Tuesday, March 24, 2009

The Mark To Market Obsession

The current debate about mark to market accounting is really a debate about assessing the ongoing viability of a financial company, especially a bank. Financial institutions and other companies are more than just a portfolio of their assets and liabilities. They are also businesses. Mark to market and historical price valuation of a balance sheet provide little, if any, information about the continued viability of the company's operations. Overly focusing on balance sheet values confusingly compares an institution to a closed end mutual fund.

Truthful income statements that accurately reflect revenues and expenses provide a clearer picture to the world of a company's ability to sell products at a price to cover expenses and provide a return to the owners. Income statements tell us whether a company has a successful business model. Its balance sheet does not. If businesses were only their balance sheets, every company with investors would succeed. Every restaurant would be crowded and profitable.

The long life of many financial assets is often the excuse for mark to market, but it does not change the worth and viability of a bank's ongoing business model. Currently, accounting income statements smoothed the earnings of loans and investments held to maturity. They attempt to match the future income against future losses and expenses. One problem is that an income statement can distort the view of a company's earning power if gains and losses from mark to market are included.

Modified versions of balance sheet mark to market are regulatory tools used to assess regulatory capital levels in investment banks, broker dealers, commercial banks and other financial institutions. The regulators monitor capital. The regulators can require a bank to raise more capital, which decreases the return to the previous investors, but avoids a government takeover and a complete loss to investors.

If the bank has insufficient regulatory capital, the government can close a bank even if the bank's future business model is valid and will be profitable,. The reverse is also true. A bank with a bad business plan can stay open if it has sufficient capital to satisfy the regulators.

A little over a year ago, Bear Stearns ran into funding problems. It posted collateral against its borrowings. As its collateral value diminished, Bear ran out of collateral to allow its debt to roll over. It faced a liquidity crisis. Investment banks mark to market every night. Changing mark to market methodology is not currently an investment banking industry concern and changes would not have solved Bear Stearns' collateral and liquidity problems.

Bank regulatory capital at large institutions pose two threats. Insufficient regulatory capital depresses stock prices because of the very real threat of a government takeover of the bank. It also depresses stock prices because the bank has to raise new capital and diminish the earnings available to the previous capital investors. In the current environment, mark to market has increased these threats to the continuation of the bank and to the previous investors. Naturally, these threats have caused an increase in the banking industry and in investors in the call for a change to mark to market use.

Mark to market debates are red herrings. The real issues are when should the government takeover a large troubled bank? How should the government deal with large troubled banks? Should we force them to raise new capital? Should the government invest in them, nationalize them, close them, merge them, etc? What do the regulators do about systemic risk?

Let us get off the mark to market obsession and deal with the real underlying issues affecting our banking system.

Saturday, March 21, 2009

Was There A Home Price Bubble?

Regions with the greatest price appreciation during the “housing bubble” were the areas with the most home development. If the prices in the housing market were irrational, developers would have tried to make abnormally high profits. In addition, there would have been a rush to sell land to developers and share in some (all) of the abnormal profits.

Material plus labor costs increases would not account for most of the appreciation of new home prices. Substitutes exist for many house components and material suppliers could increase production.

However, land cost increases might have accounted for a large part of the appreciation. Landowners would have shared in the excess profits available to developers by raising the price of future home plots. Additionally, the marginal cost of land increases as development occurs. The land in an area that is the cheapest to build upon is used first. As development continues, the land remaining for development is the more costly, requires greater preparation and has more government regulatory approval uncertainty.

I have nor not seen anything about home builders making abnormal profits for their risks. I have also not seen anything about the developers’ land and plot preparation costs to show that there were abnormal profits to developers.

Unless developers were showing extraordinarily high rates of returns on their investments, I would go with efficient markets as the most likely and not a housing bubble. I would guess that demand for undeveloped land with high marginal development costs and risks was responsible for most of the price appreciation called a housing bubble.

Wednesday, March 18, 2009

New Regulations Really Do Not Fix Problems

It is unclear that new regulations fix a problem. The causative events of the problem often cease to exist before regulations are proposed. Additionally, many problems that require government intervention to protect the public are usually those that receive a lot of public media attention.

The public and the entities modify their behaviors prior to any regulatory effects. For example, peanut butter sales are down due to the recent salmonella problem and the responsible company closed. Peanut butter companies across the US have or are modifying their production processes to prevent a recurrence and parents are choosing other foods for their children.

Undoubtedly, the government will issue new food production regulations and take the undeserved credit for "fixing" the problem. The reality is that regulations are often parallel to the corrective change in behavior, but not the cause.

Since there will be an industry and consumer change in behavior after a negative event prior to regulations, the concern about regulations becomes whether they match (codify) the natural reaction of the public and the industry or whether they distort the natural reaction and cause new problems. In addition, sometimes other industries use similar methods or inputs for different purposes but must modify their behavior and cost structure to comply without any of the benefit.

As for the current financial crisis, the first cause is not yet determined despite the public media and politicians. Most mortgage defaults and foreclosures are limited to a few states, California, Florida, Arizona, and Nevada. Yet house price declines are a national problem even in areas of the US with below historical average defaults and foreclosures, such as the Northeast. Supposedly, we were in a housing bubble, yet the areas of the US with the greatest appreciation were the areas with the greatest increases in the number of new housing stock. Since when does economics allow for price increases when there is an increase in supply and more than enough to meet demand?

Similarly, studies of subprime mortgages (see St. Louis Fed) show that at the end of three years, eighty percent of these instruments cease to exist through refinancing, repayment, etc. Due to their high loan to value ratios, when house prices declined subprime defaults dramatically increased because the homeowner could not refinance the mortgage or repay the mortgage through a sale of the home. In other words, house price declines happened before the defaults happened and were in fact a cause of the increase in subprime defaults.

If defaults did not cause the decline in house prices, what did? What structural changes were occurring in the US economy to make homes worth less across the US and not just in areas of overbuilding and high mortgage defaults?

Bear Stearns went bankrupt about a year ago for liquidity reasons. It was unable to continue to post collateral to fund its revolving debt. The market value of Bear's mortgage collateral declined substantially in value. It no longer had sufficient collateral to continue its operations. The mystery is that on a cash flow basis at that time and currently, the collateral is worth much more than the market price. What other factors besides mortgage defaults and foreclosures depressed and continue to depress the price of mortgage securities?

Until the underlying causes are determined, any regulatory response "fixing" the financial system has an excellent chance of missing the mark and causing significant future structural problems for the US economy.

Sunday, March 15, 2009

Understanding The Different Meanings Of Insolvency

A link to the Bronte Capital Blog on the different and many meanings of bank insolvency. It is an excellent discussion of insolvency. Much of the confusion in the public debate over bank insolvency has to do with the many meanings of the concept.

The following quotation from the Bronte Capital Blog explains the five types of insolvency.

"There are several definitions of solvency here – and it is not clear which definition people are using. Here is a list:

* Definition 1: Regulatory Solvency. Does the bank have adequate capital to meet the solvency tests imposed by regulators?

* Definition 2: Positive net worth under GAAP. Does the bank have positive net worth under GAAP accounting (ie yield to maturity with appropriate provisions when YTM is required or mark to market otherwise)?

* Definition 3: Positive economic value of an operating entity. If the bank is allowed to continue to operate it will be able to pay all its debt and replace its capital?

* Definition 4: Positive liquidation value. If you liquidated it today at current market prices it would have positive value.

* Definition 5: Liquidity. Does the bank have adequate liquidity to operate on a day to day basis?"

Friday, March 13, 2009

Government Regulated Medical Programs Create Social Costs

Both cost effectiveness and comparative effectiveness of medical treatments do not consider the economic social costs imposed on the patient. These studies do not save money. They shift the costs from the medical system to the patient as social costs that have a measurable dollar value. The studies do not include these social costs.

For example, there are often two or more antibiotics to treat an infection. One is usually an older antibiotic that is cheaper and the other is newer and much more expensive. The older antibiotic often will eradicate some, but not all of the possible bacteria. The newer antibiotic will often eradicate a much broader range of bacteria in a shorter course of treatment time.

In a cost or comparative benefit comparison, the recommendation is always to prescribe the older antibiotic first. It is the cheaper. If the first antibiotic is unsuccessful, the uncured patient returns to the doctor after making another appointment. It is at the second appointment that the doctor writes the prescription for the second antibiotic.

The comparative and cost benefit analyses do not include the costs imposed on the patient. In our example, the costs imposed on the patient such as time off from work to go to the second doctor visit are not included. The social costs to the patient of the discomfort and suffering from the uncured ailment are not measured. The increased risks to the patient of having the ailment for a longer time such as having the infection spread, etc. are not included in the costs. The delay and wait time until a curable treatment is implemented is not measured in these studies.

The lack of measuring social costs in any government managed or regulated medical system allows the government to say it is saving money. When the studies include the dollar value of social costs, such as rationing, treatment and diagnosis delays, need for additional treatments and the risk of a worsening medical condition, the benefits of cost and comparative analyses disappears.

Remember, there is no free lunch. The profit motive constantly pushes all companies, even the medical providers, continually to reduce their costs as much as possible to maximize their profits. Part of the costs we pay enable us as patients to have quick access to doctors and quickly effective treatment. To reduce costs in the medical system means that some costs will shift out of the medical system to the consumer as social costs. The costs shifted to us will include rationing, delays, denials, older and cheaper medicines and technologies.

Tuesday, March 10, 2009

Study On Subprime Mortgage Defaults

A very interesting study from the St. Louis Federal Reserve Bank on subprime mortgages from 2001 through 2006. The researchers found that 20, 50 and 80 percent of subprime mortgages are terminated after 1, 2 or 3 years, respectively. There are three ways to end a subprime mortgage; prepayment, refinance, or default.

The researchers found that subprime mortgages are intended to be temporary with 80 percent ended within three years after inception.

The study found that if there was house price appreciation after the mortgage was originated, it was more likely to be refinanced than defaulted. If there was no home price appreciation, then there was an increase in defaults of the subprime mortgages.

Once home prices stopped increasing and actually decreased, the risk of default on subprime mortgages increased, as the actual, recent data has shown

Other factors also contributed to the higher default rates, such as FICO scores and loan to value ratios and are discussed and in the study.

Monday, March 9, 2009

Another Economic Prof For Monetary Expansion Over Stimulus

Tyler Cowen, another economic professor who has studied business cycles, calls for additional monetary expansion. In his blog, Cowen refers to the work of Harold Vatter that showed that the growth in industrial production during the World War II years was due to monetary expansion and not fiscal spending.

Sumner For More Monetary Expansion

Scott Sumner, another great economic expert on the Depression, questions why Obama and his economic team are not doing more with monetary expansion to turn our economy around. It worked great for Roosevelt within the first 100 days of his first term. Read the comment on Sumner's blog. Industrial output rose 57 percent in the first four months of Roosevelt's term.

New Keynesian Multipliers Much Smaller

Greg Mankiw's recent post on New Keynesian multiplier research.

The gist of the research is that Government spending multipliers in an widely-cited new Keynesian model are much smaller than in the old Keynesian models; the estimated stimulus is extremely small with GDP and employment effects only one-sixth as large and with private sector employment impacts likely to be even smaller.

New Keynesian economics takes into account Rational Expectations, i.e., people adjust their behavior based on what they expect to happen in the future. Very similar to Efficient Markets.

Tuesday, March 3, 2009

Where Are The Rational Expectation Economic Theorists In The Public Media?

One does not find Paul Krugman in his NY Times column or other economists with newspaper articles writing about expectation theory, rational expectations, and efficient markets. There is little widespread mention in public media about Lucas, Prescott, and others who have laid the foundation for expectations in economics. Consumer and business expectations are the Achilles heel of Keynesian economics. Expectations were the objection to Keynesian economics even in the 1930s. In addition, Keynes was writing for his own country, England, which was heavily unionized with extremely sticky wages that would not let the labor market clear and increase employment. That is not the current US problem. Wages could not go down and jobs were not created so the only option Keynes thought was to have the government increase its spending to increase total wages and employment. Similar to the problem that Roosevelt created in the 1930s through wage and price controls. However, Keynesian economics did not work in the 1930s.

Government stimulus spending does not change consumer and business behavior and expectations to cause a permanent increase in demand. The government's stimulus spending only increases demand by at most the amount of government spending and its small if any secondary effects. Unless the public modifies its expectations and increases its own demand, the economy will not improve and government spending by itself will not shift consumer demand and cause a permanent increase to turn our economy around.

Government Actions Depressed Toxic Asset Prices

Robert C Merton of Harvard at an October 2008 panel discussion at that university about the financial crisis said that modification to mortgage terms that increased consumer rights, such as giving bankruptcy judges greater power to modify mortgage terms, would increase the consumer's cost of a mortgage through a higher mortgage interest rate. A market's perception that a higher interest rate is required on an existing investment due to an after the fact modification of existing mortgage investment terms that increase the investor's risk of loss or delay of payments would cause existing mortgage securities to trade at a discount.

With Pelosi and Reid representing the two of the four states with the highest US foreclosure rates and with President Obama's populist stance against big business and banks, the markets, which are forward looking, excessively discounted the mortgage securities prices in 2008 in expectation of government interference with existing mortgage security contracts.

Congress, the President and the bank regulators have repeatedly pressured, cajoled, coerced and threatened the banks and investors to delay foreclosures, lower existing interest rates and payments, and decrease outstanding mortgage principal amounts. In addition, efforts are under way to increase a judge's power and discretion to modify the terms of a mortgage, including mortgage principal reduction to aid borrowers. Moreover, the current administration's programs and stance reward defaulting borrowers through lower mortgage payments and increase the likelihood of default to benefit from the program. Additionally, the administration repeatedly states that it expects underwater homeowners to walk away from their mortgage obligations, a fact not supported by studies of other times of underwater mortgages in periods of economic downturns in Boston and in Texas. The President's actions and plans have increased the number of homeowners likely to default on their mortgages beyond that expected by our current economic downturn through economic rewards and tolerance of default.

The decline in the prices of mortgage related securities, the toxic assets, to a significant discount below book value is only partially due to an increase in all homeowner foreclosure rates from about the normal 1 percent rate to an almost 2 percent rate and to the lowering of home prices. Part of the discount is also attributable to the government's tolerance of default and willingness to interfere after the fact in existing mortgage loan terms, which lowers the return to investors and increases their risk of loss and delayed payments. Cashflow projections of the toxic assets show that they have a value higher than their market prices and support the contention that a significant part of the price discount is due to factors other than default rates.

The President, his administration and the Democratic controlled Congress are responsible for part of the discount in prices of the toxic assets. The deep discount is contributing to bank capital insufficiency and insolvency problems and contributed to the collapse of Bear Stearns.

There is nothing stupid about the administration's plan to recognize that market prices of toxic assets are below market prices attributable to economic conditions. The administration wants to compensate the banks for the shortfall caused by government interference in the mortgage markets and subsidize part of the discount below book value through government action to purchase the assets at an above market price.

Monday, March 2, 2009

Reason For Excessive Discounting Of Mortgage Securities

One of the logical reasons for the apparently excessive market price discounting of mortgage securities is the market anticipated the Federal government's intervention into the mortgage contract which diminished the value of the securities. The Federal banking agencies and Congress are forcing the banks to extend mortgage life, decrease the interest rate, decrease monthly payments to a lower percentage of income, and delay foreclosure proceedings. Also, there are strong indications that banks will see the principal amounts of the mortgages lowered, either through bankruptcy judges or voluntarily. All of the above factors and others cause mortgage securities to be worth significantly less than originally anticipated based on default rates and cashflow.

As the data on the current mortgage crisis reveals itself, it is becoming increasing clear that four states were the cause of the current banking problem. California, Nevada, Arizona and Florida account for most of the subprime, no income verification, underwater, defaulting mortgages, and foreclosures. Much of it was caused by the above average and rapid house price appreciation in these states combined with lax state regulation of mortgage bankers and originators within these states.

While in all recessions there are always calls by some of our Congressional representatives to help homeowners in foreclosure, this time around we had the US Senate and the House of Representatives controlled by individuals whose states were at the forefront of the problem. Pelosi is from California and reid is from Nevada. It was also clear during the 2008 presidential campaign that a Democrat was most likely to win the White House due to Bush's and the Republican's very high unfavorably ratings and that the Democratic winner would likely accede to a Democratic Congress on helping mortgage borrowers in trouble.

The depressed market prices for mortgage securities in early 2008, which led to the Bear Stearns collapse, were lower than many anticipated by the then actual and foreseeable cashflows on the mortgage securities. Even today, the payments are better on these mortgage securities than market prices would suggest. The disconnect between expected cashflows and market prices has caused the most problems in motivating banks to take write downs and in attempting to come up with a federal government solution.

If one uses the market prices of the mortgage securities instead of their book value then one would conclude that banks that hold them have assets that are less than liabilities and are insolvent. If one would use likely cashflow projections without government intervention then these banks are solvent.

Insolvency is the trigger for government intervention of the bank. So, the insistence by the banking regulators and the Treasury to use market prices instead of cashflow projection prices has caused the deterioration in banks' equity stock market prices and insolvency. However, Krugman and others should recognize that mortgage securities prices are excessively depressed due to the involvement of the Democratically controlled Congress and White House in coercing banks' to modify mortgage loans.

Did The 2008 Democratic Election Wins Lead To The Current Economic Crisis?

It is not just Obama, but also the combination with Reid and Pelosi. The four states with the highest foreclosure rates, the most underwater mortgages and the most subprime and toxic mortgages are California, Nevada, Arizona and Florida. With Reid from Nevada, Pelosi from California and Arizona a neighbor, it was predictable that, with the Democrats in control, that Congress would do something to help homeowners, mostly flippers and speculators, who overextended themselves. Most of these were the mortgages securitized and held by the investment banks.

The Iowa experimental election markets are more accurate than election polls in predicting US Presidential elections and predicted a Democratic win way before Obama took the lead against McCain in the polls.


The collapse of Bear Stearns, which was the forerunner of the crisis, was due to an inability of the firm to continue to fund itself because its mortgage securities had a sharp and excessive decline in value and were insufficient collateral. The loss in value of these securities was due to a much higher expectation that their actual cashflow would be much less than predicted. The banks that are currently holding these securities are finding that they are paying and not defaulting, which says that these securities should trade at a much higher price than they are. The decline in value and price of these securities, including at the time of Bear Stearns collapse, is due to an expectation that future, as opposed to current, cashflow will be modified and be less than anticipated.

In other words, the market anticipated the mortgage modification programs, bankruptcy cram downs, Democratic moral suasion and incentives to walk away from paying mortgages and the consequential results. This Democratic philosophy and programs led to excessive and unanticipated devaluation of mortgage securities. It also led to the inability of the investment banks and commercial banks to continue to fund themselves and impaired their capital base through write downs of the excessive devaluation of these securities. The impairment of the financial services sector would naturally lead to an increase fear by the consumers of a collapse of the US economy, which would cause consumers to be thrifty, increase savings and decrease consumer demand. As a result, unemployment would increase and further decrease the value of mortgage securities.

Of course, a collapse in the investment banking area, in banking capital and a fear of government intervention in rewriting banking lending contracts after the fact would and did lead to the current worldwide equity markets decline and economic crisis. Especially, since worldwide governments and central banks follow each other's actions.