed sale) between market participants at the measurement date under current market conditions (that is, in the inactive market).

Besides the fact that it is mumbo-jumbo, what the Financial Accounting Standards Board is saying is that the full value of an asset does not have to remain on a balance sheet when a market doesn’t want an asset – because the asset is presently worth little or nothing. In this case, accountants can go ahead and say the asset is worth whatever they think is “fair.” That’s great. I agree that the disclosures FASB included are good, but FVA and the splitting of losses between credit losses and non-credit losses is only going to cause disinformation, if not misinformation.

The fear I feel lumped in my throat is not just because of the Michelangelo treatment FASB gave its accounting rules, but because so much of what was wrong about our economy in the mid-2000s is being reintroduced to our economy in 2009 under the banner of saving the economy.

The loan-modification data put out today by the OCC and OTS is a perfect example. The government is spending $75 billion(!) to subsidize loan modifications. And what is the result? Not much.

Nine months after modification, about 26 percent of loans in which payments had dropped by 10 percent or more had fallen back into default. That compares with about half of loans in which the payment was unchanged or increased.

“This new data shows that, in the current stressful environment, modification strategies that result in unchanged or increased mortgage payments run the risk of unacceptably high re-default rates,” Comptroller of the Currency John Dugan said in a statement.

I don’t see it that way, Mr. Comptroller. You’re cutting “10 percent or more” from someone’s mortgage and you are cutting the re-default rate to 26 percent from 50 percent? Why is that good? Why is it good to artificially keep housing prices up when, over the long term, these subsidies will expire and the homeowners in them will eventually lose money upon sale? For what? For this? …

Among the loans surveyed in the report, just over 10 percent were delinquent or in foreclosure, compared with 7 percent at the end of September, the report said. Delinquencies are increasing the most among prime loans made to borrowers with strong credit, it said.

What is most upsetting about FVA is that it perpetuates a major problem in our financial system, and that is the risk of disorderly liquidation. Any investor can run up a stake in a particular asset class without fear that a drop in value will yield a drop in asset values on the investor’s balance sheet. Rather than discourage systemic risk, this facilitates it. I want to say that again, the demise of mark-to-market accounting will facilitate concentrations of systemic risk. If a market is illiquid, it is illiquid for a reason. Investors don’t need any encouragement to amplify that reason by amassing more of those assets – but that is exactly what FASB is doing. Congratulations. Someone head over to Norwalk, Conn., and buy Robert H. Herz a cigar.

I watch Timothy Geithner getting interviewed by Katie Couric (who is so clueless it is remarkable), and I start to realize, the guy is full of it. He is certainly no dummy, so he knows what has to be done – break up the banks, really eliminate systemic risk by amending the Sherman Anti-Trust Act to include such concentrations – but he doesn’t. He blinds the American public with a blizzard of acronyms and coolly doles out capital as if it were hors d’oeuvre. And, by extension, so much for a president who will change things.

Moral hazard is not some quaint idea, some philosophical theory gathering dust in a college library. It is a required bedrock of capitalism. I remember when I was a kid how many parents would snicker when they spoke of the bribery and cronyism in the Soviet Union in the 1980s. What about our bribery and cronyism? Should we just excuse it because the Dow is rallying again? Close your eyes and hope that is not the case.