"Fix the Accounting, Then Fix the System"

Your humble blogger has been saying for some time that efforts to prop up bank asset values are prolonging the financial crisis, and the the various incarnations of “bad bank” plans inevitably entail buying dud assets at above market prices. That has the ugly side effect, which some no doubt see as a virtue, of letting banks that hold similar assets mark them at phony prices. The mechanism is different, but failing to write down bad assets is straight out of the Japan playbook.

The financial system grew too large by lending money to people and businesses who could not afford them (at least, if anything remotely bad happened, and bad things happening is part of the human condition). That means it CANNOT be restored to status quo ante (unless you are willing to see it fall apart again in short order). But the plans in motion seem to be an effort to do just that.

Instead, we need a program for shrinking and rationalizing the financial system. That imeans understanding how far underwater the system and its various components are. We then need to do triage: figure out which concerns are beyond repair, and how to wind them up, which are reasonable bets with some combination of cleanup, restructuring, and new capital, and which are more or less sound (ie, they may be impaired, but not enough to put survival in doubt) This process also involves making shareholders and when appropriate, bondholders take losses, and also developing mechanisms to write off and restructure bad loans (and lend to viable borrowers, but this is getting priority at the expense of the other steps).

Roger Ehrenberg is of similar views. Excerpts from his post:

Almost all of the bailout plans being discussed fail to consider a simple fact: without the homogenization of accounting rules, any plan will represent a piecemeal approach to the problem…..The system is broken, and current proposals do nothing to address the overarching issue: we don’t know the true tangible book value of ANY financial institution, and therefore are unclear as to which have strong capital positions, which are on the verge of failure, and which are essentially bankrupt but have been propped up temporarily with taxpayer dollars. As has been suggested by many, draconian steps must be taken to repair the system. Problem is, the only thing draconian so far is the damage done to the wallets of every US citizen today and tomorrow.

What needs to happen, right now, is to make EVERY financial institution apply mark-to-market accounting to their portfolios. No readily observable market? Have an administrator apply an independent third-party valuation that takes into account polling possible buyers. The only circumstance under which mark-to-market accounting can be avoided is if an institution has the intention of holding an asset to maturity and has the term financing in place to carry it. The two biggest problems with the current accounting regime relate to leverage and illiquidity. Banks have been financed largely with short-term capital, piled on top of a sliver of equity. But when assets have maturities extended either due to a changing rate environment (e.g., rising term rates cause mortgage-backed securities to experience longer maturities) or to rising illiquidity (e.g., CDOs, CDS’, high-yield bonds, leveraged lending commitments, etc.), the lack of term capital puts them in a very precarious position almost overnight. These kinds of surprises could have been avoided by forcing mark-to-market treatment, as we would have seen a precipitous decline in carrying values much faster than we did and dealt with the problem far more quickly.

As it stands today, those who argue against mark-to-market treatment say “This will just exacerbate the capital problem at troubled banks. And after the markets unlock, those assets will be salable at far higher prices.” Exactly. Let’s smoke out the problems NOW, and figure out the magnitude of the problem NOW. The fact that assets might fetch higher prices in the future is immaterial if you don’t have the balance sheet to get to the future, and it is certainly not the taxpayer’s responsibility to support those institutions’ common stockholders and bondholders in this mission….

But in the absence of policy clarity, aligned motives and strategic thinking, we will limp out of this crisis like a terminally wounded animal. Alive, but destined to never regains its former swagger. We can get our swagger back, a better swagger, a swagger built on real value and not on vapor, if only we have the guts to effect real change. And it all starts with something as mudane as accounting…..We simply can’t afford to wait any longer.

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  1. mmckinl

    “As it stands today, those who argue against mark-to-market treatment say “This will just exacerbate the capital problem at troubled banks. And after the markets unlock, those assets will be salable at far higher prices.” Exactly. Let’s smoke out the problems NOW, and figure out the magnitude of the problem NOW. The fact that assets might fetch higher prices in the future is immaterial if you don’t have the balance sheet to get to the future, and it is certainly not the taxpayer’s responsibility to support those institutions’ common stockholders and bondholders in this mission….”


    And then, let’s not pretend that we can go back to the broken economic model of 70% consumption, even more debt and trade deficits.

  2. mmckinl

    How about a “Reverse Bad Bank ?”

    That is we give the share holders and the bond holders the level 2 & 3 assets including any assets sold to the Fed … enough to give them their share at current bank valuations.

    The tax payers keep the operating bank (nationalization) and the depositors and the reverse bad bank is put into a holding company for the "owners" , the share and bond holders, to sort out their "assets".

  3. foesskewered

    Hmm, enforcing IAS 37 sounds interesting but pretty much a hard sell for financial institutions which wither under too much light – interrogation lights that is. Would love to see the big boys squirm when they are asked to account for the sudden halving of asset values – and that’s being kind. Independent 3rd party valuations and polling of buyers are theoretically sound but enforceability is problematic, presumably none of the big 4 really want to cross their industry rivals or potential clients- lord knows what might come out of the woodwork if everyone came out into the sun.

  4. Anonymous

    There is another reason marked-to-market is proper: it is what the banks themselves truly believe their assets are worth. If they actually believed, as they claim, that they will realize much higher prices if held to maturity, then they would go into that “market” and buy up anything anyone is willing to sell, rather than drop their cash in 0% three month TBills or make 5% thirty year mortgages.

  5. polit2k

    When accountants, auditors, regulators and legal frameworks have been shown to be inadequate you are left with elected politicians to fix the system.

    With such a strong mandate in Obamas’ hands it is unlikely that draconian measures will not be enacted. No banks, especially in the TBTF category should expect that shareholders, creditors nor bondholders will be protected on the downside as the bad assets are written off.

    Laying off the risks to the taxpayers is not a real option.

  6. Anonymous

    Unfortunately, Obama is not the “one” to do it. A lot of jaw boning about “hope and change”… A lot of policies like your typical left leaning politician. The bail out is stuffed full of wasteful spending . Just more of the same

  7. Anonymous

    This process also involves making shareholders and when appropriate, bondholders take losses, and also developing mechanisms to write off and restructure bad loans (and lend to viable borrowers, but this is getting priority at the expense of the other steps).

    Yup, if the government wasn’t incompetent or corrupt that is what should be done unfortunately we live in a banana republic controlled by an elite oligarchy. They want their fraud back, they wnat their infaltion back, they want their bubble back.

  8. Anarchus

    Call me crazy, but I think part of the reason that the toxic asset problem has lingered so long is that there is no sane, workable solution.

    IF you go forward with forced, widespread M2M accounting, then Citi goes out of business immediately and gets seized by the gov’t. What do you do with Citi’s toxic assets? On and Off balance sheet that’s probably $600 billion at book value and maybe $400 billion at immediate M2M.

    IF you move to sell those $400 billion of toxic assets @ M2M quickly, you’ll find that the immediate liquidity market for that large chunk of garbage is more like $100 billion.

    Oops. Now you’ve lost BofA as their similar toxic assets are marked down an additional 75% below the M2M valuation, which their equity could hardly support in the first place. Repeat the process by puking BofA’s toxic assets into a cliff-diving market for toxic assets? That won’t work.

    There’s no getting around the need for a massive gov’t entity like the RTC that can warehouse, repackage and intelligently auction off toxic assets over a 2-3 year period.

    Btw, the problem with Buiter’s “Good Bank” solution is that it would take market share of deposits and wholesale funding away from the crippled banks at a rapid rate and drive them into receivership, nationalization or liquidation even faster than the pace they’re moving at currently.

    The problem, as I see it, is that the toxic assets in aggregate are so massive (my number is $5-$6 trillion, similar to Goldman’s) that there’s no obvious, clear way to deal with them, and as the value of homes underlying mortgages and mortgage derivatives continues to decline the size of the toxic assets in trouble inexorably grows larger and larger.

    And there’s no way to stop home prices from sliding down because the home value to income ratio is still 20%-30% ABOVE it’s long-term sustainable level.

  9. Terry

    I agree with your diagnosis, but not your prescription. We do not have time to go through the systematic triage your propose. The American and global economy, especially the financial sector, is sinking too fast.

    I have come to the conclusion that we must nationalize the US banks and other over-leveraged financial institutions, zeroing their equity and debt, taking active control, and discharging current senior management. After the nationalization, we can carry out the triage you suggest, sending the dying to an early death. We should use the Swedish bank nationalization model as an approach, returning the working parts of the financial sector to private hands as soon as we can.

    If we do not bankrupt the banks, they will bankrupt America.

  10. Anarchus

    Terry, I'm not sure we disagree.

    Take someone tough, mean and smart (my candidate is William Isaac, ex-head of the FDIC from the 1980s) and make them Czar of Failed Banks. Seize the cripples (starting with Citi, BofA and AIG) and combine similar operations where possible & layoff redundant employees, sell the few profitable money-making businesses and jam the toxic assets into an RTC-like structure (call it the Bad Asset Relief Fund – B.A.R.F.).

    That might make economic sense – but I don't know how we're going to pay for the TARP, the fiscal stimulus package, the cost of keeping FRE and FNM on life support, the Iraq War, the Afghanistan War (heating up, btw), the eventual large losses on the Fed's now-dodgy balance sheet, Social Security and the mother of all domestic fiscal crises, Medicare as the baby boom generation retires.

  11. Independent Accountant

    I have screamed about bad bank accounting for decades. I welcome Ehrenberg's comments. The problem is not the accounting rules, but their lack of enforcement. I saw the S&L crisis, 1979-86 first hand. Virtually all big S&Ls had Big 87654 CPA firms. So? What did KPMG do at Citigroup for $88 million last year? Or the CPAs at Freddie, Fannie, AIG, Lehman, etc? Mencius Moldbug at "Unqualified Reservations" has written some wonderful, albeit long-winded stuff about banks as "maturity transformers". Anyone who is seriously interested in banks unmatched maturities as a problem should go there.
    I have read books on bank managment. One wrote extensively about banks' need to match maturites and not speculate on the direction of interest rates. When was it written? 1587! Really, it appeared in Amsterdam 422 years ago. There is nothing new here.

  12. polit2k

    @ Anarchus

    B.A.R.F (or more properly the reverse) will hopefully hoover up the bad assets without paying a dime for them, whether under a nationalisation regime or simple appropiation.

    Willem Buiter’s “good bank” solution (described at http://blogs.ft.com/maverecon/2009/01/the-good-bank-solution/) makes great sense.

    Could it be achieved without nationalisation?

    To eventually pay for the governments programs you mention will require new taxes, and fewer tax reliefs probably much closer to continental european taxation models.

  13. Anonymous

    “Fix the Accounting, Then Fix the System”

    Its not just the financial system – its ‘THE system’!

    “Fix the Electoral Process, then Fix the System”

    Give it up! Its over! You have all been snookered!

    Scamerica is the world’s greatest Ponzi scheme. It has now gone global. What needs to be marked to market is the farcical electoral process that shuts out any remedial opposition and insures the continuation of the Scamerican decoy duopoly theater. Obama is just another good cop puppet in a long line of good cop bad cop puppet gangster thugs. Scamericans have to take their brainwashed heads out of their resultantly assigned little compartments and look around and see the big picture.

    The real current problem is that the ruling elite that pull the puppet’s strings have shifted from a vanilla greed mode of parasitic wealth extraction to a more pernicious mode of accumulation that embodies a far stronger societal control element and that also includes elimination of some population. Domestic populations are fair game in this new now rapidly developing arrangement. Why? Because … the path we were on was unsustainable in terms of global resources and the aggregate middle class wealth was threatening … sooooo ….

    The global financial system has knowingly and willingly been flooded with counterfeit currency (derivative products) by the ruling elite (this is not their first rodeo) so as to intentionally cripple it for the following reasons;

    • Consolidation of financial power by eliminating of competition that has been kept out of the loop.
    • Derail expansion of and cripple opposing nation states by causing their economies to tank and create domestic turmoil.
    • Reduce the ability of opposing nation states to invest in military thereby maintaining the status quo balance of global power.
    • Reduce global population by elevating food prices and disrupting supply so as to increase resource share. The die offs’ have already begun.
    • Eliminate globally the expensive to maintain elevated resource consuming managerial middle class and replace it with a less expensive to maintain more efficient law enforcement class. Control (the stick) in the end will yield greater profit.
    • Induce perpetual conflict so as to create a two tier ruler and ruled more easily controlled world where the ruled dissipate their energies fighting each other.

    A good part of creating that perpetual conflict is to keep people dissipating their energies in bickering in the blame game and trying to devise remedial measures for disingenuous ‘elected’ officials to enact.

    Give it up! You’ve been scammed! They don’t give a rat’s ass what you think.

    “As Jesse said in; “Notes from underground” …


    “There is no way out of this mess without serious pain.”

    That is true. The pain will be metered out as fast as it can be absorbed to achieve the desired effect while still maintaining control. Early opposing action from strength is superior to late opposing action from weakness.

    Deception is the strongest political force on the planet. Deception includes denial (self deception). Integrity thrashes it to the ground once in a while. One can only sound the alarm and hope.

    There are no concrete guides in such a random game as life. Past is not always prologue. Evolution will ultimately get what it wants.

    And yes … Japan has, since the end of WW II, been a pilot program for societal control and extraction of labor. What has happened to their middle class?

    Its wake up and smell the Ponzi time.

    i on the ball patriot

  14. Angry Citi investor

    How will the pain ever end as long as the financial statements remain fraudulent? The balance sheets and business model are crap and everyone knows, why continue the charade? All the accounting firms are paid by their corporate masters to issue fraudulent financial statements, there can be no doubt all the banks like Citi are bankrupt yet KPMG keeps signing off on its fraudulent financials, why?

    Why does anyone believe any of the fraudulent financial statements? Why does anyone listen to anything KPMG or other auditors have to say? Most of the banks are bankrupt yet the financials keep rolling out, no problem. As an angry Citi investor, I have tried to piece together how I lost most of my money.

    KPMG audits many of the financials with all their SIV creations which are used to off load bad loans so the losses don’t have to be recognized on the financials in an Enronesque fashion like KPMG’s client Citi (which is bankrupt).

    Of course KPMG’s never ending quest for fees does not stop with fraudulent financials, it also purveyed what Mike Hamersley would describe as fraudulent corporate tax shelters (not withstanding Hamersley’s willing participation in many of them) used by most of KPMG’s big banks including Citi, like the REIT transaction which eliminated tax on real estate loans; back to back loans or rate swaps creating interest deductions; financing arrangements generating noneconomic foreign tax credits; the list goes on forever. All KPMG’s big banks used the strategies to eliminate taxes and create what Hamersley would describe as fraudulent book income (except of course for Hamersley’s own tax shelters).

    Tim Flynn is a banking guy and was brought in to purportedly clean up KPMG in 05. Yet Flynn prior to his appointment as KPMG CEO was a high level KPMG audit partner before taking over for O’Kelley and had most of his clients involved in all the fraudulent accounting and questionable tax shelters (which according to Hamersley were fraudulent).

    There can be no doubt about the fraud as beginning as early as 2003 many were predicting the implosion that would result from the unsustainable lending patterns of KPMG’s banking clients. In fact, most of KPMG’s banks are bankrupt, what to do?

    Flynn decided to throw a bunch of tax partners having nothing to do with all KPMG’s bankrupt banks under the bus for individual shelters which were miniscule in relation to all KPMG’s failed fraudulent audits.

    Flynn hired Bennett and Holmes to do his dirty work and assist with the DOJ. Flynn had Bennett and Holmes lie to the DOJ according to an email wherein Joe Loonan KPMG’s head lawyer stated that he did not know if any of the allegations were true (“freedom is just another word for nothing left to lose”). Then to seal the deal Flynn denied legal fees to the tax partners he threw under the bus to the DOJ, even Ernst and Young paid its partners legal fees. Why would Flynn do this after O’Kelley had promised to pay the legal fees?

    One can only infer to hide the greater tragedy at KPMG, all of the failed fraudulent audits (not to mention after Flynn cut his deal, KPMG was awarded the audit of the DOJ). If I were a KPMGer, I would not only be extremely concerned about all the civil litigation that is coming for the fraudulent audits but the potential criminal actions that must be coming once the books are scoured (which you know they will be in the civil litigation plus the fraud is relatively easy to discern) because KPMGer’s must know by now the first thing Flynn will do is throw you under the bus and cut off legal fees.

    As a decimated Citi investor I am looking for any KPMGer to come forward and tell the truth.

    Angry Citi shareholder

  15. whistlefraud

    How will the accounting scams ever be solved as long as credence is given to scam artist whistle blowers working at the accounting firms? Mike Hamersley is now a government agent who purportedly blew the whistle on KPMG. What good is cleaning up the system when the scam artists just move from the firms to the government? Hamersley works for the California FTB as a high level tax shelter fraudster working in its tax shelter division confiscating income from hard working citizens. There can be no doubt Hamersley is a public figure and tax shelter fighting crusader, the Encyclopedia says so.

    Encyclopedia > Michael Hamersley

    Michael Hamersley is a nationally recognized figure, known for his relentless pursuit of truth and justice. He became a tax scam whistleblower in 2003 exposing the multi-billion dollar tax shelter fraud and conspiracy which has been referred to by the U.S. Attorney General has as "the largest criminal tax case in United States history


    I got a couple questions though, I am looking at an email right now where Hamersley advised a client substantial authority existed for a liquidation reincorporation tax shelter where Hamersley told the client if the client sold its subsidiary to the client’s lawyer for one dollar, substantial authority existed for losses that amounted to tens of millions of dollars of loss. Hamersley further advised the client that if the “substance over form” rules where upheld by the IRS, substantial authority still existed, in other words if the IRS disregarded the sham sale which could only have been done to hide the true facts from the IRS, a tax position still existed for the multimillion dollar deduction. Yet, when Hamersley testified to the Senate he specifically stated such behavior was tax fraud. Which is it, did Hamersley lie to the Senate or his client, or both? What good does it do when guys like Scamersley move from the firms to the government to continue their scams?

  16. Independent Accountant

    The DOJ to NY BigLaw revolving door revolves daily. The SEC to investment bank or NY BigLaw revolving door also works.

  17. Bob_in_MA

    Max Holmes (who I’ve never heard of) has what sounds like a simple and workable plan for a program of bad banks in today’s NYT. The gist of it is that the Feds don’t buy the bad debts from the banks, but take on an equal amount of the banks’ pre-existing debt, so no need to sell more Treasuries, etc. Though the ultimate losses to the taxpayer would be about the same, I guess.

    Or is this just moving things around in a shell game?

  18. Anonymous

    What needs to happen, right now, is to make EVERY financial institution apply mark-to-market accounting to their portfolios. No readily observable market? Have an administrator apply an independent third-party valuation that takes into account polling possible buyers.

    Yes! YeS! YES! Give the banks a uniform methodology for valuing their assets, or the assets underlying their assets (real estate, mostly) and then ask, “Would every bank that is insolvent please raise their hand?” Then nationalize those.

    Bob_in_Mass – Looks like SSDD, moral hazard and all. And he tipped his hand in the first paragrah: “One is to, in effect, nationalize the major banks, which would be hugely expensive and would undermine our free-market system.” Free-market system. What a hoot.

    And then there is this: “So far, the Treasury and the Federal Reserve have done a good job of consolidating the commercial and investment banking sector into four giants: Bank of America, Citigroup, JPMorgan Chase and Wells Fargo. But based on those banks’ continued depressed stock prices and the high cost of credit they are being forced to pay, it is clear that the market is not yet convinced of their health.”

    I’m going to file Mr. Holmes under “Tool”.

  19. Anonymous

    Between falling home prices, stock market declines, 401k losses and pension plan losses the average US citizen has probably had 40 percent, roughly, of their ‘wealth’ ripped from their hands. The US government, populated by lawyers and bankers, does not see this a crisis of personal confidence and trust. They think taking even MORE money from citizens and giving it to banks is a great idea.
    How they have gotten so incredibly far from reality is a wonder to hardly be believed.

  20. Anarchus

    I actually thought Mr. Holmes should get extra credit for ingenuity and creativity, with a substantial markdown for willful ignorance of adverse selection.

    Because the banks get to transfer assets to the government at inflated year-end book values (a step which may be necessary to any process like this to keep from further impairing bank capital), they have an enormous incentive to transfer their most overvalued assets to the government. On an honest economic basis, the government would take an immediate loss of (pick one: 25%, 40%, 50%, 75%, 90%) on the assets transferred. And with home prices still falling and having further to fall, those asset losses won’t have a chance of “recovering” the way that the bad loans of 1988 were able to recover over the subsequent 15 years.

    There’s two timing issues that make the historical context of the Holmes’ Plan: (1) 1988 was very early in the great bank crisis of 1989-90, and the attitude and willingness of equity investors to put fresh new capital into banks wasn’t the least bit similar to the (rational) total aversion to putting money into banks today. I mean, it’s not like there are thousands of highly attractive loan customers out there with improving credit profiles these days, and (2) Look at a long-term profile of US total debt to GDP and it’s been on a spectacular rising path since 1980. There was a minor blip in 1989-1990 when the bank crisis struck then, but almost immediately the rapid rise in debt/gdp began anew. WE ARE NOT GOING BACK ON THAT PATH anytime in the next 5 years and probably longer. The idea that it’s possible to have a 1990s style recovery in leverage that would allow the government to recoup much of anything for the toxic assets it takes on is – MADNESS.

  21. Anonymous

    Goerge Soros comments at Davos that we should create the good/bad banks but instead of govt backing the bad bank, it should be the reverse, ie, dump all the garbage into bad bank then put the bank’s capital THERE, not in the good bank. (shareholders would take the hit instead of taxpayers) Then likewise, the govt would back the good banks and therefore have good chance at actually getting some/much of its “govt prop up” money back. Soros also noted though that the odds of that happening are not great.

    But agree Yves, we’ve got to get this stuff out in the open one way or another. The internet allows people too much information to be fooled by lies that might have worked 20 years ago. Times are a-changin’ fast.

  22. Edwardo

    Mr. Ehrenberg is on to something that is abolutely crucial, however, without going into a long exegesis, marking to market all assets is a fiendishly difficult and highly treacherous endeavor, not the least of which is because of the corruption that is at the heart of these troubled big bank’s operations. Employing Mr. Eherenberg’s proposed method, whereby third party assessors determine market value, while on some level constructive, doesn’t really address what is so problematic about marking everything to market.

    My understanding about the current FASB rules is that they are in contradiction to long standing practices of accounting-practices going back hundreds of years- whereby bank assets are not marked to market until they are sold. Before all this blew up, the FASB rules were not enforced. Now, for obvious reasons, they are, probably selectively, enforced.

    In the meantime, banks, (not just the troubled ones) or so I have been told, are between a rock and a hard place in that they are compelled to be highly liquid, yet also badgered to lend, all the while knowing that if they make a bad loan it will impair their liquidity and capital ratios.

    To make a long story less long, the poster who asserted that we need a modern day RTC is probabl correct, for some of the reasons he stated. A new RTC probably ought to involve, among other practices, cram downs on loans so people can stay in their homes and work out payment that allows everyone at least some level of satisfaction and probably allows social cohesion as well which is, I imagine, more fragile than most of us realize right about now.

    A final note:

    I find the following sentiments from Mr. Ehrenberg
    just plain obnoxious.

    “We can get our swagger back, a better swagger, a swagger built on real value and not on vapor, if only we have the guts to effect real change. “

    Our brand of capitalism, until recently, was such that it lent itself to disaster. I say this from the standpoint that those who created and (especially) proliferated the so called instruments of financial mass destruction could have cared less about the inevitable catastrophe they almost certainly knew would ensue since they were getting their huge pile up front. And therein lies a problem far greater than a change in accounting rules. Capitalism, if it has any chance of being viable, and I freely admit that I am not convinced of its usefulness going forward, has to have, for lack of a better term, a superstructure that steers people towards practices that are more than obviously superficially beneficial to small groups at the expense of the whole.

  23. Mencius Moldbug

    The maturity problem, which Ehrenberg (like a lot of writers) seems to almost but not quite understand, is very simple.

    The price of everything is set by supply and demand. “Everything” includes loans. Loans of different terms are not fungible – both supply and demand vary for every term.

    This produces a yield curve, a graph with interest rate on the y-axis and duration on the x-axis. The supply of loans decreases and the demand increases as duration increases, so the yield curve (in a free market) slopes upward.

    Maturity transformation/mismatching (“borrowing short and lending long”) allows a financial intermediary, such as a bank or “shadow bank,” to transform demand for short loans into demand for long loans.

    “Fractional-reserve banking” is a special case of MT in which the short loans are zero-term (demand deposits). This maturity crisis, however, has seen a lot of MT schemes which are not FRB collapse – eg, 30-day and 90-day commercial paper. Because there are few ways to earn a true 30-day round-trip return, short of Vinny the Loan Shark, it is clear that this paper is backed by investments of much longer duration. Thus it can experience the same kind of “bank run.”

    Banks like MT because it is profitable. Governments wink at MT because it lowers interest rates. Unfortunately, it is just plain bad accounting; the structures it creates (sometimes described, incorrectly, as Ponzis) are unstable; and for the past few centuries it has been causing random busts and booms. This has simply got to stop.

    What this analysis means for Ehrenberg’s thesis is that (a) he is on absolutely the right track; but (b) his solution, which he thinks of as incredibly radical, is actually mild and half-hearted.

    The “market” prices he wants to mark to are junk – numerical noise. MT has shut down in the market for these securities. But their present prices do not reflect a healthy, functioning market in which long-term investors demand long-term loans. They reflect speculation about when USG will manage to apply enough financial crack to turn the market back on. This is not meaningful information in a Hayekian sense, and it will not generate meaningful prices.

    There is only one way for USG to nationalize these loans, without making up prices out of thin air: acquire their holders, by buying up the common stock of the entities that hold them (ie, the banks). Joe Sixpack does not hold asset-backed securities, at least not directly. Not all holders of term loans are traded on markets, but most are, and the rest can be finessed.

    I am slightly aghast that this has so far evaded the great minds at Treasury, but it can only evade them so long. It will not solve the accounting problem, but it will at least stop the freakin’ bleeding.

  24. Information Arbitrage


    You are misinterpreting my use of the word “swagger.” Swagger the way I am using it is means “self-esteem” and “confidence,” unlike the way we feel about ourselves today (justifiably). You are thinking of it in the pejorative. We don’t feel differently. You simply seem not to like my choice of words.


    I understand the theory. The only difference in what we are saying is that you want to avoid the asset valuation issue entirely and go straight to nationalizing the banks. But which banks? I think your prescriptive wields a blunt instrument, even more blunt than mine (which is hard to believe). There is a price for everything, Mencius. There are buyers, just not at the inflated levels reflected on bank balance sheets. By forcing price discovery, you rapidly smoke out those institutions that require being taken over in order to segregate the good from the bad and to get the good in a position to lend again. I don’t really understand in your model how you assess the nationalized from the others. Further, it becomes an objective as opposed to a subjective process of who lives and who dies. There are plenty of healthy banks out there, but the entire sector is being painted with a broad brush because of the high-profile and massive problems of a relatively small number of institutions.

    As to being aghast at the Treasury, you and I are in the same camp. I’ve written about this for some time. My mind is truly boggled.


  25. Anarchus

    Mencius, isn’t nationalization by any other name still nationalization?

    That is, the Treasury has reportedly been considering three general options: 1. Outright Nationalization of the major troubled banks, 2. Some form of Good Bank/Bad Bank, and 3. Applying occasional $25 billion injections of preferred as needed (a la Paulson).

    I don’t understand why you think that your plan to “buy up the common stock of the entities [banks] that hold them”. Functionally speaking, I thought that’s pretty much what nationalization was, though I’m not holding myself up as an expert on nationalization.

    Now I also understand that Wall Street is so unpopular right now that politicians are getting paranoid about the poll numbers, and I believe that the poll numbers for nationalization are worse than the rest, so politicians are unlikely to choose nationalization unless/until other options are exhausted.

    Otherwise, I think I agree with you, nationalization is probably where we’ll end up. My personal spin, however, would be to make cash bonus payments for any holder of government preferred verbotten, but still pay bonuses just pay them in script claims on the pool of toxic assets. If the super-smart money-center bankers don’t like it, let them en masse go seek work at some regional bank in Toledo, or Keokuk.

  26. Mencius Moldbug

    BTW, I like the Holmes plan. It’s a bandaid, of course, but it actually sounds like a decent bandaid. It includes two elements that are essential ingredients of any real solution: duration matching and assumption of liabilities.

  27. Carlosjii

    Let the games continue: from http://www.fasb.org/derivatives/01-14-09_C22.pdf
    italicized in proposed to be struck out. Much more formalized fiscal hooliganism proposed also

    Statement 133 Implementation Issue No. C22
    Paragraph 14B:
    Changes in cash flows attributable to changes in the creditworthiness of an interest resulting from securitized financial assets and liabilities (including derivative contracts) that represent the assets or liabilities that are held by the issuing entity shall not be considered an embedded derivative under this Statement. The concentration of credit risk in the form only of subordination of one financial instrument to another shall not be considered an embedded derivative subject to the application of paragraphs 12, 13, and 14A of under this Statement.

  28. Mencius Moldbug


    Of course that's what "nationalization" should mean, but people seem to mean all kinds of things when they use the N-word.

    True nationalization to me means full consolidation of balance sheets, pooling of interests – exactly as if, say, Google acquired Yahoo. USG acquires Citicorp, Citi's assets become USG's, Citi's liabilities become USG's. That's the N-word.

    But I often hear this word used to describe a situation in which the government, say, owns >50% of the shares of an entity. This is roughly the difference between cremation and zombification. Papa Doc called – he wants his tetrodotoxin back.

    As for "blunt instrument," yes. I would start by assuming that all financial assets – even home equity, even nonfinancial stocks – need to be nationalized.

    And then auctioned ASAP, of course – history’s biggest IPO. This need not be a depressing event. Indeed, how could it be a depressing event?

    To libertarians: what matters is the size of the State at the end of the operation, not the swollen mass on the operating table. We want separation of bank and state. We don’t have it. How, besides the knife, will we get it?

    Extreme nationalization is certainly necessary for any transition to duration-matched accounting. The hard problem with permanently turning off MT is that maturity-transformed demand has inflated the prices of basically all financial assets. And there is no way to compute the “right” post-MT price from either the MT-on price, or the present fire-sale price. The Hayekian information just isn’t there.

    Moreover, the true post-MT price is almost certainly much lower than even today’s fire-sale price – assuming the present supply of dollars. Remember, we live in a world with less than 2 trillion actual dollars, and something like $100 trillion of financial assets priced by dollar yield. 1:50.

    Except for the fact that you are used to it, does this make any sense to you? And without MT, what does this relationship become? I dunno, but 1:1 doesn’t seem impossible. At present we are on a slow boat in this direction. The fire sales continue to burn.

    The orthodox Austrian view is that we should just deflate to this price, and taste the pain. But we are not actually on a hard-money standard. We can and should print our way out of debt – and, ideally, to a stable monetary system with systematic duration matching and a bounded money supply.

    This won’t happen, but we can still talk about it. If our financial system isn’t in need of the ol’ Vulcan nerve pinch, what is? And what could a reboot mean, besides closing down the casino and reopening with fresh chips?

    Scrip claims on toxic asset pools are a lovely idea, however – especially generalized across the time dimension. Merge large quantities of toxic assets into one pool; blend thoroughly; issue a single tier of bonds that match the duration of the assets; price these by auctioning them to buyers who actually want to lend at that duration; and you’ve solved the problem. (There is plenty of genuine demand for long-term loans – eg, retirement plans.)

  29. Doc V-Shaped Recovery Holiday

    FASB needs to be destroyed as a rule making entity. They have used distortion for decades to front run regulations and then they create the loopholes and the mechanisms to allow the current games to turn into cancer! The FASB along with their pack of Goldman-mafia kingpins and fellow wall street scum who are in collusion, should be audited for fraud, aiding and abetting, and conspiracy!

    After The FASB is taken out, burn down The SEC, FOMC and then re-invent The Treasury and then have the FBI investigate DOJ and then have IRS start investigating why America has been run by crooks from within. The members of the previous coup should all be rooted out and then hung for treason …. but that’s just my orange juice talking and … although all that should be done ASAP, I still think we have seen the eye of the hurricane and that a V-Shaped Recovery is in progress. It’s just a matter of perspective over time, but kill as many rats as possible ASAP, before the plague spreads!

  30. Anarchus

    Mencius Moldbug, I’m loving your “Maturity-Transformation” term. Or maybe it’s not yours. Doesn’t matter.

    To my layman friends, I’ve been trying to explain the debacle as the probably inevitable disastrous outcome of financial addiction to “the carry trade”. Because they ask, my layman friends, “Where was the Gi-normous demand for MBS, CMOs, CDOs, and the rest of the stuff coming from?” and the only answer I can give them is, “carry-traders”.

    One of the top ten queasy days in my life was interviewing with Andrew Lo back in 2003, when Dr. Lo informed me that there were perhaps 3x the aggregate assets being managed by hedge funds in the “relative value” style of LTCM in 2003 versus 1998. Which made me nauseous because that made it clear that not only had no one learned the lessons of LTCM but that when the eventual debacle struck it would be that much larger than in 1998.

    And of course by the time disaster started striking in late 2007, the problem was much larger than 3x the size of the LTCM era. Worse yet, by 2007 it wasn’t just hedge funds but BANKS such as Citibank eyeballs deep in the SIV/Conduit/CDO dungheap.

  31. john bougearel

    Yves, Mencius et. al,

    While we can all share a consensus about shrinking, rationalizing, nationalizing,the powers that be last week (Geithner and Summers) confirmed their goals are to prop up and preserve the zombified financial system and get people spending again , to leave the banks privatized at taxpayer expense. Every policy is geared towards mistaken goals.

    These guys are driving drunk on the credit they create out of thin air (the cost of which is passed directly onto you and me)and killing us with whatever alphabet soup vehicles they choose to get behind. These guys need behavior modification folks, we need them off the f-in road. We need MADD on WS and Capitol Hill. They won’t do that without court-ordered push back. We need to take these matters to court, remove them from the offices they hold, and ban them from the Empire or whatever you want to call this crumbling edifice. Reform is not even remotely possible until these drunks get off the credit-creating highways. They are reckless human beings with no regard for the lives of others.

  32. Roylat

    This post and the comments are fascinating in that they focus on addressing a SOLUTION to the financial mess, instead of merely criticizing government proposals.

    The government justifications for their actions all seem to require sophistication beyond the ability of the average person to understand — which in itself seems a red flag.

    In seeking a solution, I’ve come up with my own list of “dumb questions.” After reading the post and comments, maybe they aren’t so dumb. I’d like your help in answering them.

    *What is the problem with letting all of the failing investment firms fail, with the government guaranteeing all depositors of any size?

    *Wasn’t the FDIC set up to take over failing bank? Why not let it?

    *Wouldn’t it be a lot cheaper for the government to pay off bank depositors than to take over all of the nearly worthless toxic debt held by banks?

    *Aren’t there some banks that have avoided the pitfalls of the big investment banks and would be in a position to take over the business of the failed banks?

    *Instead of a “bad bank,” couldn’t the government establish a “good bank,” one that would lend to well-run, solvent banks with excess loan demand?

    *Can some of the learned people that read these blogs provide some numbers on the amounts of bank deposits compared to loans at the big, failing banks, such as Citigroup and BofA?

    I’m putting these questions up as a post at my blog, Roylat.com, under the title, “Some Dumb Questions About Dealing with Failing Banks.” If you can take the time, please post your answers there. I’d really appreciate some enlightenment. These questions seem akin to, Is the Emperor without clothes?” But, few seem to be asking them.

  33. alan von altendorf

    Thanks, Yves. Great post. Simple and eloquent, as is all wisdom: Mark to market, fools.

    I monitored the BBC panel discussion from Davos last night. Roubini, Tyson, Swedish finance minister, president of Guyana, and vice chair of AIG. I am deeply worried that the world has gone completely stupid. Only Tyson had the stones to mention central bank culpability. No one said boo about Fannie and Freddie or Goldman’s capture of the Bush Treasury. AIG denied wrongdoing, denied that any one on the board should have known where their risk exposure was, no hint that the $85 bil backstop was a Goldman putsch.

    Sick. Very very sick. Freedom is toast.

  34. Anonymous

    @alan von altendorf, I concur.

    I posted this in regards to the Jesse quote before.

    “Their heads just can’t absorb the fact that they, the best and brightest in their Fields, are responsible for the mortal wounding of their idealogical baby, talk about denial”.

    I watched the same discussion and was flabbergasted at the denial on any level or as Doc holiday once said “BARF”.


  35. Junior

    Instead of addressing the issue, claims are that it is the standard itself, not those entrusted to uphold it, that is flawed. Shoving IFRS through without fully understanding and respecting our own accounting rules seemed to be yet another attempt to distract and divert attention from the true core of financial illness.

    It’s ridiculous.

    You are absolutely right.

    But American minds are skewed enough that they confuse a banker with an accountant (they all deal with money, right?) and Fort Knox with the Fed. So the accounting naturally becomes the perfect scapegoat.

    Wonderful post.

  36. I Concur With Tax Partner

    Angry Citi Investor, (aka Angry Citi Shareholder, Thoreau, Whistlewhat, etc.–I have to admit it is difficult to keep track of all the aliases you are using to post identical comments while appearing to be different bloggers.):

    Your comments about Hamersely just don’t make any sense at all. I too am highly skeptical that your bold statements about Hamersley could be based on any reliable evidence at all. I too read Travails in Tax and personally observed Hamersley’s testimony before the Senate Finance Committee. He seems like an exceedingly honest guy to me too. Yeah, isn’t it a fact that KPMG said Hamersely had absolutely no involvement or knowledge of tax shelters in its press release to the Senate Finace Committee after Hamersley testified in October 2003? I read that KPMG press release on the PBS Frontline website. http://www.pbs.org/wgbh/pages/frontline/shows/tax/interviews/release.html
    See also Hamersley Senate Finance Committee Testimony 003 TNT 204-35 online at http://finance.senate.gov/hearings/testimony/2003test/102103mhtest.pdf

    Are you suggesting Hamersley and KPMG are in cahoots? Wow, that would be a bold strategy seeing as Hamersley sued the crap out of them. Case No. BC 297209, Los Angeles Superior Court (June 23, 2003.), also reported in Tax Notes Today full copy of complaint 2003 TNT 124-5

  37. Tax Partner

    Hey, I think you forgot one of Angry Citi Investor’s alias: “Whistlefraud.” Can’t fault ya, it is tough to keep up with all of his aliases talking to himself in these blogs. :) No worries.

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