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.