Tuesday, September 21, 2010

Bank Reform: Simplify

This article is part of a series:
Part  I:  Banking Reform: The Debate is the Message
Part II: Banking Reform: Simplify    You are here.

One argument for banking reform is that the growing complexity of financial instruments and the inherent difficulty of valuation makes it impossible to securely measure capital and therefore bank Balance Sheets.  Therefore we must simplify their mandates.

Two years later, no one seems to know where, exactly, Lehman’s $130 Billion went on its $700B Balance Sheet.  We can not resist the temptation of bringing reader attention to just how large a $700B institution is that is leveraged 30 times based on primarily wholesale (read significant incestuous intertwining) collateral.  That is roughly 13% the size of the American economy.  But let us press on to the point of the article.

A recent and confusing article in Newsweek makes the supporting point that Lehman's was "too opaque to fail-not too big-,  and that
part of that bigger picture were regulatory deficiencies and accounting standards that helped Lehman obscure its true risk exposure and funding shortfalls. 
That is putting it mildly.  It seems Valukas (the bankruptcy examiner) uncovered a gimmick called
"Repo 105," in which loans are moved into off-balance sheet vehicles for a short period of time and booked as sales. The practice is common in the financial services industry." 
And unsurprisingly by now,
"the Repo 105 transactions were not inherently improper and that Lehman vetted those transactions with its outside auditor," said Fuld, adding that the bank had "appropriately accounted for those transactions as required by Generally Accepted Accounting Principles."

Unfortunately for the great unwashed, that is not surprising.  But it is becoming apparent that Lehman was playing funny games at the discount window and with its collateral, some of which was worth nothing.  From Valukas' Lehman report:
By early August 2008, JPMorgan had learned that Lehman had pledged self-priced CDOs as collateral over the course of the summer. By August 9, to meet JPMorgan’s margin requirements, Lehman had pledged $9.7 billion of collateral, $5.8 billion of which were CDOs priced by Lehman, mostly at face value. JPMorgan expressed concern as to the quality of the assets that Lehman had pledged and, consequently, Lehman offered to review its valuations. Although JPMorgan remained concerned that the CDOs were not acceptable collateral, Lehman informed JPMorgan that it had no other collateral to pledge. The fact that Lehman did not have other assets to pledge raised some concerns at JPMorgan about Lehman’s liquidity.
Readers are urged to consider the import of that statement wherein a shortfall of less than 1% of assets would have precluded Lehman from using clearing and settlement services and likely would have required them to pre-fund their trades.  Running an organization larger than most countries so tight would be considered gob-smacking in any other industry.    As Valukas says, "The market impact of either of those outcomes could have been catastrophic for Lehman."  Well, that is putting it mildly.

We urge anyone interested in the Wall Street collapse to read the full article at Zero Hedge (linked above) where they have done yeoman's work summarizing thousands of pages of Valukas' report, including the outright bumbling, bordering on criminality, of the SEC.  Very arguably Geithner would be frog marched off the stage in chains in a rational universe.

The simple fact is that the view that banking institutions are too complex for accurate measurement are building a straw man.  At the least they are defending a position that is ultimately indefensible.  There are any number of ways that the SEC and auditors could very easily determine viability on an ongoing basis.

The fact is that we do know how to measure and monitor these institutions.  We just do not do it.  The bureaucracy and regulation of large institutions has entered into a twilight zone of obfuscation, neglect and byzantine regulation that itself borders on the criminal.

The FASB long ago abrogated its fiduciary duty in protecting the sanctity of Financial Statements.  The SEC could not catch a child in a candy store.  Auditing firms have found a way to avoid the natural and nasty outcome of failed audits, which should have been revised 20 years ago in light of today's technology.  The quality of financial statements and their monitoring should be improving, not digressing.  It has never been easier to produce either.

As argued in this post regarding regulation, most of us live in a world where careers are made and lost based on single breaches of trust, many of them errors in judgment as opposed to intentional malfeasance.  Companies are lost because of simple errors.  The market makes no distinction regarding intent.  Fortunes are lost and must be repaid none the less.

In the world of mega-institutions and the bureaucrats in private and public organizations that monitor them, no such adjustment is exacted.  The bureaucracy and crony capitalists protects their own.  That Lehman's shaky Balance Sheet was not uncovered long before 2007 is a testament to the failed institutions that are charged with monitoring it on behalf of the public trust.

In a sane world protective of free markets, the heads of the FASB, Lehman's auditors, and the SEC would all have resigned in shame or been fired the week after the financial collapse.  Professionals and laymen alike have been calling for deep and structural changes to the operation of these institutions for decades.  If these simple changes can not be made in the face of the largest financial collapse in more than a generation, then when can they be made?

The structural infection of crony capitalism runs very deep.  Our institutions have failed us.  Saying that measuring those institutions is impossible is a cop-out.

They can be measured.  They can be monitored.  It is not happening.

Fixing the issue is very simple.

We do not need more sophisticated regulation by smart experts.  That is what got us into this structural mess.  Nuance and ever larger gray areas, many times argued by overly complex intellectual meandering, are the very tears in society that form the holes through which bureaucracy and externality and persistent failure find a home.  Markets rely on simple, easily understood and stated rules.  Like the writer said, "Sorry for the long letter. I didn't have time to write a shorter one."

Also, we need large institutions and their leaders to pay the price of failing.  For the FASB, that means no more loopholes.  We suspect that will mean simpler rules, not more of them.  This is not a game for lawyers, this is life, where intent can be attributed and often harshly.

For upper management of banks, that means loss of all personal assets when they fail.  It means responsibility for malfeasance, regardless of fore-knowledge.  We suspect everyone would play the game much more conservatively if that were the case, as it is here on Main Street.

It's a tough world out there for most of us.  There is no tenure for mistakes, no laws that can be written to protect against risk.  That is the way it should be.  That is the protection of free markets.  It is time that our large institutions stop protecting their own, and living in the free world the rest of us do.

Let us add more urgency to those who believe this article is 'extremist.'  If the institutions do not clean up this tangled, purposefully byzantine failed warren of of regulation and bureaucracy, the people will.  What do they think the Tea Party is all about?  The specter of the next collapse absent fundamental change should bring more mature focus.  The game has been rigged.  Fix it.  It really is not difficult.

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