(This guest post previously appeared at the author’s blog)
Recent “revelations” concerning the Lehman debacle highlighted a very important point: media and regulators alike have had their heads in the sand for decades. The headline of a recent New York Times article plainly makes the point: “Findings on Lehman Take Even Experts by Surprise.” If this is really true, it is quite an indictment on either the lack of intelligence or truthfulness of our regulators. Sadly, either one could be the case.
Between lobbying dollars and entrenched interests, our financial regulatory regimes have become so perverted as to have little basis in reality. I recently penned an Op-Ed in the Financial Times where I made the point that all the clamor and criticism around derivatives was ill-founded, that financial transactions completely divorced from derivatives could and have caused even more damage than derivatives themselves. The Lehman example is a case in point. This is not a story about derivatives, no more than Enron was a story about derivatives. But the key take-away should be that if our rules and regulations are so porous as to allow transactions like Lehman’s to gain approval from their “blue chip” legal counsel and expensive “Big Four” accountants, then there is a serious problem with the state of our regulatory framework.
The SEC is a highly politicized organisation and the Financial Accounting Standards Board (FASB) is a kind of self-regulatory organisation that is ultimately a stooge of industry. Consider this, taken directly from the FASB website (bolding my own):
Since 1973, the Financial Accounting Standards Board (FASB) has been the designated organisation in the private sector for establishing standards of financial accounting. Those standards govern the preparation of financial statements. They are officially recognised as authoritative by the Securities and Exchange Commission (SEC) (Financial Reporting Release No. 1, Section 101, and reaffirmed in its April 2003 Policy Statement) and the American Institute of Certified Public Accountants (Rule 203, Rules of Professional Conduct, as amended May 1973 and May 1979). Such standards are important to the efficient functioning of the economy because investors, creditors, auditors, and others rely on credible, transparent, and comparable financial information.
The SEC has statutory authority to establish financial accounting and reporting standards for publicly held companies under the Securities Exchange Act of 1934. Throughout its history, however, the Commission’s policy has been to rely on the private sector for this function to the extent that the private sector demonstrates ability to fulfil the responsibility in the public interest.
Do we need any more examples of the private sector’s inability “to fulfil the responsibility of public interest?” I think not. The FASB has accumulated exceptional power and influence over the years, yet has merely served as an appendage of those whom it was supposed to be regulating. Consider further these points made on the FASB website:
To accomplish its mission, the FASB acts to:
- Improve the usefulness of financial reporting by focusing on the primary characteristics of relevance and reliability and on the qualities of comparability and consistency;
- Keep standards current to reflect changes in methods of doing business and changes in the economic environment;
- Consider promptly any significant areas of deficiency in financial reporting that might be addressed through the standard-setting process;
- Promote the international convergence of accounting standards concurrent with improving the quality of financial reporting; and
- Improve the common understanding of the nature and purposes of information contained in financial reports.
Has the FASB really acted to improve usefulness, kept standards current, considered promptly any significant areas of deficiency and improved common understanding? It is pretty clear that they’ve broken almost every one of their stated precepts, and the SEC has been complicit in allowing this charade to continue. Someone has to call these people out and demand a change. And I am calling for nothing less than a complete de-certification of FASB and the creation of a new group of practitioners that have no linkage to industry whatsoever. Because we can’t continue with a regime that is so clearly biased and ineffective, and which has been instrumental in permitting the spate of financial “revelations” to continue apace. I think this group needs to be a mix of accounting practitioners and theorists, with the practitioners coming from the ranks of those who have gamed the system for years. Because they know best how to plug the holes that they themselves marched through for the benefit of their firms and their firm’s clients. It is akin to taking an accomplished hacker and putting them in charge of an NSA Tiger Team focused on preventing network intrusion. Who better than those who have beaten the system to fix the system?
I ultimately think this group should be part of the SEC, but that the SEC itself needs to be re-tooled. Lifelong politicos need not apply. It also needs to be staffed by practitioners who are pragmatic and beyond the influence of lobbyists and the like. They can have no conflicts with legacy firms through shareholdings or contractual relationships. The last thing we need is another Geithner/Paulson replay where their integrity and judgment is questioned at every turn because of ties to prior firms. We need people who really understand the markets and view such a position as an opportunity to impose ground-breaking change and to create a legacy of common sense, pragmatism and integrity. It would a refreshing change to the political morass that the SEC has become.
I have written many posts about changes to improve transparency, efficiency and fairness in both regulatory and accounting rule-making, but here are five issues (plus a bonus issue) I’d like to see changed – tomorrow.
1. End off-balance sheet transactions. If the substance of a transaction is a sale with all the risks and rewards of ownership transferred to another party, then take the asset and related liabilities off the balance sheet. But if there is some risk retention, even if it is structured to be “remote” (e.g., a sharp ratings downgrade; you see where that got firms like Citigroup, etc.), the assets and liabilities need to remain on-balance sheet. This would also end the use of securitization as a vehicle for improving balance sheet presentation. Debt is debt, regardless of where the obligation is housed. This covers the “Lehman type” transactions as well as those entered into by Enron and myriad municipalities. Substance over form must rule.
2. Impose mark-to-market accounting on bank balance sheets based upon asset funding. Financial assets should be marked-to-market. This has been a hotly contested issue for reasons that baffle me. Bottom line: if a financial firm does not have the financing in place to carry an asset to term, then it has to be marked-to-market. Mortgages and illiquid investments funded with short-term liabilities should not be able to be carried at cost. It creates an accounting charade that hits at precisely the worst time – when financing is hard to get and the assets are unable to be sold. But if stable financing is in place and the asset can (and is intended to) be carried for the long-term, then by all means reflect it at historical cost (less a haircut for permanent impairment).
3. Move over-the-counter derivatives transactions to exchanges. This is black-and-white; the fact that there are detractors to this shift amazes me. The focus should be on standardising derivative instruments (interest rate and foreign exchange swaps and options, credit default swaps and options, etc.) and making the use of over-the-counter derivatives prohibitively expensive through capital requirements. The OTC clearing house approach would include posting of initial and variation margin, with margin thresholds that are routinely changed based upon changes in the volatility of the hedged instrument. We have the technology and the maths to be able to do this. We should move towards this regime change immediately.
4. Create a cap on derivatives to be written equal to the physical underlying. A big part of dislocations in the credit derivatives market relates to the derivatives written being a multiple of the underlying asset. It theoretically and practically makes no sense that, for example, $5 billion of credit derivatives should be written on a $1 billion bond issue. This can create both increased volatility and increased risk of market failure upon settlement. This cap should be an immutable fixture of the derivatives markets.
5. Enact common sense rules regarding the capital structure of financial institutions. The suggested changes above will help better define the true liabilities of financial firms. But the one missing piece is the mismatch between the assets and liabilities of many firms, creating massive gaps in both interest rate and liquidity risks that have consistently brought down firms for generations. Whether “riding the yield curve” (lending long/borrowing short) and bleeding cash/draining capital when short rates spike (thousands of S&Ls in the 1980s), or getting into a liquidity crunch when asset values decline and short-term funding sources dry up (Bear Stearns, Lehman, etc.), this is a dangerous practice that has to be stopped. Maximum liquidity gaps need to be imposed, as well as policies around “Too Big to Fail” (TBTF – the source of a future post). These policies along will substantially enhance the stability of our financial sector, and create a more sustainable (though less profitable) industry.
Bonus issue: Eliminate the flawed financial presentation of leasing. This is related to (1) above. The hard-rules differentiating between operating (off-balance sheet) and capital (on-balance sheet) leases has created a multi-billion dollar industry more focused on accounting presentation than economic efficiency. If the substance of a lease is really a loan, then both the asset and the associated liabilities should be on the balance sheet. The threshold of what constitutes a “capital lease” (booking the asset and liability) should be sharply reduced to prevent transactions that fundamentally give rise to a debt-like obligation to be treated merely as a lease payment.
This is intended to be the start of a conversation, but one which is important and cannot be pushed aside or politicized any longer. The safety and stability of our financial system depends on it.