The GAAP between politics and economics

Congress has thrown everything it can at the financial crisis, and has left appropriate concerns -- whether moral hazard, corruption, subsidies, or upholding contract law -- to the side. This may well be a sensible approach: with workers out of work and the financial system collapsing, Congress and the Administration had to step in to prevent a potentially devastating negative cycle. But one must question a break for the financial system that occurs by deliberately obscuring the truth, which is exactly what Congress's call to suspend mark-to-market accounting did.

Mark-to-market, the process of valuing assets at the price of the last sale in the marketplace, has been a staple of accounting for financial assets under Generally Accepted Accounting Principles (GAAP). Congress, in arguing the practice should be suspended, is agreeing with financial firms that claim mark-to-market is creating the appearance that banks are losing money on assets when in fact the assets continue to perform as expected. This is particularly troublesome for banks that have to maintain capital buffers above expected losses -- the marks cause bank capital to fall, eliminating buffers and requiring banks to raise new capital. The financial industry, and their lobbyists to Congress, want to eliminate the need for new capital by failing to mark assets to the appropriate value.

This point of view makes sense from a regulatory capital perspective. If banks are holding these assets to maturity (as opposed to trying to sell them now), the assets make continue to perform and make required payments, posing no capital adequacy issues. However, mark-to-market accounting is not simply used for regulatory purposes; it is also used by investors. For this purpose, mark-to-market makes infinitely more sense. Instead of buying assets from a bank, an investor could buy those assets in the marketplace at the current lower price. If instead they buy a bank with the same assets, one would reason that the assets should be thought of at the current market price. Pundits cite this logic when arguing against suspending mark-to-market.

This creates a gap (sorry!) between GAAP accounting for investors and regulatory accounting. Congress is attempting to provide regulatory relief to the firms, but is inadvertently (or perhaps deliberately) making it difficult for investors to assess the value of financial institutions. Furthermore, and even more troubling, the alternative to mark-to-market is to leave valuation to the discretion of bank management. From this, troubles abound -- leaving accounting to judgment is inviting abuse. A little short on profit this quarter? Presto chang-o! Remark some assets! About to have regulatory problems because your bank issued bad loans? Zam! Not any more, we just changed our "judgment" on the value of some assets... and so on.

Alas, the banks won the issue, and Congress threatened the accounting industry (specifically, the Financial Accounting Standards Board, FASB) with legislation to change GAAP. Congress has done this before, on stock options expensing, with high-tech firms arguing it would spell the end of Silicon Valley. Last we checked, the Valley is doing fine, even now that they have to tell the truth about their financial condition -- and FASB told Congress tough luck and implemented options-expensing. Perhaps FASB sensed more was at stake here, but this blog thinks they would have been better off to dare Congress to intervene in independently set accounting standards.

Oh the places you'll go!

The details of the 2010 budget have been handed over to Congress, and they are indeed mindboggling. Over ten years, the federal government will spend $42 trillion dollars. It will take in $35 trillion in taxes, leaving a $7 trillion deficit. Individual income tax receipts will nearly double, as will corporate tax receits and social security outlays.Medicare and Medicaid will more than double, as will net interest payments on the national debt.

This is...a forecast, of course. If our last presidency was any guide, forecasts aren't exactly FASB compliant.

A look at forecasted outlays vs. actual:

Forecasted receits vs. actual:

A combined picture:

And the resulting deficit:

With these table stakes, let's just hope that past events aren't indicative of future performance, otherwise our credit rating will be on the fast-track to subprime.

Finance's shrinking piece of the pie

This year just keeps getting worse for the financial industry. As if the crash and the TARP fiasco weren’t enough to dent their public image, Congress and the Obama administration have maintained a constant barrage of criticism. Earlier this week, the President excoriated hedge funds for holding out during bailout negotiations, stating:

I don't stand with them. I stand with Chrysler's employees and their families and communities. I stand with Chrysler's management, its dealers and its suppliers. I stand with the millions of Americans who own and want to buy Chrysler cars. I don't stand with those who held out when everybody else is making sacrifices.

While it remains to be seen if the courts will uphold the government’s prepackaged bankruptcy, the public damage to the industry has been done. In a far ranging interview with the New York Times Magazine, President Obama made it clear that he expects the financial industry to shrink in the near term, either as a result of natural economic rebalancing or due to specific government actions:

What I think will change, what I think was an aberration, was a situation where corporate profits in the financial sector were such a heavy part of our overall profitability over the last decade. That I think will change. And so part of that has to do with the effects of regulation that will inhibit some of the massive leveraging and the massive risk-taking that had become so common… Wall Street will remain a big, important part of our economy, just as it was in the ’70s and the ’80s. It just won’t be half of our economy.

Whatever one believes the relative merits (or inequities) of the financial sector to be, Wall Street represents nowhere near half the economy. Clearly the president was speaking figuratively, but his comments highlight a misperception that many people have in the country- that going into the crash the financial sector was the biggest part of our economy, and that it was too large by orders of magnitude. In reality, the financial sector has never been a majority or even a plurality of the U.S. economy, nor has it been all that overpaid. According to Thomas Philippon, a professor at NYU Stern and a leading researcher on this subject, the financial sector as a percentage of GDP grew from 2.5% in 1947 to roughly 8% in 2008. During that time period, the percentage of wages capture by the financial sector was consistently higher than its contribution to GDP, but rarely strayed by more than a percentage point.

By contrast, during that same time period, the government’s share of the government has risen from 20% to nearly 35%, representing a smaller relative increase, but a nominal increase that is twice the size of the entire finance sector.

So why did the financial sector grow so much, and what is the "optimal" size? Philippon presents an intriguing argument for the rapid post-war growth of the financial services industry. According to his research, the growth was fueled by an increase in the corporate finance sector, which was responding to increased demand for financial intermediation services. This increased demand for intermediation services stemmed from a shift in the types of investment opportunities available to investors- namely, away from large firms and towards smaller, riskier firms. According to Philippon:

After the War, large established firms with high cash flows appear to have the best investment projects. As a result, the demand for financial intermediation is small. Starting in the 1970s, investment opportunities shift away from large profitable firms towards young firms with low current cash flows, and the demand for intermediation increases. These predictions of the model are consistent with the historical evidence on General Purpose Technologies, the role of Electrification in the 1920s and Information Technology starting in the 1970s

His research provides some compelling evidence of this trend. Since WWII, the percentage of financial services provided to corporations with low cash flows (read: higher risk) has grown dramatically. These services are necessarily more complex, requiring more intermediation (read more fees) thus fueling the rise in the financial services industry.

Philipon’s equilibrium model suggests that the finance industry will need to shed roughly 700,000 jobs to bring it back into equilibrium. Concordantly, the degree of intermediation and complexity will decrease, and investment opportunities in larger, higher cash flow firms will be relatively more attractive.

Food, Feed, & Fuel - the Biofuel Battle

The battle over renewable energy rages own, California recently adopted new fuel standards which could pose a serious threat to Midwestern corn farmers. It was projected that ethanol would eventually account for a third of US corn production. California has typically been a leader in automobile emission standards and the recent announcement could be the first domino to fall in a nationwide alternative fuel debate. On May 1, in an email to the DTN Ethanol Center, the US Environmental Protection Agency (EPA) stated that the EPA was considering revisions to the renewable fuel standards.

The University of Nebraska recently revised their report, Indirect Land Use Emissions in the Life Cycle of Biofuels; the report attempts quantify the opportunity cost of land, such as rain forests being converted to farmland for the production. The report highlights the competitive forces in biofuel markets. Corn has three main usages, food, feed, and fuel; as corn shifted from the first two alternative to the later, corn prices rose. Increased demand for corn led to the conversion of grasslands and forests to farmland. This conversion depletes the carbon offset opportunities.

This land conversion was previously not considering in assessing the most efficient and environmentally friendly fuel sources. The California Air Resource Board (CARB) used the Global Trade Analysis Program (GTAP) from Purdue University to evaluate various fuel options. The analysis assigned traditional gasoline a "life cycle intensity" value of 96 grams of CO2 per megajule. Prior to the life cycle analysis, corn-based ethanol was assigned a value of 69; however, the recent studies have assigned a value of 30 to the land use of corn. The new life cycle intensity of 99 has effectively eliminated corn as a viable alternative fuel in California and delivered a hard blow to corn farmers and ethanol producers.

On either side of the aisle, the role of the government is to provide public goods and correct market failures. Air quality is a public good that often suffers from the tragedy of the commons and thus requires government action to correct failures. The classic economic theory points to sheep grazing in England. Shepherds that utilized the land for grazing lacked incentive to prudently use the land, the would be over used, depleting the land. A regulatory body is required to manage the land and restrict the number of sheep grazing. Legendary links courses in Scotland are the greatest positive externality to arise from grazing lands. Deep burns and bunkers sheltered the sheep from the salty sea breeze.

Unfortunately, government action can create new distortions and market inefficiencies. Minnesota has recently opened the ethanol subsidy for debate, the state of Minnesota has awarded $314 million in subsidies since the program started. The subsidies were designed to incent building and production of ethanol in belief that as production came on line, the scale would enable plants to produce ethanol at efficient prices. In retrospect, state and national subsidies likely created overbuilding in the industry. Additionally, supply distorting practices by the OPEC countries artificially inflated oil prices, further incenting inefficient building of production capacity. The result has been financial difficulties for US ethanol producers, notably VeraSun with its October Chapter 11 Bankruptcy filing.

In the current scenario, the US Government originally picked, likely as a result of heavy lobbying, corn ethanol as the preferred alternative automobile fuel. Another example of the government picking winners; with another change of the rule in the middle of the game, now ethanol is the loser. An alternative route would be to tax fossil fuels, artificially raising the price of traditional options and leveling the playing field for new sources. The market would be free to choose petroleum, corn ethanol, sugarcane ethanol, or biodiesel. Similarly, the Government could provide an 'award' for developing new technologies, similar to the battery proposal.

Generally, the Government plays a vital role in correcting market failures, but should focus on not creating new inefficiencies. The environment is a public good that is easily exploited beyond an individual's allotment. Government action is required to correct this particular inefficiency, but has done so incorrectly in the past. New solutions are required that create prudent investment and usage of fuels. Energy independence is not easily achieved. However, when push comes to shove and oil, gas, and coal are no longer available, the market it innovate and solve the problems, with or without Government assistance.

Car Creditors Cry Foul

Two of the US top automakers will soon be controlled by their retirees and the Government. Today, Chrysler announced it would file for Chapter 11 bankruptcy. The current plan results in the UAW owning 55%, the US Government owning 8%, and the Canadian Government owning 2%; additionally, Fiat would initially own 20%. Under the current proposal, the UAW and the US Government would own 89% of General Motors. In both cases, the bondholders are crying foul. The secured lenders would like to preserve the integrity of the US capital markets. The table below breaks down the proposals:

Source: Barron's

In General Motors case, the bondholders are looking for a greater equity stake given there secured position. The bondholders’ counterproposal calls for a division of equity in accordance to claims against GM; the bondholders would receive 58%, VEBA (UAW health-care obligation entity) receive 41%, and current equity holders would retain 1%. The Government’s $20 billion loan would remain just that, a loan.

Likewise, a group of investment firms were blamed for the Chrysler bankruptcy. Obama stated,

“While many stakeholders made sacrifices and worked constructively, I have to tell you, some did not,” Obama said. “In particular, a group of investment firms and hedge funds decided to hold out for the prospect of an unjustified tax payer-funded bailout.

Where as, the group of 20 hedge funds said they were ‘systematically precluded’ from negotiating with the Government and Chrysler. The hedge funds’ disapproval of the bankruptcy is warranted; Obama felt a group of creditors owning 70% of the debt were cooperating. This group of creditors, Goldman Sachs, JPMorgan, Morgan Stanley, and Citigroup are fresh of long meetings with Congress trying to save their good names. Those entities have received billions in TARP funds and in Citi’s case the US Government is a significant shareholder. Huge conflicts of interest exist with the 'banks.'

In both the GM and Chrysler case, the bondholders’ proposals appear to have fallen on deaf ears. The bondholders have been accused of speculating, but many of these individuals and entities make a living, albeit a good one, restructuring firms. Some of these firms need only a new balance sheet, while others require a significant shift in strategy – the automakers fall in the later. Neither party and neither administration is innocent; the US Government Officials appear to make a living changing the rules in the middle the game, not balancing budgets, and monetizing the debt.

Changing the rules continues to put pressure on the stagnant credit markets. The regulatory risk premium on loans makes it difficult for lenders to put money to work. Credit investing is based heavily on legal documents and understanding the course of action when a debtor breaks a covenant or defaults on their obligation. The most successful creditors have extensive experience negotiating with the debtors for creative structures to allow the companies to continue to operate (hopefully profitably) and continue to service the outstanding or restructured debt. Lenders are perhaps fearful that all new and existing credit agreements can be amended or simply place in the vertical file by the current administration.

Obama’s claim that hedge fund holders are holding out for a bail out may indeed by the case. With the exception of Lehman Brothers, the Government has shown a strong appetite for throwing money at all ‘systemic’ institutions; most of which were financial institutions. The probability of future Government aid was probable, but the restrictive nature is far from preferable. These speculating investment firms likely felt the implicit Government backstop place nothing more than a floor on their investment. A value creating restructuring would provide a far greater return on investment than additional Government equity or loans.

Furthermore, the investment firms often do create value for multiple stakeholders. GM bondholders claim their proposal would save US taxpayers $10 billion; the new structure would enable GM to service the Government debt, ultimately resulting in the return of principle and interest. A prudent restructuring of both Chrysler and GM can at least return a few flagship brands to the world of mediocrity.

The Obama administration is preaching fuel efficiency, the probably should be preaching sales. People are buying Japanese and German automobiles because of style, performance, and reliability. The Government cannot design automobiles, manage a diversified investment institution, or price debt securities. The faithful public servants need to stick to public policy. America’s meteoric rise to the World economic superpower was a rocky road for the first 160 years. After the Great Depression, America was surprisingly stable; short sighted policies today run the risk of stifle the growth and innovation of the next 160 years.

Dollar, Dollar Burning Bright

The most adverse effect of expansionary US fiscal (see Stimulus Bill) and expansionary US monetary policies (see Federal Reserve balance sheet) in an economy with stable demand conditions is inflation. Simply put, more currency exists in circulation for the same basket of goods. In countries with similar patterns of inflation, one would expect nominal exchange rates to remain constant. If the US had higher inflationary expectations than the Euro zone, one would expect the US Dollar to fall in value against the Euro.

One of the most interesting outcomes of today's crisis is actually that the Dollar has risen against the Euro. Since the summer of 2008, the US Dollar has appreciated by 20%. This seems completely contradictory in the face of lower real interest rates in the US than in the Euro zone. Fortunately for US consumers, this "flight to quality" in the world currency market means that they can continue to run a trade deficit (import oil and Chinese manufactured goods) in the face of a domestic economic policy that would have sank any other country's currency.

This is the pattern of facts at the heart of China's current consternation. The Chinese central bank is the largest foreign holder of dollar denominated assets which they have built up over the years by reinvesting their trade surpluses in order to keep a fixed exchange rate. Any inflation in the Dollar will pose a risk to all of the financial assets held by the central bank, but any decrease in the real Yuan-Dollar exchange rate would sink China's export led economy. Hence in the current equilibrium, the Chinese central bank finds itself in the odd position of having to increase its own Dollar reserves in order to maintain the fixed exchange rate, despite the fact that these assets are losing value as they are being accumulated. China's proposal has the effect of creating a new standard for international reserves, which are the "special drawing rights" as set up by the IMF. The SDR was originally designed to replace gold in international transactions and consists of a basket of currencies. The Dollar only comprises 44% of this basket; the Euro, GBP, and Yen make up the remainder. It is the hope of the head of China's central bank that this will allow countries to maintain reserve currencies in such a way that will not make their financial systems as tied to the US. For China, the additional benefit is to offload much of its dollar reserves without accidentally triggering a devaluation.

China has come to realize that the US consumer-led world economy is unsustainable. The American government and American consumers have been allowed to increase their liabilities in an effort to maintain a standard of living not supported by real income growth. Interestingly, it is possible that the world returns to the status quo after this current recession has abated. Developing countries can subsidize the United States' domestic inflation as it slowly winds it way out a debt problem. The US once again becomes solvent and serves as the consumption center for China who has now dodged an unemployment problem. However, their reserves would then be worthless. What China really wants is to somehow maintain low levels of unemployment and decrease its dependence on the US economy, all while unwinding $2 trillion in reserve dollar assets.

Where does the future of the Dollar lie? It serves as the reserve currency for most of the developing and the undeveloped world. The US is also the world's largest economy and actor in international trade and thus its currency serves as the medium exchange for transactions in the financial and real sectors. Most of all, the power of the US Dollar lies in the faith of governments and private individulas around the world that it will hold its value because the US economy will always be stronger than those around it. True decoupling does not yet exist, and as the current crisis is proving, most other places are in worse shape than the US. If China does walk the tightrope, the US Dollar could start to lose its place of importance in international finance. When that happens, it will be harder for the US to borrow in its own currency, and all of us will have to accept a lower standard of living as a result.