Wednesday, October 01, 2008

The Root of the Problem

I agree that this financial crisis is a problem, but don't have much faith in the wisdom of our leaders to handle it correctly. One example is Congressman Brian Baird from Washington State:

“You’ll be screwed,” Baird said, drawing a nervous laugh from his audience.

Business loans, home loans, car loans — and, of course, college student loans — would dry up immediately, the Vancouver Democrat told students.

“The whole (lending) chain is frozen up” because lax regulation has allowed shady accounting practices that have massively overstated the value of assets now gone bad, Baird said.

Except he has this completely backwards. From a rather good editorial in this morning's Wall Street Journal:

OK, get out your NoDoz and let's wade in. Under current interpretation of accounting rules, banks can be obliged to value loan holdings based on their liquidation or fire-sale value, even if (as now) the fire-sale values are lower than might be suggested by the cash flow and payoff prospects of the underlying assets.

Now recall that accounting is a language of abstraction. In the normal case of a public company, whatever method it uses to value its assets, it merely provides a benchmark for investors to make their own judgments. Nobody takes accounting values as the final word.

Banks, though, are subject to regulatory capital standards and therefore can be rendered insolvent overnight based on an accounting writedown. At the moment, many banks are clinging to "market" values for loans that are higher than probable fire-sale values, and doing so on tenuous grounds. In kibitzing over the Paulson plan, indeed, one knotty question was how Treasury could buy such loans at a price "fair to taxpayers" without propelling the sellers into federal receivership.

Because of all this, the regulatory state finds itself in a somewhat absurd position --
its own rules could render many financial institutions insolvent in a manner inconvenient to the state.