Sophisticated Reasoning

I’m trying to get my feeble mind around this – in the current meltdown, one thing was obvious to any who even casually observed: Deregulation was in whole or in large part responsible for the mess. But there existed in ancient Greece and in our country today people who are very good at the art of obfuscation. They were then known as Sophists, and though once admired for their skills, “sophistry” today is not something to admire. In fact, it is the root of the words “sophomoric” and “sophisticated”, the latter not intended as any kind of compliment.

So I happened by Dave Budge’s the other day, expecting the sophists to be hard at work, and came across his most recent entry, How Regulation Is “Killing” Banks. If I may be so bold as to summarize, at the root of our failure to contain the financial meltdown is a law passed in the wake of Enron’s collapse, Sarbanes Oxley. Part of that law requires that public financial institutions use “mark-to-market” accounting for valuation of assets.

Mark-to market has been the Financial Accounting Standards Board (FASB) standard since December of 1991. It’s not new. Sarbanes Oxley did not create it, but simply moved it from Generally Accepted Accounting Principles to public law.

What is Mark-to-market (m2m)? It is simply a requirement that assets be valued at the their fair market value on any given day. If a bank owns a stock that it purchased at $100 a share, and it is only worth $25, it has to value it in its financial disclosures at $25. Similarly, if the stock is worth $150, that is its mark-to-market value. (It should be noted that Enron got in trouble in large part by inflating the value of its off-book partnerships by deliberately setting them up in such a way that they could use m2m to overvalue them.)

Well and good. It runs contrary to the previous standard accounting practice, which conservatively required “lower of cost or market” in asset valuation, never allowing companies to recognize gains until realized. That’s too conservative, probably. The problem with m2m arises, however, when we have a meltdown, a panic, when investors won’t touch supposedly toxic assets, when their immediate value is zero. In that situation, m2m creates a huge vacuum, and entire companies are sucked under. It may well be that their assets will fetch considerably more down the road than now, but m2m won’t allow for future valuations, or even for a discounted present value of future cash flows from those assets. So the requirement that banks use m2m, in effect, killed the banks.

So, sayeth the Budge. Hence, “Regulation is “Killing” Banks.” The problem with this line of reasoning is that it is obfuscatory rather than revealing. It pushes off to the side all of the problems that led us to the crisis we are in, and lays it all on a practice meant to inspire transparency in accounting. M2m is but a small part of the problem – the larger problem was lack of transparency – trillions of dollars in unregulated financial assets that were mostly invisible to people outside the banks. When real estate prices began to collapse, when mortgagors began to default, we began to become aware of the problem of these assets. They were not assets at all. And they were not insured in any meaningful sense. M2m did not cause that – in fact, m2m was a neutral force in the matter, as few knew and even fewer stated openly that the exotic-toxic asset valuations were suspect.

Even so, FASB and the SEC relaxed m2m requirements late last year. It’s no longer an issue.

There’s really very little that can be done in a meltdown but to do what we have done – start bailing. Investors are a panicky lot, but mostly savvy. They were fooled by the banks, but not by m2m. In fact, had we had true m2m, we would have known about the problem long before we did. Investors now are mostly scared by the fact that we seem to be in the midst of a collapse. Me too.

In the comments section of the post, The Budge says

I’m say[ing] that it [Sarbanes Oxley] may have exacerbated the problem taking it from a manageable market event to a $8 trillion dollar bailout.

A practice that came about in 1991 exacerbated a meltdown in 2008? Where was the Budge in 2006 and 2007, when m2m was showing the investing public huge financial gains?

And it was a “Manageable market event”?! I have accused him in the past of generally putting all market failures in the lap of government. In this post, I accused him of putting his eggs in a “non-disproveable hypothesis” in order to obfuscate. Later, he tells me (before a shunning) that

The reason the investment banks became too big to fail was because of the collusion with government…

Got that? I’ll do a sterile translation – the reason we had a meltdown is because the regulators failed to regulate, allowing financial institutions to become too big to fail. The Budge believes in regulation. I can take that to mean nothing else. If the regulators had not colluded with the bankers, there would have been regulation, and perhaps no meltdown.

But let’s not forget, regulation is “killing” the banks, and this was a “manageable market event”, so absence of regulation was really not that important anyway.

The Budge is educated, smart, erudite, seemingly well-reasoned. And a practitioner of the art of sophistry, in my ever-so-humble opinion.