Posted by
Wendy on Sunday, February 08, 2009 11:00:00 PM
Suppose that the economy were struggling against a background of extensive dislocations in a major sector of the economy. The root cause of this situation was the loose monetary policy of the Federal Reserve, with contributing causes being federal laws and entities that distorted the markets and shunted economic activity into that sector. The dislocations were slowly correcting over a period of years. Now suppose that someone informed you that the government would soon issue a decree stating that much of the wealth financial companies had in their possession did not in fact exist because companies were lying about the value of their assets on the books. The decree would mandate that to set the record straight, the financial sector would be forced to erase wealth from their books over the coming months. The decree would not say which companies would have to erase wealth or by how much they would have to erase it. The standard a company would use for determining how much wealth to erase would be one unknown individual’s decision as to how much he would be willing to pay for the company’s assets. Companies that unloaded its weakest assets first on the open market would therefore have a survival advantage; the unloading would lower the market price for such assets, and companies still holding such assets would be forced to write off yet more wealth on the basis of the newly decreased value of its assets. In the end, the amount of wealth erased would equal the size of the current “stimulus plan.”
What effect do you think this would have on banks, the financial sector, the stock market, and the economy at large? Given that the financial sector provides the lifeblood of the American economy, and that each dollar creates an additional nine dollars in lending capacity, you would probably rightly conclude that a write-down death spiral and the bankruptcies of nearly every legacy investment bank, the collapse of the financial industry, a stock market crash, and a major recession were now unavoidable.
In November 2007, the Financial Accounting Standards Board (FASB), the organization designated by the SEC as the accounting rule-making authority, issued Rule 157, which decreed that companies must use the mark-to-market method of accounting for the class of assets later implicated in the meltdown. Also called “fair value accounting,” this method dramatically affected the assigned value of the assets now popularly described as “toxic.” Companies are required to account for the value of these financial assets at market price, the price the asset currently fetches in the market. This replaces other methods, including mark-to-model, in which an asset’s value is determined by economic models which use information such as discounted cash-flow and historical or projected value. The rationale behind the rule is that only market prices are objective, and that modeling represents non-substantive wishing at best, and at worst, outright fraud.
Rule 157 and its antecedents are a violation of the rights of businessmen, shareholders, and employees. It follows years of the SEC and FASB mandating fair value accounting for other types of assets. Such rules are deeply flawed, but the flaws are not merely technical in nature. The flaws are rooted in bad philosophy.
Note the inherent contradiction in the Rule 157 philosophy. How is the market price of a complex asset determined? It is determined by what individuals are willing to pay for an asset. How does an individual determine how much to pay for it? He determines this by taking into account such factors as how much cash flow an asset produces, the time value of money, and what the asset will likely be worth in the future. In other words, the market price is ultimately determined by financial modeling.
Implementing a business strategy requires expertise across a number of professions. One of these areas of expertise is accounting. Accounting is not a disconnected intellectual pursuit that passively provides out-of-context enlightenment. Nor is it supposed to be an espionage operation reporting cobbled-together evidence of “misdeeds” to paranoid investors and hostile anti-business groups. Properly, it is an active, dynamic, interactive profession that both assists companies in strategizing and necessitates certain real decisions for them. Mandatory mark-to-market accounting artificially deflated balance sheets, requiring companies to sell assets to meet capital reserve requirements, margin calls, or other contractual obligations. It also resulted in company credit quality downgrades. The downgrades forced companies to further sell assets to strengthen their balance sheets to meet legal or contractual requirements. The securities markets collapsed. Mandatory fair value accounting was not an innocent messenger shot for shining the light on bad investment decisions. It was the murderer.
The high priests of Rule 157 play on guilt by pointing out that mark-to-market accounting is nothing new and that companies, including Enron, fought for the right to use it for long-term assets. Rather than being a real argument, it is a threat to establish guilt by association. This subtle psychological attack can be defused by realizing the real issue at stake: Whether the government has the right to force an accounting method on private entities.
They also say that mark-to-market forces companies to disclose the fair market value of their assets, and that even so, companies are not required to write the assets down to zero, only to the expected value of any remaining good mortgages in the security. Further, they say, in cases where it is virtually impossible to determine its current market value, companies can report their best guess as to the current value as well as the reasoning behind the estimate. How is any of this fundamentally different from a mark-to-model method, which also uses “expected value” and “best guesses” supported by reason?
The fair value apostles also say that companies can choose whatever method they want for any class of assets, just that they must stick with a method once chosen. But why should they not be allowed to change their method, especially when circumstances and strategy change? Because, they imply with some disdain, companies only wanted to change their method mid-game to protect or improve their profits, and banks should not have been in the short-term mortgage security business anyway. But the profit motive is precisely what makes it moral. Companies are legally and morally obligated to pursue strategies available to them that increase profit to its investors. An asset may have value to its owner, such as cash flow, that is not limited to the price it can currently fetch in the market, and this should be reflected in the company’s accounting and strategy. As long as companies disclose their accounting honestly, there is nothing inherently wrong with changing accounting methods. Nor is there anything wrong with branching out into new types of investments. The shareholders, who are the owners of the company, should have the final say as to accounting methods and operations, not the federal government.
They say mark-to-market should apply because it is the appropriate method for securities that were meant to be held short-term and traded. This is an attack on arbitrage and is complete subjectivism. Who intended to hold them, for how long? The assets owners intended to hold them until they could make a profit. If a company continues to hold the assets after they have fallen in value until its price recovers, their intent is to hold the asset long-term, and a mark-to-model method is appropriate. Government should have no say in this.
Finally, the disciples of fair value say that mark-to-market did not exacerbate the crisis, because investors only shorted the companies they thought did not write down their securities far enough. This ignores the fact that investors would not be expecting such extensive writes-down had mark-to-market accounting not been forced on them in the first place.
Rule 157 is a failure in philosophy, and those who believe that this issue is merely a technical one, one in which the Rule 157 advocates fail to understand that mark-to-market does not work when the market is illiquid, fail to understand the profound philosophical differences that separate the two sides.
Rule 157 is a failure in metaphysics. The first error of the Rule 157 priesthood which stands out to the casual observer is the mind-body dichotomy. In its modern form, it holds that theory has nothing to do with practice; there is knowledge, and then there is the real world. Unconscious acceptance of this notion explains why advocates can state with a straight face that mark-to-market accounting has nothing to do with write-down spirals, credit downgrades, and stock market sell-offs.
If theory cannot be relied upon as a description of the real world, what can? Social metaphysics—the view that reality is what other, superior consciousnesses determine it to be.
Rule 157 is thereby a failure of epistemology—the theory of knowledge, i.e., the relationship between man’s mind and reality. If one’s means of knowledge is what other people say, it then becomes a question of whose consciousness reveals reality. What more accurate method can there be than utilizing the judgment of the greatest collection of expert consciousnesses possible—all the minds of the market? Their collective judgment is embodied in a single concrete, the highest market bid, and endowed with intrinsic truth.
Such an approach is anti-intellectual. Projecting into the future is a requirement of every profession. On what basis is accounting any different? The mentalities that regard only current market values as real and projections of future value as little more than quasi-fraud are what Ayn Rand called “concrete-bound, range-of-the-moment, anti-conceptual mentalities that long for liberation from principles and future.” It is the mentality of a bureaucrat who wants automatic omniscience without having to exert mental effort, who regards the say-so of men (market bids) as an irreducible fact—the only reality possible—and who resents the future as unreal and unknowable.
In decreeing that certain concretes are the essence of reality, the mark-to-marketeers failed to grasp that there can be no value of a thing without an individual mind making a valuation. In attempting to replace the highly abstract, conceptualized value-judgment of individuals with an intrinsic value as revealed in some easy-to-see concrete (market bids), they fail to see that it is ultimately an individual mind that must determine that value anyway, and that it must do so by highly abstract, conceptualized means.
There is no such thing as intrinsic truth, falsity, virtue, or vice to any method of accounting. The accuracy and value of accounting methods are objective—they must serve the purpose of the entity trying to make a profit by providing a way to mathematically identify, track, and predict profits and losses in a certain context. No method is intrinsically more accurate or more virtuous than another. Whether a method is right depends on the context—what information its users are logically trying to glean from it in their pursuit of profits in a given set of circumstances.
Rule 157 is also a failure in the philosophy of ethics. The ethics behind it is that of altruism, the notion that others are the standard of value and that an individual’s justification in existence is self-sacrifice to others. Observe that for every asset sale at the given market price, most owners were not willing to sell their possession at that price. The mark-to-market evangelicals believe that an owner’s valuation of an asset is selfish and therefore due no consideration. Only disinterested others may assert the value of the asset, which ultimately means that these others determine the relationship of all owners to their assets, which means that all owners are deprived of their right to deal with their assets as they see fit, which means that their right to property has been violated.
Therein lies Rule 157’s failure in the philosophy of politics. The political philosophy behind it is that of collectivism, the notion that the collective is the standard of political value and that individuals should be sacrificed for the greater good. In this view, the government has the right to force companies to use whatever accounting method it deems in the public interest. In practice, the “public” is an ad hoc coalition consisting of temporarily aligned pressure groups: (Politically) activist shareholders, incompetent shareholders, resentful accountants, lazy financial analysts, parasitical lawyers, and businessmen who have gamed the system and see such rules as a means to handicap their competition, aided and abetted by the incompetent Bush cronies of the Securities and Exchange Commission, who are psychologically committed to defending their major mistakes to the death, the death of the American economy.
This death is seen as just a transient phase on the way to a higher purpose, for the public interest takes the form of economic purification, “a reckoning” which will cleanse us of the toxins from our previous splurges. The Rule 157 worldview regards profits as amoral or even evil, a corrupting force, rather than life-serving and necessary. Financial companies are arbitrarily regarded as pathological liars, guilty until proven innocent, infected with the sin of “greed,” itching to cook the books in a never-ending quest for gluttonous profits at the expense of others, the stockholders. Mortgage-backed assets are the filth that must be purged, and only an all-powerful state can save the people from all this evil. (The liberals take it one step further. They would root out this evil through the witch-trial of bank nationalization, and any bank that survives the test drowning is good enough to continue existing).
Survey the results of this mysticism-altruism-collectivism philosophy in reality. Throughout the crisis, even the best minds of the major financial companies could not figure out the supposedly obvious and straightforward “market value” of their assets, so they had to hire a pioneer of the mortgage-backed security market, Larry Fink, as a consultant—whose financial interests lie in the continued lack of clarity in asset values—to model what their assets were worth. At one point in this opaque confusion, the singular consciousness of John Thain ultimately determined the amount of wealth in the economy, based on his analysis of his own company’s financial self-interest, with no regard whatsoever to the consequences his decision would have on other companies or the economy as a whole, with everyone completely mystified as to what any asset was worth now that the light of “transparency” had been shone on it, and with billions of dollars in our society’s wealth destroyed.
This kind of collapse into self-contradictory absurdity is the inexorable outcome of bad philosophy, via the infection of specialized fields such as economics and law.
Rule 157 had its theoretical roots in the efficient market hypothesis (EMH), which holds that market prices rapidly equilibrate to values justified by all known information. Though this hypothesis has served as a banner for some free market advocates seeking to explain why free markets always work best, the Irenaeuses of the financial world made the EMH into official doctrine, proclaimed that market prices possessed intrinsic truth, and forced the conversion of the world’s gnostic bookkeepers, who were required to burn their calculations and replace each one with the one true number. The apologia goes something like this: If market prices are always correct at any one time, then the true value of an asset is its market price, any other valuation is false, and a rule is needed to force selfish heretics to mark their assets to market. It was thus that a hypothesis historically used to justify the free market came to justify why the government should violate it. The alleged defenders of the free market, having lost track in the confusion of what it was they were supposed to be advocating, agreed to the notion of compulsive fair value accounting. The liberals, though disdainful of the smell of anything touched by laissez-faire philosophy, have thus far held their noses, content for now to accept the self-imposed dhimmitude of the right and their unwitting prostration before the principle of an all-powerful god-state. Expect “pragmatic” changes in the liberal ijma on this issue shortly.
Rule 157 has its legal roots in the Sarbanes-Oxley (SOX) Act of 2002, a major government incursion into free accounting. Also under that banner of “transparency,” the law presumes companies to be guilty until proven innocent and forces them to reveal information of strategic value. SOX has been nothing short of disastrous for the economy. The list of the harm done runs like a roll of toilet paper: Decision-making has been stymied or slowed to a crawl as personnel await the squaring of their decisions with the bookkeepers, accounting costs have increased as a new army of professionals has emerged to dedicate their working lives to enforcing the new law, CEOs spend their valuable hours pouring over balance sheets to ensure no irrational bureaucrat has the pretext to fine him or send him to jail, IPO creation in the United States has virtually died, equity capital has been shunted into untried (and often fly-by-night) private equity and hedge funds, and CEO pay has skyrocketed as companies with the newly disclosed information began to engage in a salary bidding war for the best executive talent.
SOX also required bond traders to report their spreads, which demolished their profits. The most experienced bond traders then flocked to a more profitable economic niche—credit derivatives, including mortgage-backed securities. Along with the Community Reinvestment Act, the government-sponsored mortgage enterprises, and the Federal Housing Administration, Sarbanes-Oxley did its part for the supply of mortgages.
Such is the inevitable result when a government attempts to supplant the professional judgment of individuals in a free market with arbitrary decrees. What is urgently needed is a separation of the accounting profession and state. This will require an understanding of what separation consists of, why it is necessary, and why it is moral. It will require businessmen to resist the temptation to try to skulk past government or to beg bureaucrats for permission to make up accounting gimmicks, such as some of the fair value compromises or illogical asset shell games now being offered, to mitigate their losses. Businessmen have a responsibility to their shareholders to aggressively fight interference by the government on principle.
The enemies of capitalism say that this crisis is proof that a free market inevitably fails. The opposite is true. Even a somewhat free economy is extraordinarily stable, hardy, and resilient. It took a multi-decade massive government assault across a number of professions to incapacitate our relatively free economic system. Only a move away from statism and back toward freedom can restore an economy back to health.