In the old childhood game Battleship, kids would take turns taking shots at five ships on a grid they could not see. The goal was to deduce where the other player’s ships were on the grid and to destroy them by taking shots, mostly in the dark.
Today, markets are playing their own version of Battleship, but instead of playing with five plastic pieces, resembling destroyers, friggits and aircraft carriers, current market makers are playing the game with hard-to-value financial assets.
Using David Einhorn’s name as representative of the recent past, let’s remember that it was a small consortia of well researched investors who began to take shots at the assets on the books of large financial firms. Much like the game of Battleship, they first had to deduce where the bad assets might be, and then they had to size them up.
Today, most of the planet know what the bad assets might look like, mortgages, CMOs, CDO, CLOs, MBSs, etc, and it may be fair to say that the vast majority of them, at least, have been located.
However, we still have a “sizing” problem on our hands, as long as the size of these assets are allowed to shrink perpetually, beyond their “fair-market-value”.
Since I first remarked on the need to consider revising or suspending “fair value” or “mark to market” accounting for the troubled assets in the system, a great number of columns have appeared throughout the mainstream media, and the topic has reach capital hill by lobbyists for the American Bankers Association. (I’m not taking credit, just pointing out!)
Of course the argument by Bernanke and other economists that fair-value accounting is in place to promote transparency and to protect shareholders is a valid one. In normally functioning markets, assets are priced fairly and appropriately at regular intervals.
Today this is no longer the case. Markets have seized, many assets no longer trade, except when a firm is in massive distress. Firms in distress act a lot like people facing personal bankruptcy selling their most valuable assets first to raise as much cash as possible. (Think of the recent article of Dick Fuld selling his art collection.) Now imagine selling a wedding ring to a pawn shop. Sure, you’ll raise cash, but first its gonna hurt and then you are only going to get a fraction of the ring’s value anyway. Thus, the end result of that transparency today, if left unchecked, is going to result in full transparency into a growing number of insolvent firms who would raise less and less cash by selling assets whose prices are in perpetual downfall commonly known in business acumen as a “death spiral”.
There is even some chatter this morning that FASB is looking into the matter, as a possible part of the revised bailout legislation.
The following two Op-Ed pieces in the WSJ from the other day do a nice job simply summarizing some of the most salient points in the argument to suspend current fair-market value rules for troubled assets.
While the long term effects of such changes are equally unknown to the current plan, and while broad changes to the accounting rules of assets outside the purview of troubled loans might be more than drastic, the current $700 plan is at least equally opaque in its potential efficacy, but a less logical solution considered by itself.