clifp
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- Oct 27, 2006
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I found this article in the WSJ very thought provoking. I don't think a WSJ sub is required but if it is here is some of the important paragraphs
One of the most important thing I've learned as an investor, and certainly Buffett talks about this a lot, is price and value can be widely separated. Now over time the price and value of asset tend to converge, but on any give day, week, month, or year they can be vastly different. Who can argue that the value of the future earning stream of all of the US corporations (and virtually the rest of the world) is ~10% lower today than it was on Friday, but the price of these same assets is.
For instance, say AIG offered insurance on credit swap involving say GE capital debt, and JP Morgan debt due in say 3 years. Now the chance of these two companies defaulting on the debt is very low. (Of course one could have said the same thing about AIG... but they haven't default yet...) . However, because of the turmoil in the system there was no market for these credit swaps, so AIG was force to value the risk associated with the insurance based some crazy prices. Imagine if the only comparable sale was credit swap for GM capital and IndyMac bank and the default risk for the lousy corporation had gone up a lot and the price/cost had decline by 10x. But regulations are regulations and if the computer models say that CDS for AAA companies are worth 2x more than junk CDS, suddenly a AIG balance sheet has taken a huge hit. However, the actual risk associated with JP Morgan or GE defaulting on debt isn't at all reflected in the price.
Another example of regulation and Congress exacerbating the problems. Increasing home ownership has been goal of Dem. and Rep. administrations for decades, with much cheering and legislation form Congress. One of the regulation that was put in place was to insure that banks didn't discriminate in lending against poor/minorities. Now this is worthy goal, but lets be honest poor people in general have worse track record of paying back money than richer people. So right now all of the Congress critters (I just heard Barney Frank complain about this.) are yelling that we didn't have regulation of non-banks making mortgage loans and that is are problem.
However, just a few years ago banks were being pressured to loan more underserved communities by Congress and regulators. To a large extent how they meet their poor/minority goals was by making funding available to mortgage broker who worked with poor people with poor credit. Viola Sub prime mortgages are born. Of course banks not being stupid didn't want to carry these crazy loans on their books and sold them off!
Bolding mine....
The crisis on Wall Street has, of course, become a political football. Cries of "moral hazard" and "socialism" on one side are drowned out by charges that the current mess is the result of deregulation, and too cozy a relationship between "Wall Street fat cats" and the current administration in Washington. If only reality were that simple. The blame game will continue, but it won't do much to fix what's broken.
Let's get a few canards out of the way: First, yes, stupidity and cupidity and complacency and hubris are involved, and yes, there is gambling in Casablanca. Second, the idea that there is this thing called "the free market" that governments tame or muck up with regulation is a fiction. Governments create the legal conditions for markets; markets shape what governments can do or are willing to do. Regulation versus free-market is a false dichotomy. Maybe in some theoretical universe, if we could start with a blank slate and construct society anew, it wouldn't be. But we exist in a web of markets and regulations, and the challenge is to respond to problems in such a way so that we decrease the odds of future crises.
And that is where AIG becomes instructive. Even good regulations can't prevent all future crises, especially ones that are the result of new technologies and changes that result from them. The capital flows, derivatives contracts and nearly frictionless interlinking of global markets today are the direct result of the information technologies of the 1990s. The implications weren't known until very recently, so it would have been nearly impossible for regulations to have prevented what is happening. But if good regulation can't prevent crises, bad regulations can cause them.
The current meltdown isn't the result of too much regulation or too little. The root cause is bad regulation.
Call it the revenge of Enron. The collapse of Enron in 2002 triggered a wave of regulations, most notably Sarbanes-Oxley. Less noticed but ultimately more consequential for today were accounting rules that forced financial service companies to change the way they report the value of their assets (or liabilities). Enron valued future contracts in such a way as to vastly inflate its reported profits. In response, accounting standards were shifted by the Financial Accounting Standards Board and validated by the SEC. The new standards force companies to value or "mark" their assets according to a different set of standards and levels.
The rules are complicated and arcane; the result isn't. Beginning last year, financial companies exposed to the mortgage market began to mark down their assets, quickly and steeply. That created a chain reaction, as losses that were reported on balance sheets led to declining stock prices and lower credit ratings, forcing these companies to put aside ever larger reserves (also dictated by banking regulations) to cover those losses.
In the case of AIG, the issues are even more arcane. In February, as its balance sheet continued to sharply decline, the company issued a statement saying that it "believes that its mark-to-market unrealized losses on the super senior credit default swap portfolio . . . are not indicative of the losses it may realize over time." Unless one is steeped in these issues, that statement is completely incomprehensible. Yet the inside baseball of accounting rules, regulation and markets adds up to the very comprehensible $85 billion of taxpayer money.
One of the most important thing I've learned as an investor, and certainly Buffett talks about this a lot, is price and value can be widely separated. Now over time the price and value of asset tend to converge, but on any give day, week, month, or year they can be vastly different. Who can argue that the value of the future earning stream of all of the US corporations (and virtually the rest of the world) is ~10% lower today than it was on Friday, but the price of these same assets is.
For instance, say AIG offered insurance on credit swap involving say GE capital debt, and JP Morgan debt due in say 3 years. Now the chance of these two companies defaulting on the debt is very low. (Of course one could have said the same thing about AIG... but they haven't default yet...) . However, because of the turmoil in the system there was no market for these credit swaps, so AIG was force to value the risk associated with the insurance based some crazy prices. Imagine if the only comparable sale was credit swap for GM capital and IndyMac bank and the default risk for the lousy corporation had gone up a lot and the price/cost had decline by 10x. But regulations are regulations and if the computer models say that CDS for AAA companies are worth 2x more than junk CDS, suddenly a AIG balance sheet has taken a huge hit. However, the actual risk associated with JP Morgan or GE defaulting on debt isn't at all reflected in the price.
Another example of regulation and Congress exacerbating the problems. Increasing home ownership has been goal of Dem. and Rep. administrations for decades, with much cheering and legislation form Congress. One of the regulation that was put in place was to insure that banks didn't discriminate in lending against poor/minorities. Now this is worthy goal, but lets be honest poor people in general have worse track record of paying back money than richer people. So right now all of the Congress critters (I just heard Barney Frank complain about this.) are yelling that we didn't have regulation of non-banks making mortgage loans and that is are problem.
However, just a few years ago banks were being pressured to loan more underserved communities by Congress and regulators. To a large extent how they meet their poor/minority goals was by making funding available to mortgage broker who worked with poor people with poor credit. Viola Sub prime mortgages are born. Of course banks not being stupid didn't want to carry these crazy loans on their books and sold them off!