Is Suspension Of Mark-To-Market Rule Irrelevant?

Good counter-argument to what former FDIC chairman Isaac and Newt Gingrich have said regarding the role of mark-to-market accounting rule:

Even if mark-to-market rules are suspended immediately, it won’t change the makeup of a company’s balance sheet. Investors have decided that these assets are toxic and no matter how a bank accounts for them in its books, that sentiment isn’t likely to change unless investors see some proof that the instruments are actually undervalued.

Read more here.

On the other hand, there is the other argument:

“For almost every bank, especially the regionals, what they’ve taken the biggest hit on is mark-to-market securities,” said (Joshua Siegel, managing principal of Stone Castle Partners, a private equity group). “This is what they needed to do first – not cut a $700bn check. They first need to take the pressure off earnings.”

For now, it appears the SEC is moving towards suspending the rule.  In the meantime, it was announced Tuesday that “managers could use their own judgment when valuing securities in illiquid markets, which means they can use measurements other than actual market prices.”  The revised rule can be read by clicking here.

I am not sure that sort of ambiguity is what is needed to help this crisis.  Perhaps a sane rule that doesn’t devalue assets based on immediate marketability would help investors better than leaving the valuation to the whim of the managers.  Further, taking the point of Phil Izzo from the Wall Street Journal’s “Real Time Economics” Blog, is it too late for the change to make a difference in the current crisis?  Can you really go back and increase the value of assets that you have already deemed toxic and worthless and expect anyone in the market to trust it?

Opinions on mark to market are strong and more and more people are speaking out on it:

• Jeff White, Financial Post; “Mark To Market Madness”
• The Motley Fool, “Mark-to-Market Accounting Basics”
• Andrew Willis, Globe And Mail, “Making the case for mark-to-market Rules”
• Joshua Boak, Chicago Tribune, “Critics Say Accounting Rule Off Mark”
• Floyd Norris, New York Times, “Mistakes Of Past Live Again”
• The Economist, “Fair Cop:  Fair Value Accounting Becomes A Political Issue”

Another To Blame: IFRS

Funny that the world markets would be tanking at the same time the US market tanks.  The arrogant American in me just presumes that it is the thrust of our power internationally that we can pull others into financial chaos when we have a large (seismic) correction.  But there is another explanation.  What a surprise – the rest of the world that uses IFRS utilize fair value accounting.  And our adoption of it was to conform better to the world’s accounting standards!

When proposing the adoption of FASB 157 (providing Fair Value Accounting for financial assets and liabilities), Leslie F. Seidman, FASB member and Board collaborator on the project, said

Today’s proposal also helps achieve further convergence with the International Accounting Standards Board, which has previously adopted a fair value option for financial instruments.

Oh my.  We are emulating the international community.  In fact, we are abandoning our own accounting standards for those employed internationally.  The same international group of nations that make up (at least part) of the United Nations, a body not known for its credibility.  Now we face an economic crisis not seen since the 1930′s and we can point to movement from the GAAP to IFRS for at least exacerbating the crisis.

Some have come out for the immediate suspension of the mark-to-market, or fair value accounting, rule. I am amazed that it hasn’t already been done.  In fact, it is surprising that the (unsuccessful) “bailout bill” only reiterated a power that is already in the hands of the SEC:  the power to suspend the rule.

The only reasons put forward are conspiratorial in nature so not worth discussing.   If in fact the suspension of the rule saves the taxpayers several billion dollars, it is in the best interest of our economy that it be suspended.  If it we do nothing but throw more money at the problem, it is my view that the correction will take much longer and a return to prosperity will be long delayed.

However, if we suspend the rule and our markets recover, then once again we can show the world how free markets prevail – without government intervention – and maybe help them re-think some of their accounting standards.

Keep in mind that even without our current crisis, our economy was already heading into an ugly time period where our growth was minimal and inflation was creeping up.  The prosperity we have enjoyed for many years is likely to end for at least a few years – perhaps more if government intervention doesn’t work or is employed improperly.

A great read on Fair Value Accounting, written by Robert E. Jensen, can be read by clicking here.

“Bailout” Includes Authority To Suspend Market-To-Market Accounting Rule

Last week I wrote about how the effects of the financial market implosion would affect law firms.  The National Review has posted a discussion draft of the House version of the “Emergency Economic Stabilization Act of 2008″ and it appears that at least one of the suggestions made by former FDIC chairmain William M. Isaac made it into the bill:  the suspension of market-to-market accounting rules (or at least the potential for suspension).  

Under section 132 of the Act,

The Securities and Exchange Commission shall have the authority under the securities laws (as such term is defined in section 3(a)(47) of the Securities Exchange Act of 1934 (15 U.S.C. 78c(a)(47)) to suspend, by rule, regulation, or order, the application of Statement Number 157 of the Financial Accounting Standards Board for any issuer (as such term is defined in section 3(a)(8) of such Act) or with respect to any class or category of transaction if the Commission determines that is necessary or appropriate in the public interest and is consistent with the protection of investors.

Further, section 133 requires a study be done to determine:

 (1) the effects of such accounting standards on a financial institution’s balance sheet;

(2) the impacts of such accounting on bank failures in 2008;

(3) the impact of such standards on the quality of financial information available to investors;

(4) the process used by the Financial Accounting Standards Board in developing accounting standards;

(5) the advisability and feasibility of modifications to such standards; and

(6) alternative accounting standards to those provided in such Statement Number 157.

Other provisions include (as reported by media outlets):

• creating an insurance program guaranteeing “troubled assets originated or issued prior to March 14, 2008, including such mortgage-backed securities”;
• creating a “financial stability oversight board” which will be responsible for:

(1) reviewing the exercise of authority under a program developed in accordance with this Act, including—

     (A) policies implemented by the Secretary and the Office of Financial Stability created under sections 101 and 102, including the appointment of financial agents, the designation of asset classes to be purchased, and plans for the structure of vehicles used to purchase troubled assets; and

     (B) the effect of such actions in assisting American families in preserving home ownership, stabilizing financial markets, and protecting taxpayers;

(2) making recommendations, as appropriate, to the Secretary regarding use of the authority under this Act; and

(3) reporting any suspected fraud, misrepresentation, or malfeasance to the Special Inspector General for the Troubled Assets Relief Program or the Attorney General of the United States, consistent with section 535(b) of title 28, United States Code.

• foreclosure mitigation efforts, including a requirement that “the Secretary shall consent, where appropriate, and considering net present value to the taxpayer, to reasonable requests for loss mitigation measures, including term extensions, rate reductions, principal write downs, increases in the proportion of loans within a trust or other structure allowed to be modified, or removal of other limitation on modifications;”
• Mortgage assistance, including encouraging mortgage holders “to take advantage of the HOPE for Homeowners Program under section 257 of the National Housing Act or other available programs to minimize foreclosures.”  Such assistance also includes reduction of interest rate and reduction of loan principal;
• Prohibiting “golden parachutes” for executives of companies in the event of involuntary termination, bankruptcy filing, insolvency or receivership – although the terms aren’t included in the Act.  Instead, the Act requires the Secretary of the Treasury to come up with guidelines within 2 months of the Act’s enactment;
• Minimize negative impact to taxpayers by selling the assets only when the asset’s value is high (among other provisions);
• Limiting authority to purchase assets to $250 billion at any given time, except when given the written certification by the President, in which case the amount may be up to $350 billion.  Congress then has 15 days to enact a joint resolution of disapproval – if none is made, the amount increases to $700 billion;
• Requiring the financial sector to reimburse the treasury for any assets sold at a loss.

To read all of the provisions of the House version, click here.

In my view, short term jubilee, long-term disaster and further eroding of capitalism in America.  As my contracts professor in law school would say when discussing government intervention in markets, “Hello Havana!”

How The “Market Meltdown” Affects Your Law Firm

This past week has been a scary time for the financial markets.  According to democrat Senator Chris Dodd last week, “we’re literally maybe days away from a complete meltdown of our financial system, with all the implications, here at home and globally.”  The New York Post reported that traders were “500 trades away from Armageddon on Thursday” with pre-open sell orders inundating the market and forcing the fed to pump $105 billion into the market to avoid a total collapse of the financial system.   There is little question that last week was historical.

I don’t believe that the end of this crisis is near.  The Executive Branch, along with the Federal Reserve, is planning a “bailout” (or what I would rather call a “clean out”) of the albatross of bad mortgage debt that is seriously deprecating the value of bank collateral and causing institutions to stop lending to each other.   Some are saying upwards of $1 trillion.  You can add another trillion to that (UPDATE:  Try $30 trillion).  And this is to just keep our financial system from collapsing.

The damage has already been done.  Our economy will be feeling the effects of the past week well into next year – and perhaps for several years to come (and I am not counting the effect of the massive printing of money to pay for the bailout).

What caused this to happen?  And how does it affect your law firm?  

In the Friday (September 19th) Wall Street Journal, William M. Isaac, chairman of the Federal Deposit Insurance Corporation from 1981-1985, wrote an opinion piece titled “How To Save The Financial System“.  Mr. Isaac compared the current crisis with the one he faced when chairman of the FDIC – at that time, the prime rate was 21%, the savings bank industry was insolvent more than $100 billion, “the S&L industry was in even worse shape, the economy plunged into a deep recession, and the agricultural sector was in a depression.”  3,000 banks and thrifts failed.  However, if the rules that are in place now were in place then, Isaac argues, it could have been much worse:

The country’s 10-largest banks were loaded up with Third World debt that was valued in the markets at cents on the dollar. If we had marked those loans to market prices, virtually every one of them would have been insolvent. Indeed, we developed contingency plans to nationalize them.

The economic conditions of the current crisis were nowhere near as bad as it was then.  What caused an estimated 20% loss to mortgage debt to institutions that held them to bring our financial system to the brink of collapse?  Isaac believes “[t]he biggest culprit is a change in our accounting rules that the Financial Accounting Standards Board and the SEC put into place over the past 15 years: Fair Value Accounting.”  

Fair Value Accounting dictates that financial institutions holding financial instruments available for sale (such as mortgage-backed securities) must mark those assets to market.

The rule can be a boon for an asset when times are good.  However, a company must also “mark the assets to market even though there is no meaningful market”.  Even though the value of the assets are depressed because of market conditions, not actual value of the asset, regulators have still required that accountants continue to mark down assets as the market tanks.  This has led to heretofore financially secure banks to go to the brink of bankruptcy within days of bad news.  Isaac argues that regulators must suspend such rules when the health of the industry is at risk.  

On November 15th, 2007, Fair Value Accounting was officially enacted by the FASB in rule FAS 157.

Isaac also argues that regulators should suspend the “naked selling” (or short selling a stock without possessing it).  Late last week it was announced a ban on short selling altogether.  This sweeping measure was met with opposition by options traders, who argued that the ban was “a draconian measure that will result in the sudden and severe removal of liquidity from the marketplace.”  The argument is that disallowing short selling altogether prevents investors from learning the real value of a company – in essence, taking away information from investors – and thus will discourage investment.  Isaac only argues for the ban of “naked selling”, not all short selling.

Finally, Isaac argues that the new Base II regulations, though perhaps too new to have caused this crisis, must be suspended before they make matters worse:

Basel II requires the use of very complex mathematical models to set capital levels in banks. The models use historical data to project future losses. If banks have a period of low losses (such as in the mid-1990s to the mid-2000s), the models require relatively little capital and encourage even more heated growth. When we go into a period like today where losses are enormous (on paper, at least), the models require more capital when none is available, forcing banks to cut back lending.

Contrary to the rhetoric coming from both Presidential campaigns, the problem hasn’t been lack of regulation – but the regulations (and regulators) themselves.  At this point it is academic, and any remedy will not undue the damage done.  What firms need to do is prepare for cash flow problems in the near and long term.

As with any economic slowdown, transactional practices will suffer and litigation will do well.  However, if lending dries up, firms need to confront the possibility of losing significant numbers of corporate clients.  They also need to confront the high probability of clients having difficulty paying their bills.

As law firms are typically the bottom of every client’s stack of invoices (due to the lack of late fees and interest – unless you are one of those who actually charge for lack of payment), it may be a good idea to consider retainer billing your corporate clients.  Retainer billing simply requires a certain amount to be paid up front and set off against work performed.  When the retainer goes below a certain amount, a letter is sent to replenish the funds.  This ensures cash flow and, in coordination with setting budgets for services, can provide clients with some cost certainty – something corporate clients will be requiring with more and more frequency.

If your firm hasn’t addressed receivables that are over 90 days and don’t have a coherent, consistent, and reliable collections process, the time is now to develop and implement one.  It may be the difference between your firm managing a difficult economy and becoming a victim of it.

Quote of the day

”These two entities — Fannie Mae and Freddie Mac — are not facing any kind of financial crisis,” said Representative Barney Frank of Massachusetts, the ranking Democrat on the Financial Services Committee. ”The more people exaggerate these problems, the more pressure there is on these companies, the less we will see in terms of affordable housing.”

from the New York Times, September 11, 2003 (click to read the entire article).

The cause of the current financial crisis can be traced to the insistence, by Congress, that financial institutions provide “affordable housing” to those who couldn’t afford it.  Congress is to blame, not President Bush.

Penn & Teller On World Peace

Penn & Teller have an Showtime series called “BS” (shortened).  One of the more recent shows was posted on YouTube and is pretty funny (and in my opinion spot-on accurate) – a good way to start the weekend.  (Language warning – Penn is not diplomatic with speech or use of acceptable words:  read:  curse words used.  Watch at own risk).

Penn & Teller on World Peace: Part I

Penn & Teller On World Peace:  Part II

Penn & Teller On World Peace: Part III

The Case Against Universal Healthcare

A major part of the Democrat platform is the advancement of universal health care.  And who would blame them?  The health care system is ridiculous.  It is as far away from market-based as it has ever been in this country.  But is the solution to have it centrally managed by the federal government?  Or to return it to it’s market-based roots?

In my opinion, health care costs were bad in 1992, but since then have spiraled out of control.  I believe some measure of blame can be made on the universal coverage push made by then First Lady Hillary Clinton.  Though the objectives were noble, it mandated employers cover employees via heavily regulated HMOs.  HMOs had been around since the early part of the 20th century, but it wasn’t until the 1980′s in response to threatened socialization of medicine that they became popular.   The commercialization of HMOs came to a head in 1992, when for-profit HMOs were more numerous than non-profit HMOs.

There is little question that the 1993 health care plan exacerbated HMO growth and insurance carriers have taken over health care decisions ever since.

So is the answer federally guaranteed health care?  I went to a specialist the other day (referred by my primary care physician who seems more a referral stepping stone than a physician) who was refreshingly frank as to why doctors wouldn’t perform a certain procedure that used to be routine – lack of repayment by insurance carriers.  Insurers are controlling doctor decisions.  Even when doctors will perform procedures, they have to go through hoops to ensure payment even if they are certain the procedure must be done.  This causes needless delay and makes health care more expensive.

If I were a conspiracy theorist I could easily blame this on those seeking to instill universal healthcare on us – make the system so unworkable that people just want something different – change.

I prefer to think it is the meddling of health care by politicians with good intentions but with poor business sense.  If I were to go to 10 attorneys, I would get 10 variances in quality representation.  Based on the results, demeanor and cost I could determine who was the best and go to that attorney.  If I were to go to 10 doctors, I can only choose based on results and demeanor.  Cost is completely out of the picture.  This takes a market force and throws it in the trash – and is wrong.

Our country has safety nets for indigents that are subsidized by taxpayers – Medicare, Medicaid, and the Emergency Medical Treatment and Active Labor Act, which requires ambulance and hospital access to anyone regardless of citizenship status, legal status or ability to pay.

However, there is a problem with insurance coverage and preventative care.  Solving it, in my opinion, requires giving consumers the freedom to choose their care based on their pocketbook – not the pocketbook of an insurance carrier.  If individuals were able to choose care and insurers were only able to insure against catastrophic care (something, like any other supplemental insurance, can be done relatively inexpensively) the cost of care would reduce.

How?

How does the market work in every other arena?  Competition. Competition fosters efficiency and innovation and that leads to lower costs.

The alternative is universal care, or socialized medicine.  The argument for socialized medicine always starts with “every other industrialized nation has it”.   The Cato Institute has an article from 1996 that addresses European socialized medicine.  A highlight:

The Europeans have run into a very simple economic rule. If something is perceived as free, people will consume more of it than they would if they had to pay for it. Think of it this way: if food were free, would you eat hamburger or steak? At the same time, health care is a finite good. There are only so many doctors, so many hospital beds and so much technology. If people overconsume those resources, it drives up the cost of health care.

I maintain that we have been operating under a semi-socialized system for several decades.  Even if you consider the cost of health care in your paycheck, if you have met your deductible or have unused purchased health care, you are apt to use it more often, regardless of need.

I also believe that if the federal government were to control health care (and the cost of health care) it would damage the system tremendously.  Why?  Because lower cost reduces the incentive for quality doctors.  The best doctors would be in highest demand and those who don’t want to sit on a waiting list would pay a premium.  In other words, the only people would would benefit from universal care would be the rich, those who could afford paying extra.

Don’t fall for the rhetoric:  universal health care is a bad idea.  Our health care system needs to be fixed, but instead of socializing the system, we should look to lessening the presence of insurance companies in health care decisions.  In my view, putting the cost decision in the hands of consumers is a good step.

A federal tax incentive for saving for health care would encourage saving for your needs.  Rather than forcing you and your employer to set aside over a thousand dollars per month for a family of 4 that is paid to an insurance carrier, how about saving it in a money market account?  Then if you don’t use it, it accumulates and if you live long and healthy, you have saved up a nice retirement supplemental fund.

Catastrophic care needs insurance.  However, the risk associated with this for those who are healthy are low, meaning low premiums.  For those with chronic ailments, I believe the taxpayers are willing to help expand the safety net for those who need it.  It will still cost less than covering everyone.

What do you think?  Do you think universal coverage is a good idea?  Please let me know why.  If not, please give me your opinions on an alternative to what I propose above.

Amlaw Daily: Profit Down in 2008

AmLaw Daily reports that during the first two quarters of 2008, “profit margin compression–that is, expenses increasing faster than revenue–was the greatest it’s been in the last eight years.”  The Wall Street Journal Law Blog takes a look at the highlights of the report:

• Too many lawyers:“Because law firms continued to add lawyers to their ranks despite the drop-off in demand,” writes [Citi Private Bank’s Dan] DiPietro, “firms experienced a slowdown in productivity comparable to the second quarter of 2001 and lower than every other second quarter between then and now.”
• Unproductive lawyers, beware: Among other things, DiPietro advises firms to “consider sending a tough message to unproductive lawyers at every level,” and to “conduct a systematic expense review to eliminate redundant or nonessential support staff and functions.” As for hiring in a soft economy, he writes: “[I]t’s particularly important to vet candidates to differentiate between laterals who are looking to move because they’re not happy and those who are looking to move because their firms are not happy.”
• Associate bonuses (a/k/a “The elephant in the room”):DiPietro is paring back earlier estimates for 2008 profits-per-equity-partner. “[W]e now believe PPEP will be flat, or even down by as much as 10%, in 2008,” he writes. “The top-tier firms will have an even tougher year, with profits down by 5-15%. Our reason for providing a range is that there is an elephant in the room: How will firms, particularly the top-tier firms, handle associate bonuses this year? The rational approach would be to pare them back, but, while lawyers display rationality and dispassion in the practice of law, they have exhibited ‘irrational exuberance’ on this issue in the past.”
• Most profitable firms hit hardest:Demand drop-off and expenses were accelerated at a more rapid pace at the top firms, writes DiPietro. He explains that top-tier firms tend to rely on high-end private equity deals, securitization, and structured finance, and have more financial service clients. Now, with those markets in decline, top-tier firms “are paying the price,” and the practices that firms typically rely on in a downturn, such as restructuring, bankruptcy, and litigation, haven’t helped “cushion the drop-off in transactional work.”
• A silver lining?“A bad year (and the numbers suggest 2008 will be even more trying than 2001, when partner profits were down slightly),” writes DiPietro, “will enable firms to take steps that partners would resist in a good year-winnowing out unproductive lawyers and applying greater discipline to expense control.”

 What can law firms take from this report?  Measure performance.   Of Counsel Consulting was created to help firms perform better.  Whether you need help in determining your profit drivers, need help in measuring them, or need help in implementing technology to make you more efficient, Of Counsel Consulting can help.  For more information, call (205) 588-4OCC (4622).

Russia Re-Establishing Ties With Cold War Allies

History is a great teacher.  Just think, it was less than 100 years ago when a fateful crime was committed that started a chain of events affecting most of the world for arguably 80 years.  The crime was the assassination of the ArchDuke of Austria, Franz Ferdinand, by Serbians ostensibly authorized by top officials of the Serbian government.

The response by Austria was an ultimatum that, if accepted, could have changed the course of history.  But that isn’t the subject of this article.  Serbia was backed by Russia and Austria was backed by Germany.  Both of the small Baltic countries knew that they had “super powers” who would help them defeat their opponent.  The result was the first of two World Wars that would dominate the 20th Century and a cold war between the remaining super powers that would only end in the twilight of the Century.

What is occurring now in Eastern Europe is eerily reminiscent of 20th Century politics.  The US has encroached into Eastern Europe, threatening Russia, and Russia has been consolidating their influence on their former satellite countries.  And today it was announced that Syria, another of Russia’s Cold War allies, is in talks to purchase Russian weapons in exchange for allowing Russia to re-establish a port base in their country, giving Russia’s Navy ”its first foothold in the Mediterranean for two decades.”

Poland just signed a treaty with the US for a missile system, and both Poland and the Ukraine are desperately trying to get into NATO before a feared Russian invasion of their countries.  Georgia’s membership has “kicked off” already.

Arguably, the real driver that is causing this unrest to “bubble up” is oil.  Oil is still at record prices and the area is flush with the stuff.  It is still the rule that he who controls the oil controls commerce. 

What this means to business is, unfortunately, the end of two great decades of record sustained growth.  Political unrest and widespread war that affects oil supplies will keep the money of investors away from the volatile markets (and thus sapping the life out of the main driver of risk and by extension growth).  Our best hope is to keep inflation at low levels to maintain the value of our currency.

From the looks of it, that too is taking a turn for the worse.  Globally, central bankers are avoiding the tough decisions and are keeping interest rates low.  The reasoning, according to Lehman Brothers Holdings’ chief economist Ethan Harris is that “[n]ext year we’re going to have extremely low inflation, and a lot of that weakness is due to the decline in energy prices“.  We’ll see.  For the moment, the federal reserve has decided not to raise interest rates in the hope that Harris’ prediction pans out.

The fall of the Soviet Union wasn’t a quick process.  It seemed that way on Christmas day, 1991, when Gorbachev resigned and ceded power to Boris Yeltsin.  Moreover, the time period between the start of Gorbachev’s glasnost and perestroika programs and the dissolution of the Soviet Union was only 4 years.  Perhaps ironically, it was the war with Afghanistan that was one of the driving forces behind perestroika. 

Today the US almost mocks Russia with its rhetoric.  Calling Russian comments “bizarre” and “losing their credibility”, Secretary of State Rice joins others who still look at Russia without respect for its past.  You’d think that one who had served under Brent Scowcroft as his “Soviet Expert” in the National Security Council under George H.W. Bush would understand the Russian mindset.  In fact, “according to R. Nicholas Burns, President Bush was ‘captivated’ by Rice, and relied heavily on her advice in his dealings with Mikhail Gorbachev and Boris Yeltsin.” 

I am not sure whether Georgia started this or if Russia is using the situation to expand its influence.  The fact is that Russia is expanding its influence.  Whether the alliances are short term or if this is the beginning of a military build-up is not certain.   

We can only hope that the alliances Russia is toying with creating is more a show of frustration rather than long-term intent.  We seriously can’t afford another cold war.

Core Inflation Soars to 5.6%

The July Consumer Price Index was released today and core inflation soared to its highest rate since January of 2001. This follows a trend I noted on More Partner Income in March where I discussed the impact inflation has on your firm’s bottom line.

Inflation for the year is averaging 4.4%. Please keep in mind that inflation has averaged under 3% for the past two decades. Your forecasting needs to include the deflated value of your purchasing power. Expect the Federal Reserve to increase interest rates soon to counter the inflation threat.

UPDATE 8/15/2008:  Federal Reserve officials state that although inflation is a concern, it will “fade over time“.  They are even talking lowering rates.  For those who hated Chairman Greenspan’s philosophy, it looks like we will see what it’s like to not be a hawk on inflation.  My suggestion:  save money.

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