“The financial services sector has enjoyed a fine summer rally, but I just can’t get too excited about a bunch of financial stocks leading the market higher.

I mean, we are talking about banks, for heaven’s sake. These are the same charlatans and ne’er-do-wells who got us into this mess in the first place.” (Emphasis added)

Where to start?

First, let me simply say that, in my 36-year career with the Fed, I met many, many bankers. I don’t recall any that would fall into the category of charlatans and ne’er-do-wells. Not any.

What about “who got us into this mess in the first place”?  Most of the subprime loans were made by nonbank and unregulated mortgage brokers who sold them to major New York investment banks for securitization and resale as mortgage-backed securities. The commercial banks implicated in that process were mainly those who had previously merged with investment banks or mortgage companies. Citi and Chase come to mind. You can probably count them on the fingers of one hand.

Virtually all of the 8,500 or so banks in the country were victims of the “mess” rather than the cause of it. Many had purchased MBSs as liquid, conservative investments that yielded a bit more than Treasury securities. By the way, they were rated AAA, and the bank supervisors approved. As trading in MBSs froze because of the toxic mortgages in the underlying mortgage pools, too-strict application of mark to market accounting rules forced drastic write-downs that destroyed billions of dollars of regulatory capital. Many failed unnecessarily. And, since FASB didn’t make its modifications of mark to market rules retroactive, many more may fail because of that. Bankers were the victims of the mess, not the villains.

To call these pillars of communities all over the country charlatans and ne’er-do-wells adds insult to injury.

 "It's fascinating that the not-so-tiny matter of a
$30 billion loss comes down to accounting arcana,
but it does."

I copied that quote down last night when half asleep and this morning I can't recall where I got it. Now I can't find it. My best guess is the WSJ.com. My apologies to the author.

The article was about the unfortunate suicide of a Freddie Mac official, despite the fact that he had recently won a ruling from the SEC worth $30 billion. In my previous post, "Stressing Over Bank Stress Tests," I had tried to make a similar point: How accounting rules, which often seem arbitrary and not well suited to the situation at hand can make a huge difference and how bankers' challenging the results of the recent stress tests have about as good a chance of being "correct" as do the bank supervisors. I didn't feel like I had made my argument clear enough; so, last night I realized that what was missing was the term "accounting arcana."

Accounting arcana can make a huge difference. In my example, I cite reports that The Fed thought Bank of America might need $10 billion more capital while Bank of America thought it might have half a billion more than necessary. In that example, accounting arcane had $10.5 billion on the line. This morning papers indicate that the perceived capital need may be as much as $35 billion. That's a lot of money riding on "one turn of pitch and toss," otherwise known as a regulatory ruling.

Accounting arcana can cover so many issues that the bank might prevail on most of them but be done in by another one. As I've noted previously, there are many accounting issues related to marking assets to market, when impairment is "other than temporary," whether the impaired asset is in a "hold to maturity" account or an "available for sale" account and whether it's possible to change initial classifications. Then there is the whole issue of how much capital must be set aside in loan loss reserves or in reserves for securities mark-down. That is not as clear cut as it sounds either. When traditional risk weights devised in simpler times are applied to some of today's exotic securities, nonsensical answers sometimes result, such as a downgraded mortgage-back security requiring reserves greater than its total value.

Anyway, I wish I had thought of "accounting arcana" earlier. It helps get to what I meant to say. Whether arcane or not, accounting is becoming as toxic as some of the toxic assets being accounted for.

I just heard, once again, on TV this morning that the first step it solving the banking crisis is just to shut down the insolvent banks.  Okay, but my point is simply that knowing which banks are insolvent is not simple. There are many accounting issues that can tip banks from one side of the insolvency line to the other. And the "correct" answer is not at all obvious.

When a subcommittee of the House Banking Committee held hearings on mark to mark accounting, Congressional intent was very clear.

Either the Financial Accounting Standards Board (FASB) make some common- sense changes or Congress would do it through legislation.

Those hearings were held on Thursday, March, 12.  FASB met the following Monday and proposed a couple of reasonable-sounding modifications and a reasonably- short comment period. Their modifications were inadequate, but they would have been modestly helpful had they not applied only to the future.

Banks have lost billions of dollars of capital unnecessarily and unfairly from accounting rules that never should have applied to commercial banks in the first place. It would have been easy and only fair to allow them to correct the last few quarters. Instead, FASB offers no relief to banks near the brink because of faulty accounting rules.

It makes no sense to me for FASB to "fix" the accounting rules, but limit the fix to future applications only. What can possibly be the argument against correcting the mistakes of the recent past?

If a cure for cancer is discovered, should it apply only to those who get cancer in the future even though the cure is readily available now? If DNA evidence proved the innocence of a wrongly imprisoned inmate, I expect the court would not wait until the "next quarter" to release him. Is the same too much to ask of the high court of accounting?

It's good to be back in Hong Kong, the poster child for free enterprise and a stable currency. My first visit was to speak at a conference on currency boards, at the Hong Kong Baptist University.

How many Baptists do we have in the audience?

Me neither.

I was raised as a Baptist but I soon learned that being Baptist doesn't keep you from sinning; it just keeps you from enjoying it.

Back then, Hong Kong and Argentina were the two largest economies with currency boards-involving a hard peg to the U.S. dollar.

Argentina couldn't hold on as Hong Kong did.

I think the lesson is that fiscal discipline is necessary, as well as monetary discipline.

On my first time in Beijing, in 2003 I think, the dollar and the yuan were declining together.

Depreciation was probably appropriate for the U.S., with its huge current account deficit, but not for China, with its surplus.

I visited the Chinese agency in charge of maintaining the exchange rate, and they asked me to write something in their guest book. I wrote, very diplomatically, I thought, something like,

"Congratulations to China on its rapid growth rate. May our currencies remain strong together."

If only my friend, Tim Geithner, were so diplomatic.

The last time I was in China, in October 2006, I did a lengthy TV interview, in which every other question, it seemed, was whether the newly appointed Fed Chairman, Ben Bernanke, would be able to fill Alan Greenspan's shoes.

I said yes.

I think I was right, even before Greenspan's shoes shrank.

During my first China visit, I was part of a group received by the new Premier, Wen Jiabao.

He went around the room asking his guests for any advice for the new premier. Just before my turn, a distinguished Harvard Professor-as I recall–emphasized how important it was for the young males coming into the cities to work to bring their wives with them. He was concerned about social stability if too many unattached males were wandering around the cities.

My turn came next; so, I told the Premier that I thought the Harvard Professor had watched too many episodes of "Sex in the City."

(I don't think he got it either.)

More recently, my friend the Premier, has become more outspoken. At Davos, he pointed a finger, unnecessarily in my opinion, at the country most responsible for the worldwide financial crisis. Guess who.

And, more recently, he expressed publicly some concern about his country's U.S. investments, primarily in U.S. government securities. He said he was concerned about their safety.

If it's credit risk that concerns him, he should relax. We still have a printing press, and default is unnecessary, as well as tacky. If it's interest-rate risk he's concerned about, how low can rates go? Not much below zero.

They have already benefited from our going to near zero rates on their existing portfolio. New additions to their portfolio may be another matter.

China may diversify out of dollars, but all countries can't. They can only sell them to each other.

As long as the U.S. keeps running a current account deficit, surplus countries collectively will keep accumulating dollars. It's not a question of "will they continue to buy dollar assets?" If they don't accept American goods in payment, they must accept our debt.

It's not a separate question. The balance of payments always balances. The imbalance above the trade/capital line, must have an offsetting imbalance below the line. Our deficit and their surplus are the two sides to the same coin. It's arithmetic.

Turning now to the U.S. economy . . .

Officially, the recession began in January 2008 but if you're comparing its length to some norm, start counting around September, when the recession worsened. That makes it about 6 months old.

Employment declines were fairly mild until September, when they accelerated significantly and the momentum is still strongly downward.

The main dilemma we have is what Keynes called the Paradox of Thrift. Consumption used to be sustained by capital gains, in real estate, and the stock market, but now, both those positives have turned negative. Most U.S. families desperately need to save more, but the reduced consumption necessary to do so will deepen the recession.

We have declining consumption and declining investment. Until recently, a decline in our foreign trade deficit had been positive for GDP growth. But an inexplicable strengthening of the dollar puts that at risk.

My view on a stronger dollar is similar to St Augustine's view on chastity: He said, "Lord, make me chaste, but not just yet."

I say, "Lord, give us a stronger dollar, but not just yet."

In recent months, our exports have declined, reflecting weakness abroad, but our imports have declined more, reflecting weakness at home. The trade deficit has shrunk, but so has total trade. This pattern is true worldwide. No matter their trade balance, most countries are experiencing a decline in both imports and exports.

This hurts trade-dependent countries, like China and Japan, more than countries that are relatively more self sufficient, like the U.S.

Last time I looked we exported 12 percent of GDP and imported 17 percent, with a deficit of 5 percent. It may be down to 4 percent by now.

As world trade declines, the world runs a great risk of renewed protectionism, and nationalism, by Jingo. Traditionally "beggar my neighbor" policies take the form of attempts at currency devaluation, which cancel each other out as they destroy trade. But they can take the form of discriminatory bailouts, as in we'll bail out GM, but not their European affiliates, with Europe considering the same from their side.

The U.S. has been pretty good so far in letting our currency rise as others' fall. But Congress did put a "Buy American" clause in recent legislation. Congress also just formally abrogated a part of NAFTA allowing Mexican trucks to operate inside the U.S. Naturally, Mexico just announced retaliatory tariff increases. We're on a very dangerous slippery slope here.

Turning to Government actions to thaw credit markets and stimulate the economy. You are aware of U.S. Treasury actions through TARP and other programs to unfreeze credit and save the banking system . . . 

and the extraordinary and unconventional efforts of the Federal Reserve,

and the efforts of both to prevent failure of systemically important financial institutions and stimulate the economy.

While they all get lumped together to get a dollar total, let me point out that some of these measures are more important than others,

some are more effective than others, and some are more costly.

The $787 billion stimulus bill reminded me of a hunting experience a few years ago. The stimulus bill is like shooting hogs with a shotgun.

[See blog: Shooting hogs with a shotgun]

Unlike the stimulus bill, which is old-fashioned spending, as in down a rat hole, government support for the banking system involves, not old-fashioned spending, but "investment" in financial assets that may later be sold at a profit, or at a loss far less than the original outlay, whether it be preferred stock in banks,

or, the purchase of their illiquid assets.

I think there's a good chance that the taxpayer

may ultimately earn a profit, not necessarily on every transaction, but at least in the aggregate. 

Not only are these efforts less costly; they are more important. Stabilizing the banking and financial system is a prerequisite for economic recovery.

While I think the Fed has done a good job under terrible circumstances, and the Bush Treasury did a pretty good job, one government agency has been MISSING IN ACTION. That is the SEC (the Securities and Exchange Commission).

In my opinion the SEC should have reinstituted the "uptick rule" in short selling, and enforced vigorously the rule against "naked shorts." By the way, regarding "naked shorts," you do know the difference between "nude" and "naked," don't you? Nude is when you don't have any clothes on, and naked is when you don't have any clothes on and you're up to something.

But, most importantly, the SEC has not leaned on FASB, the Financial Accounting Standards Board, to rescind or modify "Mark-to-Market" Accounting. Franklin Roosevelt got rid of M2M accounting during the Depression-1938, I believe.

When the SEC was contemplating bringing it back in the early 1990s, the head of the Federal Reserve (Alan Greenspan), the head of the FDIC (William Taylor), and the Secretary of the Treasury (Nicholas Brady) all wrote letters arguing that, while M2M might be appropriate for traders, it was not appropriate for banks, whose business model involved holding assets over time, often to maturity. The SEC didn't listen-obviously.

M2M in its current form dates to 2007.

Thousands of banks, thrifts, and other financial institutions, who had nothing to do with making or securitizing subprime loans, invested in them as liquid and safe assets, as evidenced by their AAA rating.

When individual sub-prime mortgages in big mortgage pools began to go bad, the market for mortgage-backed securities dried up.

You might say some of the mortgages were toxic, but the securities are illiquid.

Under mark to market, the whole ball of wax had to be written down when only a few of the underlying mortgages became impaired, if they were in an account indicating they were available for sale.

This was true even if the bank was both willing and able to hold onto the illiquid security until the market recovered, partially recovered, or even to maturity if necessary.

The big problem is that these write-downs, much larger than necessary, destroy regulatory capital dollar for dollar. Potential or hypothetical, losses some time in the future, under mark to market, destroy real capital in the here and now.

I participated in Congressional hearings on this issue last Thursday, which prompted a meeting of FASB yesterday. I understand that

FASB made some modest adjustments to the rules, probably too modest since the stock market didn't react.

I don't have more time here, but my testimony is posted on my blog if you are interested. [McTeer testimony]

Go to http://www.bobmcteer.com/ and click on blog.

The most knowledgeable and credible advocate for M2M reform is former FDIC Chairman, William Isaac. His testimony is the latest posting on my blog. [William Isaac testimony]

Thank you.

Here is a copy of my testimony.

During the hearing, Representative Spencer Bachus, Ranking Member of the parent Committee recommended my blog post, "My Mark-to-Market Nightmare," to the other subcommittee members and later asked that it be entered into the record. Here is a link to "My Nightmare."