Tuesday, September 30, 2008

Changing the Rules Part 2 - Let's Get Rid of Mark to Market Accounting!!

Most market participants recognize that the ban on financial stock short sales has been a joke. Of course, the rule change triggered a vicious short squeeze on September 19(you could practically hear the morons in Washington slapping each other on the back when markets closed on Friday, September 19). But, as I suspected, the demand was artifical and temporary because asset prices cannot be rigged over the intermediate and long-term. The rule is not enforceable because there are numerous strategies that easily enable institutional investors to circumvent the rule change (Buy Put/Sell Call= Synethic short stock, total return swaps, ect). The short-selling ban will be remembered as an act of desperation that actually damaged long-term confidence in the financial markets.

The reason I bring the short-selling ban up again is because there is speculation in the market that FASB and the SEC are going to change the mark-to-market accounting rules. If FASB 157 was no longer enforceable, the damage to market confidence would be far worse than the ban on short-selling. Changing the accounting rules would be an absolute disaster and would shatter longer-term confidence in the markets. Sure, the short-sellers would freak out again because they would be scapegoated as part of this rule change. But, who would actually invest long money in a bank if management was allowed to use some other kind of metric (maturity values, ect) to value the assets they hold on their balance sheet? More importantly, who would extend credit to a bank overnight or through the short-term funding markets if they did not have confidence that the assets on their balance sheets were being marked properly?

The regulators that set the rules and the politicians that approve them have no clue how the financial markets work. The regulators and politicans are in the process of shattering the price discovery mechanism. Eliminating fair-value accounting would make the financial institutions at the root of this problem MORE OPAQUE. Rules should be changed to increase transparency.

Although I believe the TARP legislation is necessary in order to protect the financial system, the biggest flaw in the bill is that the Treasury was granted wide discretion in the prices they pay for the distressed assets. The Treasury MUST pay fair value for the assets through an auction or some other kind of mechanism that establishes a "clearing price" for the distressed assets. This is the only way to rekindle demand in the credit markets.

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