Tuesday, September 16, 2008

Fasten Your Seat Belts.....

Joseph Schumpeter is turning in his grave as we speak.

Who's he?

Joe is the guy who coined the term ‘creative destruction’ in the 1940’s to describe the impact of entrepreneurial innovation in a capitalist economy. He'd be amazed at how creative we have become.  We have devised plenty of new ways to destroy our economy---and ourselves.  The way I see it, smart men and women invested too much intellectual capital in the creation of off balance sheet financial derivatives at the root of the current crisis, instead of channeling those smarts and energies into the creation of new ventures, new products, new jobs, and long term competitive advantage for our workers and our country.  A necessary function in a complex financial system, I suppose, but don’t you think we could use less of those capabilities right now? 

Simple explanations of how we got into this mess just won’t do, so I’m trying to resist the temptation to file this issue under Greed, Republican F-ups, Regulatory Collapse, Capitalist Excess, etc. etc.  So, how and why could this have happened?

One of the fundamental tenets of financial accounting is the idea of valuing assets at the ‘lower of cost or market’.  So, for example, if Mrs. Jones ended last winter with a half-full 500 gallon tank of home heating oil because of a milder than expected winter, and she wants to top it off this month for the winter season ahead, how much will that full tank of home heating oil be worth?  Well, last fall, she paid $2.75 a gallon, and the bill from her local distributor for this month is $4.30 a gallon.  So, from a cost valuation standpoint, looks like the average cost per gallon in the tank is about $3.52.  If Mrs. Jones wanted to use the value of the oil in her tank as an asset to collateralize, say, a loan for repainting her house, the value of the oil would be easy to figure out---$3.52 x 500 = about $1750. 

Are we done?  No.  If Mrs. J later decides to go south for the winter and doesn’t need much oil for the season ahead, she might try to sell most of the oil in that tank.  How much do you think she could get for those 500 gallons today?  Well, after the cost of pumping it out and transporting it elsewhere, that price is probably going to be pretty close to the $4.30 market price.  So, valuation of the oil on the basis of market is $4.30 x 500 = $2150.

If Mrs. J follows the ‘mark to market’ valuation principle, she has an asset worth more than the average price of what she paid.  But financial reporting standards don’t allow that, at least for public companies.

The sub-prime mortgage crisis is an example of the exact opposite scenario, in which the underlying asset values---home prices—now have market values much less than the cost at which these mortgages were acquired, packaged, and resold to other financial institutions.  Of course, here the complexity of the calculations is enormous, but the principle is the same.  The big difference from valuing a tank of oil is that valuing a mortgage asset depends on variables like the cost of money, the time frame over which the debt obligation is incurred, and—most importantly—the risk that the buyer will default, along with a vast number of other quantifiable risk factors.  (I know I know, this is going on way too long, but bear with me….).

The sub-prime lending scheme caused a unique financial reporting challenge for companies, so someone figured out a way to package these mortgages and distribute the financial risks by using financial instruments that were not required to be reported on balance sheets and therefore hidden from investors and regulators.  All perfectly legal, as far as I know, and it worked beautifully as long as the assets—the homes—continued to increase in value every year.  Plus, these practices had a medium term positive economic impact, because lenders could afford to pump more money into home lending and expand home ownership among a whole segment of the population that had never been able to afford it. 

This all came tumbling down when borrowers began to default on loans that they could not afford (often because of very marginal if not fraudulent loan disclosure practices).   The asset values began to plummet---so much so that the financial legerdemain necessary to deal with this problem began to affect publicly reported assets and liabilities---and the jig was up.

End of Part 1, to be continued....

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