Mortgaging America

June 5, 2008 11:15 AM

America's for sale. Just ask Treasury Secretary Henry Paulson. With the U.S. economy in shambles, Paulson just spent four days touring the Middle East, hat in hand, looking for investors to bail us out. Specifically, on Monday, Paulson met with heads of the Abu Dhabi Investment Authority, the world's largest "sovereign wealth fund" with roughly $875 billion in assets, and encouraged them to buy American businesses. Mortgaging America by Eric J. Weiner (LA Times Op Ed)

What are Sovereign Wealth Funds? According to the article:

"Sovereign wealth funds, or SWFs, basically are mutual funds that invest the excess capital generated by a region or country. The first one was established by Kuwait when it still was a British territory. After World War II, as Kuwait was negotiating independence, its leader, Sheik Abdullah al Salem al Sabah, asked the British to help him create a fund that would invest the nation's oil profits. The Kuwait Investment Board, which eventually became the Kuwait Investment Authority, today has about $250 billion in assets and is one of the largest sovereign wealth funds in the world....

(snip)

In 1990, the funds held just $500 billion in assets combined. Today, that figure is about $3.5 trillion. For comparison purposes, that's more than all of the assets controlled by all of the hedge funds in the world. And by 2012, the figure will be at least $10 trillion, according to estimates by the International Monetary Fund...."

A congressional task force on soverign wealth funds (SWFs) will will speak at a Capitol Hill briefing sponsored by the National Council on U.S.-Arab Relations today, and "one of the goals of the task force is to avoid 'any unforeseen political reactions to their investments.'"

This is critical, because, according to this article, "the Kuwait Investment Authority has said it might raise its stakes in Citigroup and Merrill Lynch, signalling a vote of confidence in US investing. [It may be Lehman Bros. that needs the cash infusion, however.] Kuwait’s statements in London could indicate that Gulf sovereign funds are convinced that protectionist rhetoric in the US won’t jeopardise their investments." [Emphasis added]. The WSJ has quoted Paulson as saying that the U.S. would like to "benefit from sovereign-wealth-fund investments," provided that a set of "credible best practices" is followed by such funds:

"Among some sovereign-wealth-fund managers, our initiative has raised concerns that we are trying to limit the scope of their activities or release privileged information," Mr. Paulson said. "In fact, our purpose is just the opposite. We are trying to quell calls for restrictions by urging sovereign-wealth funds to endorse best practices to create a dynamic rise to the top and help allay concerns about opacity and systemic risks," he added.

Meanwhile, Harvard economist and former IMF economist Kenneth Rogoff wonders if it makes sense "for...Paulson to be touring the Middle East supporting the region's hard dollar exchange-rate pegs, while the Bush administration simultaneously blasts Asian countries for not letting their currencies appreciate faster against the dollar?," and suggests "the US should be supporting the International Monetary Fund's behind-the-scenes efforts to promote de-linking of oil currencies and the dollar."

Also meanwhile, "Worries about the health of the U.S. financial system, on the decline since mid-March, have snapped back as investors brace for more big loan losses at Lehman Brothers and other large investment banks..."

Worries about the Credit Default Swap (CDS) Market remain, as well as about record home foreclosure levels.

Banks are very hesitant to loan right now, and "US banks fear accounting changes could impact lending as they force $5 trillion of assets back on to their balance sheets." Some argue that the economic ripple effect from the credit crisis is far from over:

"What began with the repackaging of subprime loans into AAA rated securities is unraveling on Main Street, wreaking havoc with businesses and lives far from New York, as house prices continue to fall and foreclosures rise. That, in turn, means more bad news for banks...."

posted by ornate insect (42 comments total)

"[T]he US should be supporting the International Monetary Fund's behind-the-scenes efforts to promote de-linking of oil currencies and the dollar."

If the United States isn't backed by Petrodollars, what reason do other countries have to keep lending dollars back to the US, when its economy is propped up on unsustainable consumption?
posted by Blazecock Pileon at 11:36 AM on June 5, 2008

Blazecock--I'm just the messenger. Rogoff's argument, and I quote:

Perhaps the Bush administration worries that if oil countries abandoned the dollar standard, today's dollar weakness would turn into a rout. But the US should be far more worried about promoting faster adjustment of its still-gaping trade deficit, which in many ways lies at the root of the recent sub-prime mortgage crisis. The administration's multi-pronged effort to postpone pain to US consumers, including super easy monetary and fiscal policy, only risks a greater crisis in the not-too-distant future. It is not at all hard to imagine the whole strategy boomeranging in early 2009, soon after the next US president takes office.
posted by ornate insect at 11:40 AM on June 5, 2008

They'd better hurry before they're Chinese businesses.
posted by tommasz at 11:42 AM on June 5, 2008

If this works I have a bridge to sell them in Brooklyn too.
posted by skewedoracle at 11:46 AM on June 5, 2008

If this works I have a bridge to sell them in Brooklyn too.

Back when it was the Japanese buying up everything, there was a great SF short story I read in an anthology, about a Japanese billionaire actually buying the Brooklyn Bridge. Here's the google books search result, if it works.
posted by tachikaze at 12:21 PM on June 5, 2008

what reason do other countries have to keep lending dollars back to the US

cough
posted by tachikaze at 12:23 PM on June 5, 2008 [1 favorite has favorites]

Sovereign Wealth Funds buying up US companies is a good thing. The money goes into the pockets of US investors and entrepreneurs who turn around and re-invest it in new companies. It's not a zero sum game - unless you consider SWF money could be going into the pockets of, say, German business owners, instead of Americans.
posted by stbalbach at 12:33 PM on June 5, 2008

"the US should be supporting the International Monetary Fund's behind-the-scenes efforts to promote de-linking of oil currencies and the dollar."

OH NO. OH GOD NO.

I'm not a fan of American Empire or Manifest Destiny, but if there is a single economic reason for the United States to declare war on, oh, just about anybody, it's this. Imagine a world where Middle Eastern Petrostates suddenly decide that they're going to switch to Euros. Imagine a world where the Federal Reserve prints $100 billion worth of shiny T-bills to cover our deficits -- but nobody buys them.

Imagine a world where the free-money-from-Arab-princes spigot is shut off, or even greatly reduced. Imagine what that would be like.

No, we need them to buy our businesses and our debt. Especially our debt. Yes, we're mortgaging our future, but the alternative (no more debt financing for us, being forced to raise taxes to actually pay our bills, putting an end to endless spending), is much, much worse in the eyes of Bernake and others.

We're like a family that owes tens of thousands of dollars in high-interest credit card debt. We make the minimum payment every month, but of course that will never truly pay it off. So instead we refinance our house every year to pay off our creditors, only to run up the bill all over again -- but we're not worried! No sir, there will always be someone out there ready to finance our debt. Yup. Always. Nobody will ever turn us down. Never.
posted by Avenger at 12:34 PM on June 5, 2008

Nobody will ever turn us down. Never.

When other banks say NO, LendingTree says YES! Right???
posted by spicynuts at 12:56 PM on June 5, 2008

We're pwned. When the oil dries up completely and our markets experience the 'big correction' investors will repossess our offspring and ride their sorry broken asses around town. The fat one's'll be eaten for dinner.
posted by valentinepig at 1:00 PM on June 5, 2008

As long as it's not me (or something bizarre like Rev. Moon), I don't care who owns the place where I work. I get the same amount of money either way. I'd like to be in charge, but if it's not me then a German boss or a Venezuelan boss is just as good as an American one.

I benefit by having investments. I don't see how I benefit by swapping owners around of investments that I don't own. It's not like we're talking about resources that are going to be liquidated and removed from the country. The profits from SWFs invested in American businesses are in USD, and that's good for the people who live here, as I understand it.
posted by a robot made out of meat at 1:20 PM on June 5, 2008

stbalbach and a robot made out of meat: I don't necessarily disagree that this may in some ways be a good thing, and I'm not at all reactionary or xenophobic regarding foreign investment, but I'm more interested in the larger question of what it suggests about the tenuous status of our own economic health. There is somewhat of an air of desperation here, reminiscent of the credit bleed that hit the news so forcibly this past March. From the Forbes article in one of my links above:

Rep. Jim Moran, D-Va., along with other members of the task force, will speak at a Capitol Hill briefing sponsored by the National Council on U.S.-Arab Relations. Moran and Rep. Tom Davis, R-Va., visited several Middle Eastern countries last week, including the United Arab Emirates, which hosts the largest sovereign fund.

(snip)

Moran's comments came as reports surfaced Wednesday that investment bank Lehman Brothers Holdings Inc. may seek additional capital from foreign investment funds due to recent losses.

Sovereign funds first leapt onto the international scene late last year, after they invested approximately $40 billion in ailing U.S. and European financial services firms, such as Citigroup Inc., Merrill Lynch & Co. Inc. and UBS.

Also, one wonders what kinds of terms are being offered for these investments? If I were an oil-rich mideast prince, I'm not sure expanding my portfolio to help prop up ailing investment banks on Wall Street would be a sure bet. Wind farms, on the other hand...

And, in a related note: Foreign interest in U.S. Rail Company CSX sparks alarm (echoes here of the NJ Port deal).
posted by ornate insect at 1:37 PM on June 5, 2008

I guess the question is.. what happens when they pull the money out?
posted by dirtynumbangelboy at 1:49 PM on June 5, 2008

...looking for investors to bail us out.
Let's be a bit more accurate...They're looking for investors to bail corporations and banks out. They don't give a fuck about the actual "us".
posted by Thorzdad at 1:56 PM on June 5, 2008 [3 favorites has favorites]

Wow interesting collection of links, thanks.

But America has always been for sale. In fact this isn't really news as last March The Department of Commerce launched their 2008 Invest in America program, of which Paulson's trip no doubt figures large. Attracting investment is one of Commerce's regular activities. Carlos M. Gutierrez (Secretary of Commerce) was banging this same drum last year, but I guess having the backdrop of a market meltdown gets some folks all nervous about agendas and intentions, making this regular activity newsworthy.

Foreign Direct Investment (FDI) in America, regardless of the source of the money is, as others upthread have pointed out, a good thing, for many reasons. We could discuss how trade drives communication, creating and strengthening bonds, lessening the chance of misunderstanding, or comparative advantage, but those are rather abstract concepts for the man in the street who is interested in one thing - his/her own finances.

To that end then. In 2007 FDI into America (to distinguish the investment activity The United States undertakes into other countries) "...created more than 107,000 jobs in the US, representing $46 billion of investment...". And those 107,000 jobs in turn supported other American jobs. And families.

As stbalbach points out, FDI isn't zero sum; in fact the United States is the worlds single largest investor in other countries, with some $249 billion being devoted to FDI in other countries. So some money comes in, some money goes out.

Just to clarify further: FDI is one of those wide ranging terms that aggregates a wide range of investment activities into a country other than one's own: outright acquisitions, mergers, new projects, reinvested earnings (rather than repatriating earnings back to the originating country), and cross border activities such as loans and the movement of capital between subsidiaries. Needless to say, there isn't a single authoritative source of this data, so figures vary. But over the period 1997-2006 the United States attracted some $1.6 trillion of FDI (Wikipedia, citing the CIA Factbook, put in at $1.8 trillion)

Our debt load is only part of the reason for the renewed focus on attracting FDI; with Visa restrictions, the war on terror and other rather unfriendly activities our nation engages in, The United States is attracting less FDI than other countries. Not in absolute terms, but the rate of change, the increase in FDI is slowing due to the attractiveness of some of the BRIC economies.

So Paulson is out there doing what he should be doing - selling America.

"Worries about the health of the U.S. financial system, on the decline since mid-March, have snapped back..."

Ah, but that's the nature of the markets. Advance, decline. More noise in the system. Two factors that must be considered here - the trend line and the horizon.


Curious link to Das' blog re: Credit Derivative Swaps; he's written a few very important texts on Credit Derivatives (I've linked to them off my profile, as I've previously recommended these books to MeFites, and maintain a list of relevant finance books there). He seems to be concerned not so much about the instruments rather their use which has expanded past the original intent. Fair enough, but the cynic in me wonders if he'll write another book now?


"US banks fear accounting changes could impact lending as they force $5 trillion of assets back on to their balance sheets.""

Well, those accounting changes are (AFIAK) still under discussion, no pronouncements have been made by the various accounting boards (yet), so its sorta jumping the gun to post it as a done deal. But it would actually be a good thing, and is just one of the reasons I've been telling folks to stay clear of investing in banks. They are going to be raising capital for quite a while, and there are plenty of other places to invest now without taking on undue risk.

Actually what's gonna blow peoples minds more when the mainstream media finally picks up on it is FASB 159. I've previously mentioned FASB 157, or the accounting standard requiring firms to market to market, not model. FASB 159 allows firms to mark both assets AND LIABILITIES to market. Think about that for a minute.

If a firm has an asset acquired at $100M, and if this asset, once marked to market, is only valued $50M they post a $50M loss. Fair enough.

But FASB 159 cover the other side. If the firm has liabilities of $100M, and mark to market value is now only $50M this is reported as a gain. Yep. And many firms are doing it - Merrill Lynch booked some four billion of revenue this way over the past two / three quarters.

So I can't wait for mainstream media to pick up on this. Funtime.
posted by Mutant at 2:09 PM on June 5, 2008 [2 favorites has favorites]

Sovereign Wealth Funds buying up US companies is a good thing. The money goes into the pockets of US investors and entrepreneurs who turn around and re-invest it in new companies. It's not a zero sum game - unless you consider SWF money could be going into the pockets of, say, German business owners, instead of Americans.

Well actually most of the money gets gobbled up in the overhead costs we call Wall Street. The moneymen didn't get that social security cash Bush promised at the start of his second term, the sub-prime seqeeze is making money tight, and all that insider trading isn't paying the bills so Paulson is pimping for them overseas to see if they can find a bigger sucker than the American public. Fools and their money. He's in the right part of the world to find them.
posted by three blind mice at 2:18 PM on June 5, 2008

3 blind mice : because why? The arabs are rich? They are stupid? Both?
posted by garlic at 3:21 PM on June 5, 2008

We plebes are not supposed to talk about this until after the elections.
So hush up before they stop payment on the economic stimulus checks.
posted by Fupped Duck at 3:22 PM on June 5, 2008

> If this works I have a bridge to sell them in Brooklyn too.

Maybe we can work something out. I have $471,000,000 in confederate money.
posted by jfuller at 3:44 PM on June 5, 2008

Mutant, I understand that marking to market rather than model may cause drastic re-evaluation of the worth of illiquid instruments like CDOs. I don't understand your comment on liabilities being marked to market with ML given as an example and booking these as a gain.
Can you march us simpletons through it?
posted by bystander at 4:18 PM on June 5, 2008

On the bigger issue, I must say it smacks of xenophobia, just like that old footage of some US politician smashing Japanese cars and electronics in the 1980s.
As pointed out, the US has been buying up (directly investing) companies around the world for years, and the same arguments can be leveled at that action. For example, Kraft owns Vegemite, Campbell's Soup owns Arnott's etc. and what protection do Australian worker's have against the decisions or political agendas of the US parent companies?
If the American way is to allow relatively unhindered capitalism, it should accept it as a positive when others want to get in on the act.
Consider also that these investments will be subject to US laws and regulations, which brings transparency to the investment. Which is preferable to having these billions sloshing around in a hedge fund or Russian mafia account.
posted by bystander at 4:31 PM on June 5, 2008

So I can't wait for mainstream media to pick up on this. Funtime.

Too counter-intuitive for the mainstream media. That said, an investment opportunity waiting to happen. How are Merrill short options looking these days? (That's not entirely a rhetorical question, by the way, and if you know of any other such oddities, well, inquiring minds want to know, if only to watch the fun times unrole. )
posted by IndigoJones at 4:32 PM on June 5, 2008

>>If the American way is to allow relatively unhindered capitalism

A great many of us aren't in favor of this. In the minority, but we're here.
posted by SaintCynr at 4:36 PM on June 5, 2008 [1 favorite has favorites]

If the American way is to allow relatively unhindered capitalism

Apparently the American way is for the Fed to bend over backwards to ensure the mostly criminally underregulated investment banking industry is kept afloat through taxpayer money and foreign investment. It may be a good idea to ensure this, but without regulatory constraints that address the core problems of unaccountable speculation that have led us down this road, just shovelling money into Wall Street seems like a stop-gap measure at best. I'm glad Paulson is requesting some oversight into the mideast SWF investments he is eager to secure, but that seems driven more by the politics involved than it does from a genuine desire for more transparency. But maybe I'm too cynical.

Furthermore, I do think there's a difference in just allowing foreign investors to invest in US banks and companies as part of the natural course of things, and openly and aggressively soliciting for said investments on a governmental level. The former is indeed, at least in theory, good old market capitalism, but the latter could be, depending on context, a sign of serious financial distress. Which is the whole point of my post.
posted by ornate insect at 4:55 PM on June 5, 2008

Yeah, about that sovereignty thing...
posted by eratus at 5:21 PM on June 5, 2008

bystander -- "I don't understand your comment on liabilities being marked to market with ML given as an example and booking these as a gain."

Gosh I'm sorry, I was rushed for dinner and my explanation was a little brief. But I do think you're being too hard on yourself - FASB 159 is such a counterintuitive and totally out there idea that it boggles the sane mind. Many of us are still trying to figure out just how this one got passed. It's very strange, to say the least. Actually, I've heard the phrase "silly" uttered by stone cold CFAs and CPAs when talking about FASB 159 ... its a very, very odd accounting standard.

The fundamental idea here is a firms balance sheet consists of two columns, Assets and Liabilities (this is a condensed view).

Accounting rules have us calculate the value of a firm as Assets minus Liabilities. This is good stuff, as most of us do the same calculation when looking at household budgets. In other words, income minus bills equals what's left for us, yes?

So, if the value of assets goes down, not a problem. After all, in the example, $100M reduced to $50M (market to maket, not mark to model) says we've now only got $50M on the Asset side of the balance sheet. Sorta sucks, but its ok.

However on the Liability side, a change of $100M to $50M is -$50M. So the firm's Liabilities have been reduced by $50M, and this change is recorded as a net gain (heh) of $50M. How? Well, we subtract Liabilities, and minus a negative $50M equals plus $50M (disclaimer: this actually slots into what's called "other comprehensive income", but has the same effect on the overall results regardless of what we call it or where it is added up).

Justification: overall Liabilities were reduced by $50M, using the same mark-to-market accounting the Asset side was subjected to, so this adjustment must be fair (so goes the argument that I don't necessarily agree with).

Truth be told, nobody is really sure how this one slipped by; The Fed apparently objected, as did the FDIC as other heavy hitters. There was a letter to the FASB saying that it [FASB 159] would "...have the contrary effect of increasing a bank's net worth at the same time its financial condition is deteriorating.''

In any case, pretty neat math, huh?

I've previously mentioned to folks that profit is just an accounting concept, and has no analog in the real world. FASB 159 (as well as FASB 157 under some circumstances) only reinforce this message.

Yeh, IndigoJones I agree fully this looks like a trading opp, but I haven't looked at Merrill puts myself recently (I'm a cash flow investor and I just like to watch the fun for the most part). However I have heard lots of chatter about money betting on Citi getting whacked hard, maybe as much as 50% off from current prices. Lehman & Merrill don't look much bettter and lots of chatter about them as well.

Of course a deep pocketed SWF could change all that.
posted by Mutant at 5:31 PM on June 5, 2008 [1 favorite has favorites]

So Mutant, they could hypothetically buy their debt back for less than face value (since people are spooked about them and don't want it anymore) and have turned a profit? That's awesome.
posted by a robot made out of meat at 5:41 PM on June 5, 2008

From Mutant's Bloomberg link about FASB 159:

The new math, while legal, defies common sense.

Meet the new math, same as the old math.

This is like Enron-accounting applied to an already shaky market.

More choice quotes:

Merrill, the third-biggest U.S. securities firm, added $4 billion of revenue during the past three quarters as the market value of its debt fell. That was the result of higher yields demanded by investors spooked by the New York-based company's $37 billion of writedowns from assets hurt by the collapse of the subprime mortgage market.

``They can post substantial gains as a result of a decline in their own creditworthiness,'' said James Cataldo, a former director of treasury risk management for the Federal Home Loan Bank of Boston and now an assistant professor of accounting at Suffolk University in Boston. ``It's completely legitimate, but it doesn't make sense by any way we currently have of thinking of net income.''

The paper profits have helped offset more than $160 billion of writedowns taken by U.S. financial-services companies during the past year. Now some investors and analysts say the winnings are illusory and may have to be reversed.

``The piper will have to paid eventually,'' said Robert Willens, a former Lehman Brothers Holdings Inc. accounting analyst who left the New York-based firm earlier this year to become an independent consultant.

(snip)

The rule was enacted after lobbying by New York-based companies, led by Merrill, Morgan Stanley, Goldman Sachs Group Inc. and Citigroup, which wrote letters to FASB arguing that it wasn't fair to make them mark their assets to market value if they couldn't also mark their liabilities.

...(surprise, surprise!)...

That's an unprecedented degree of leeway, said Willens, who is also an adjunct professor at Columbia University in New York.

``It's kind of a dumb rule,'' Willens said. ``In the entire panoply of accounting, this is the most flexible and elective and optional rule that we have.''

(snip)

Here's how it works, according to Richard Bove, an analyst at New York-based Ladenburg Thalmann & Co. A company decides to designate $100 million of its subordinated bonds as subject to mark-to-market accounting. The price of the bonds drops to 80 cents on the dollar from 100 cents. So the firm books $20 million on the ``presumed savings that you have on your liabilities,'' Bove said.

``In the real world you didn't save a dime,'' he said. ``You still owe the $100 million. It's another one of these accounting rules that basically takes you further and further away from reality.''

The Federal Reserve, Federal Deposit Insurance Corp., Office of the Comptroller of the Currency and Office of Thrift Supervision objected to the rule before its passage, saying in a joint 2006 letter to the FASB that it would ``have the contrary effect'' of increasing a bank's net worth at the same time its ``financial condition is deteriorating.''

Split at FASB

The regulators remain so skeptical that they refuse to let banks apply the phantom revenue toward minimum capital requirements, according to reporting rules posted on the Web site of the Federal Financial Institutions Examination Council. Deborah Lagomarsino, a Washington-based spokeswoman for the Federal Reserve, declined to comment.

Not even the FASB was united on the new standard. Two of its seven board members -- Thomas Linsmeier and Donald Young -- voted against it, according to the February 2007 statement. Linsmeier said the rule ``will provide an opportunity for entities to report significantly less earnings volatility than they are exposed to,'' according to the statement.

OK, this is insane. And it just fulfills my worst suspicions about how cooked and crooked Wall Street is. Great article, though. Thanks for the link.

The piper must be paid, indeed.
posted by ornate insect at 5:56 PM on June 5, 2008

So Mutant, they could hypothetically buy their debt back for less than face value (since people are spooked about them and don't want it anymore) and have turned a profit? That's awesome.

Actually any company could always do that, and it happens all the time. That has nothing to do with FASB changing the rules.

I'm not sure why you find it so perverted. You lend me 10 bucks, I buy ten bucks worth of fruit. Something happens and you get nervous about my ability to give you your ten bucks back, and you can't compel me to pay you back on your demand, so you say "Why don't you just pay me back 8?" I sell $8 worth of fruit and give you the money. I got $2 worth of fruit for free.

The FASB rule is - You lend me ten bucks, get nervous I can pay you back, so you tell the world the $10 in assets you had (The loan to me) is really only worth $8. I hear that and tell my friends "sweet, I used to owe that guy $10, but know he says I just owe him $8, so I can tell people I have an extra $2 to spend on whatever" - the problem is you have no intention of asking me to just pay $8, instead you'll hang around until the loan is due and you either get the ten bucks or force me to go bankrupt. So logically I still owe you ten bucks, even if you could only sell my loan for $8 today.

Of course this rule is also an issue for you, as you still think I won't go bankrupt, and you fully expect to get the $10 back, so why should you be forced to pretend its only worth 8?

The problem with these FASB rules is that they are predicated on the hardest form of efficient markets - the market price is always right. Yet experience has shown again and again the market price is often very very wrong.
posted by JPD at 6:08 PM on June 5, 2008

The problem with these FASB rules is that they are predicated on the hardest form of efficient markets

The problem with FASB 159, as I understand it, is it creates yet one more accounting loophole to allow Wall Street to create money out of thin air. I know that some people here think that "profit is just an accounting concept," but to my ears that sounds like saying "gravity is just a physics concept" (or, if you will, like Cheney's infamous, "Reagan proved defecits don't matter.") If 159 was enacted, as the article states, at the behest of the very firms who are already troubled and stand to benefit from it, and yet was resisted even among the FASB, there are a lot of red flags that, as the specialists quoted in the article all argue, this new accounting rule will, in the long-run anyway, make a bad situation already worse.
posted by ornate insect at 6:19 PM on June 5, 2008

erm, an already bad situation worse.
posted by ornate insect at 6:47 PM on June 5, 2008

ornate insect -- "The problem with FASB 159, as I understand it, is it creates yet one more accounting loophole to allow Wall Street to create money out of thin air. "

Well I couldn't agree more. Having worked both on Wall Street in New York and The City in London, I've experienced both regulatory regimes and I do believe the UK system is superior for many reasons (although not without problems of its own).

Ok, I'm by no means someone who should be considered an expert in regulatory umbrellas, I've just worked under them, done Series 7 training in the United States and FSA in the UK, but still this is effectively lay opinion.

The fundamental difference between the two - the UK system is based on principles, while the US is "rules driven". The UK relies far more on self-regulation than the heavy handed American approach (SEC, etc). Self-regulation happens on multiple levels, so effectively you've got everyone watching each other, with the FSA watching everyone else. The system works just fine here (albeit with issues from time to time but no system is perfect).

In the UK regulators enforce the "spirit of the law", while in the US the "letter of the law" is enforced. Its easy to see why you end up with a dense rulebook rife with loopholes as the newly enacted law / regulation didn't cover every possible contingency. Which creates a need for a new law to close the loophole which, all too often, creates a loophole of its own, on and on.

And this isn't restricted solely to Capital Markets regulatory issues either - take a look at the growth of the IRS tax code, for just one example - there are others in The United States. I'm not a lawyer, don't know why this difference exists, suspect its cultural and probably based on the American notion of "fairness".

So the dialog would go something like this. Question in America - "who says this is illegal?. Answer in America - "The rulebook - its right there - look at it. Its THE LAW". Question in the UK - "who says this is illegal?" Answer in the UK - "its just not how we do things ole chap. Those guys over there and me, we don't do things that way so you're not going to do things that way either" (gross simplification, but not far from the mark).

Another major difference worth pointing out between the US and UK - in the UK there are certain financial crimes where the burden of proving innocence falls squarely upon the accused. In other words, you are guilty until you prove your innocence. Clearly that would never be acceptable in the United States, but in the UK boy howdy does one toe that line. 'Cause I personally know people who know people have been accused and ultimately proved their innocence but were bankrupted, lifes destroyed while doing so. No, in the UK the mere appearance of impropriety is to be avoided. In the United States however, folks don't really seem to care - "see you in court" and all that.

Its been a very long time since I've gone through the FSA training (UK regulatory regime) and even longer from the US side; it would be especially interesting if someone with a current US Series 7 could comment.


"I know that some people here think that "profit is just an accounting concept," but to my ears that sounds like saying "gravity is just a physics concept" (or, if you will, like Cheney's infamous, "Reagan proved defecits don't matter. "

I'd have to take responsibility for that statement but it's not jut me thinking this - thats how accounting works. Anyone who has run a business or had significant experience with business knows it's possible for a cash rich enterprise to be run at a loss. Happens all the time.

A personal anecdote: I've had a small business here in London for a couple of years, and we're currently doing well with gross margins a little above 200%. But we're running at a loss as we're actively expanding into other areas and there is some cross entity funding going on (I've got more than one business interest). So, in terms of operating profit (you might have heard this also referred to as EBIDTA) we're fine. But talking about net income? Profit? Nope, my business is running at a loss. Again, not unusual at all.

Conversely its possible for a profitable firm to go under, bankrupted, out of business. For example, a company that has sold and booked revenue shows a profit. But if customers default before actually paying, or an intermediary who collected the money doesn't remit as expected then that profitable company goes out of business. Again, happens all the time. Not all businesses operate in a paypal like "real time" manner. Very common for businesses to sell things and receive payments 30/60/90 days later. Very common for default to impact earnings, to the point of bankruptcy. Happens all the time.

I realise profit is a rather abstract concept and I understand your confusion. When I took my first accounting classes it threw me as well. But profit is not a natural law - its a man made, concept, a useful construct. Nothing more.



"If 159 was enacted, as the article states, at the behest of the very firms who are already troubled and stand to benefit from it, and yet was resisted even among the FASB, there are a lot of red flags that, as the specialists quoted in the article all argue, this new accounting rule will, in the long-run anyway, make a bad situation already worse."

Yeh, FASB looks pretty bad on this one and its strange, as they usual are a bunch of hard asses (that was said with maximum respect in case anyone from The Financial Accounting Standards Board is reading this!).

Well, I wouldn't get too worried about FASB 159 because, unlike gravity, its man made and given all the furor in the industry (and its relative anonymity to date outside of banking circles) I don't think it's gonna be in force that long, at least not in its present form.

FASB 159 was only made effective for fiscal years beginning after November 15th 2007. Its not really a secret what's going on, as if management decides to report via 159 they've got to disclose this in their regulatory filings with the SEC. Folks watching things like this (uhmmm, that would be me again to some extent) notice these things and react accordingly.

But FASB isn't some kind of old boys club; quite the contrary, its an open and public orgaisation. And they do a lot of good work driving GAAP and, in fact, they passed FASB 157 in the first place. Thus kicking off a some part of the current mess.

So they shouldn't be pilloried for FASB 159. The same organisation that passed FASB 159 (The Fair Value Option for Financial Assets and Financial Liabilities) also passed FASB 157 (Fair Value Measurements, I've posted regarding this on Metafilter before and also in this thread ) and FASB 158 (Employers’ Accounting for Defined Benefit Pension and Other Post retirement Benefits, forcing employers to more rigorously account for employee pensions). There probably were other amendments but I tend to only look at things that would materially impact share prices or perhaps markets.

I first saw paper on these amendments Q1 2007. I thought FASB 157 problematic, and FASB 159 - well, strange.

But I do know that FASB is scrambling on 159; the most recent set of meeting minutes that I've got at the moment are dated April 3rd (there have been many since) and out of a four hour discussion some three hours was spent talking about FASB 159 and revenue recognition; I suspect they'll be fixing this very, very quickly.
posted by Mutant at 3:37 AM on June 6, 2008

I wanted to amend somewhat; something happened during preview and some text disappeared. I'll italicize my original comments, and clear text the vanished paragraph.

I first saw paper on these amendments Q1 2007. I thought FASB 157 problematic, and FASB 159 - well, strange. But the way FASB works is they first push these out for review / comments / etc and then, and only then, are they approved. I could see FASB 157 would have some material impact, but I'm a Capital Markets guy and knew from structuring CDOs myself that sometimes model and market drifted - significantly. I wasn't sure how much, nobody really was (or if they did they weren't say as they were trading) and the same goes for 159. I couldn't get my head around it until Q4 2007 and then thought it rather unusual. Again, folks talk and talk about these things but sometimes its tough to foresee impact, especially when we're dealing with dynamic markets and very complex, market driven instruments.
posted by Mutant at 3:57 AM on June 6, 2008

Mutant I have to respectfully strenuously disagree with your comments on the effectiveness of the FSA vs. the SEC. IMHO while the SEC is seriously flawed, the FSA is an absolute joke when it comes to enforcement. I can sit here an list incredible stores of clear insider dealing and manipulation that were brought to the attention of the FSA whose response was "Wow those are shady, but there isn't actually anything we can do"

The difference is the SEC assumes everyone is a crook, and by definition has an adversarial relationship with those they regulate, the FSA assumes everyone is basically honest. Unfortunately as you and I both know this is not true.

And don't get me started on the rampant tax evasion that the UK's tax system permits compare to the US' or Australia's
posted by JPD at 4:09 AM on June 6, 2008 [1 favorite has favorites]

JPD -- "...stores of clear insider dealing and manipulation that were brought to the attention of the FSA whose response was "Wow those are shady, but there isn't actually anything we can do"

Ah, I've heard of several as well. I think a lot of the issues regarding lack of effectiveness of UK regulatory organisations relate to the fact that insider trading was only outlawed in the UK in 2000 (specifically, Section 118, Market Abuse, which built upon legislation in The Financial Services of 1986). I did my FSA in here in London in 1998, coming over from New York where I'd been through Series 7 a couple of years earlier, and I was pretty amazed it was still (largely, not but totally) legal here then.

To get some perspective, in The United States insider trading has only been illegal for about forty years, and that definition isn't like murder - its open to interpretation. And, no surprise, other G7 countries that also outlaw dealing on "inside" information disagree with the United States on precisely what constitutes insider trading. It's a very complex area, definitely not my domain of expertise (and I suspect pretty much anyone else on Metafilter for that matter although I'd love to be surprised in this regard as I've been interested in this topic for a long time now)

But even so, in The United States insider trading laws are still actively debated / examined / changed. Reg FD, October, 2000 for example. And this area of jurisprudence has been evolving since the 60's. In 1966 Henry Manne proposed that all insider trading be legal (Manne, H., 1966, INSIDER TRADING AND THE STOCK MARKET).

Of course when he wrote this American legislation was still embryonic, and insider trading wasn't totally illegal in the United States.

Manne's argument was twofold - first, he claimed that everyone benefited from insider trading as the market price of the security in question would move as shares were bought / sold. Market participants would notice the changes and react accordingly. So everyone would benefit from increased price accuracy.

Second, Manne argued that insider trading more effectively compensation managers ("insiders") who would then be incentivised to increase shareholder wealth.

Ribstein (2007) has a good overview of Manne's work (Ribstein, Larry E., "Henry Manne: Intellectual Entrepreneur" 2007. U Illinois Law & Economics Research Paper No. LE08-009). Manne himself stated he was motivated "...to look for things that made markets work rather than to doubt that they did."

In any case, Manne (and other legal scholars) have been very, very active in this area. A few citations (I haven't read all of these btw, I barely have enough hours in the day to keep with Capital Markets let alone an entirely different area of financial expertise)

Manne, H. G. 1966, Insider Trading and the Stock Market, JSD dissertation, Yale University
Manne, H. G. 1966, Insider Trading and the Stock Market, New York: The Free Press
Manne, H. G. 1966, In Defense of Insider Trading, Harvard Business Review, November/December
Manne, H. G. 1967, Should Fund Managers Use Inside Information Personally? The Institutional Investor
Manne, H. G. 1976, What's So Bad About Insider Trading?, Challenge
Manne, H. G. 1985, Insider Trading and Property Rights in New Information, The Cato Journal, Winter, 1985
Manne, H. G. 1986, The Real Boesky-Case Issue, The New York Times, November 25

Manne isn't the only researcher active in this area; I'm just familiar with some of his work as we read his 1966 book when I took my first Masters and I got curious about this area. But even in The United States today, legal scholars still debate the pros & cons of insider trading.

So yeh, FSA has a tough job in that regard, but they're still in their infancy and desperately need a series of high profile convictions to put the fear of God (or regulatory bureaucrats which might be worse) in all market participants.

Guys don't shoot the messenger, this isn't my area of expertise - I'm certainly not endorsing insider trading. I'm just interested in this topic, its rich and long history. And I don't think this is one of those typically American, "black and white", "good or evil", "with us or against us" things. Its very complicated and folks (like Manne but loads of others) have done doctoral work in this topic.



"And don't get me started on the rampant tax evasion that the UK's tax system permits compare to the US' or Australia's"

Curious - but what tax evasion is allowed in the UK that isn't in the US? The systems are different to be sure, so what's allowed in the UK shouldn't be construed as evasion when viewed through a US prism. Or vice versa. For example, deducting interest on home mortgages is legal under The US Tax Code, but not in the UK (thank you Margaret Thatcher). Trying to deduct such interest from taxable income would be evasion.

That being said, there is definitely a black market economy in The UK; anyone who's done business with builder knows you can negotiate a cash price at least %17.5 less than a VAT inclusive quote (hint: push for %30 and you'll get it). But such evasion is not permitted rather it (my own view here) is a natural side effect of inappropriate levels of taxation. We know that as tax rates increase the incentive to cheat increases as well. Effectively, the tax avoider is placing a risky bet, and as tax burden increases the positive payoff from that bet also increases.

But I'd be surprised if there was much of this going on with listed companies though.
posted by Mutant at 6:07 AM on June 6, 2008

The FASB rule is - You lend me ten bucks, get nervous I can pay you back, so you tell the world the $10 in assets you had (The loan to me) is really only worth $8. I hear that and tell my friends "sweet, I used to owe that guy $10, but know he says I just owe him $8, so I can tell people I have an extra $2 to spend on whatever" - the problem is you have no intention of asking me to just pay $8, instead you'll hang around until the loan is due and you either get the ten bucks or force me to go bankrupt. So logically I still owe you ten bucks, even if you could only sell my loan for $8 today.

I don't have a problem with it; I'm trying to understand why it's a loophole and not a legitimate thing. If I'm willing to sell the loan for $8, presumably I'd be willing to sell it to you for $8, right? To get the cash, you'd have to issue a new loan for $8 and a higher interest rate to more risk-tolerant people. Would the present value of those liabilities be the same, is that it? As long as the same loan is floating around you still owe $10, but don't you have the chance to interact with the loan market and realize the change in value? Is the problem that you get to put on revenue despite the realization never happening?
posted by a robot made out of meat at 7:49 AM on June 6, 2008

Mutant--I think your notion of profit would only conceivably apply to the financial services industry, i.e. the investment banking industry that has revealed itself in recent months to be little more than a giant Ponzi scheme or shell game. I understand the idea that a business can operate at a loss and still make sense (I have more business experience than you might assume, also worked at a dot com during the boom and know what a P&L budget is, so I'm not totally in the dark about this kind of thing), but I believe that it is precisely this MBA voodoo-economics (i.e. the notion that profit is not important) that has driven the dangerous speculative excesses of the investment banking industry. After all, the industry exists to exploit capital in often highly questionable and counterintuitive ways.

I'm not talking here about "profit" as a mechanism of running certain kinds of financial businesses, or for cash-flow/start-up times and break-even in certain kinds of ventures, I'm talking about the fact that the common sense notion of profit is what applies for 99% of all business--and is what grew capitalism in the first place. The complexities of the global financial industry are an attenuated and historically recent development: Wall Street speculates on the profits of real-world industries that cannot afford to be abstract about what constitutes profitability . The notion that profit does not really matter is a very dangerous and slippery notion, and it accounts to a great extent for the hyper-speculative shakiness of the global economy at the present time.
posted by ornate insect at 8:57 AM on June 6, 2008

ornate insect "-I think your notion of profit would only conceivably apply to the financial services industry, ... "

Uhhh, not really. GAAP accounting is remarkably indifferent about the industry one operates in. And its not my concept, but the concept of profit as Accountants understand it.


"...this MBA voodoo-economics (i.e. the notion that profit is not important) "

Well, nobody said profit wasn't important. Just that its not a natural law, like gravity. One more time - profit is just an accounting concept. I agree its important (to some extent) but its hardly natural law that all businesses must be run to generate a profit.


" i.e. the investment banking industry that has revealed itself in recent months to be little more than a giant Ponzi scheme or shell game."

Ok, look ornate insect you had a pretty interesting set of links (even though some were very weak e.g. that pay for WSJ article), but you're sorta ruining the objectivity of your post overall by the constant editorialising. We know you're anti-banking. You've said as much in your FPP and in other threads.

I mean, seven out of thirty seven comments in this thread alone are from you and every one is more of the same anti banking stuff. Why do you feel obliged to drive it home, point after point?

Its ruining an otherwise interesting FPP that's given rise to some fascinating side discussions.
posted by Mutant at 9:23 AM on June 6, 2008

I'm not anti-banking. I'm against the cult of faith in pure speculation that implies the concept of profit is incidental, rather than fundamental, to capitalism. I'm not talking about profit as an accounting concept, but rather as the fundamental force that drives capitalism in any of its various stages: language is also not natural, but without language civilization largely ceases to exist. Likewise, without the notion profit, capitalism loses all meaning. I'm unsure why this is controversial. I'm not talking about capitalism-as-ideology, or capitalism-as-accounting-practice, I'm talking about the fact that businesses exist to make money. I think you are talking about profit in a far more narrow sense than I am.
posted by ornate insect at 9:35 AM on June 6, 2008

ornate insect -- "I think you are talking about profit in a far more narrow sense than I am."

Just to clarify - I'm a part qualified CIMA Accountant, so I'm talking about profit as an Accountant would discuss profit. I hate to say it but in spite of the fact you're responsible for about half of the word count in this thread, I'm not sure what you're really saying when you discuss profit, in spite of the fact you've done no small amount of hand waving about banking and finance and capitalism and business.

As I mentioned earlier, its too bad you're determined to editorialise and bully discussion in this thread into your viewpoint. But have it anyway you'd like.

Folks - any open points I've left open please visit my profile and MeFiMail. Glad to continue objective discussions via email. The community here doesn't gain much by watching me argue with an Internet Economist.
posted by Mutant at 9:54 AM on June 6, 2008

I'm not sure what you're really saying when you discuss profit

Let's back up a bit an establish a definition.

Here is one from the American Heritage Dictionary:

a)An advantageous gain or return; benefit.
b)The return received on a business undertaking after all operating expenses have been met.
c)The return received on an investment after all charges have been paid. Often used in the plural.
d)The rate of increase in the net worth of a business enterprise in a given accounting period.
e)Income received from investments or property.
f)The amount received for a commodity or service in excess of the original cost.

Quite simply, profit is to business and capitalism (neither of which I am against) what reproduction is to sex or language is to culture: i.e. indispensable. That does not mean that certain kinds of businesses have to always operate at a profit, but rather that most businesses are motivated by profit. This so basic and obvious and noncontroversial I'm surprised it has to be dwelled upon.
posted by ornate insect at 10:09 AM on June 6, 2008

kinda late but...
I don't have a problem with it; I'm trying to understand why it's a loophole and not a legitimate thing. If I'm willing to sell the loan for $8, presumably I'd be willing to sell it to you for $8, right? To get the cash, you'd have to issue a new loan for $8 and a higher interest rate to more risk-tolerant people. Would the present value of those liabilities be the same, is that it? As long as the same loan is floating around you still owe $10, but don't you have the chance to interact with the loan market and realize the change in value? Is the problem that you get to put on revenue despite the realization never happening?
posted by a robot made out of meat at 10:49 AM on June 6 [+] [!]

Its not predicated on what price you would sell it for, but rather what price the market would buy it for. If I still think you'll be able to repay the debt on plan, I still think its worth 10, but my accountant told me that market only thinks its worth 8 so I have to say its 8, even if I would only sell it for ten. If I were willing to sell it, and you bought it from me then yeah, it'd be totally legit (though you don't report it as revenue from an accounting perspective). It would be exactly like my first example of a company buying its debt in the public market at a discount to par. But in this particular case the debtholder recognizes the difference between par and market w/o knowing if they can actually crystallize the difference between par and market.
posted by JPD at 9:02 AM on June 8, 2008