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.