I might stand corrected
Last night, I had dinner with several venture capitalist guys who are all a heck of a lot smarter on the financial markets situation and the proposed bailouts than I am. Here was the crux of the conversation:
1) The largest issue with the banking crisis is FAS 157 (FASB is the Financial Accounting Standards Board and FAS is Financial Accounting Standard). FASB is the organization that recommends and implements financial accounting standards for all businesses is the US and is generally driving many international accounting principles. They start with a recommendation and the allow for discussion on the recommendation, then in most cases the recommendation becomes a regulation. Once the recommendation becomes a regulation, the regulation becomes part of GAAP (Generally Accepted Accounting Principles) and most companies implement immediately. More on FAS157 below.
2) The bailout is needed. The reason the bailout is needed at this point is FAS 157 creates a “death spiral” for the broader financial markets. Again, look below for explanation. Everyone at the table agreed that the bailouts were a bad thing, and certainly a bad direction for the country, however, it was just about the only thing we can do to prevent a wider collapse of the financial industry.
FAS 157 and the economy
In its simplest form, FAS 157 talks about valuation. In the past, companies (Savings and Loans, Japanese Banks, Enron, etc.) artificially inflated or stated valuation of assets. This placed the shareholders in a situation where they were unable to understand the true financial situation of the company. FAS 157 basically says a companies valuation on assets must reflect what those assets could sell for on the open market TODAY. Not yesterday, not last year, nor next year. This sounds like a great idea right?
Well, yes and no. The issue we are having today is: Let’s say I am a bank and I have 1000 mortgages in my portfolio. All 1000 loans are current and in good standing. Each loan is $100 in value and I am receiving a 6% year over year return. I would be receiving $6,000 of revenue and my portfolio would have a valuation of just about $100,000. This is a great situation for a bank! However, apply FAS 157 to the valuation of the loan portfolio in today’s economy. No one is buying mortgage paper (by this I mean no banks will buy the mortgage, this issue has no effect on the homeowner), which means even though I have a well performing portfolio of loans, the market value is as little as 5% of the true value of my portfolio, which means I now have to adjust my valuation from $100,000 to $5,000! Nothing has happened, I am not losing money, my bank is in great shape, however I just took a write off of 95% of my portfolios net worth! Multiple my number by millions and that is in large part the issue we are seeing with the banks and investment companies.
We have been lead to believe these banks are losing billions of dollars, and in most cases they are not losing money, they are losing valuation due to FAS 157. Add an additional ingredient: most banks have a requirement to maintain a certain amount of capital (money) in reserve. These banks now have to raise up to 95% of their old valuation to make FAS 157 work with the existing capital. It is a crazy situation and the worse the market gets, the more value all of the portfolios lose, causing more write downs. FAS 157 is the principle cause of the spiral we are in.
I am not smart enough to understand the global implications of rolling FAS 157 back, and many banks adopted FAS 157 1/1/07, which is 11 months earlier than they had to. They did this for two reasons: 1) It is easier to account for a whole year using the same account practice for the entire year. 2) In many cases the bank received greater valuation for current assets.
The bailouts will grant capital to banks and other institutions caught in the FAS 157 death spiral, and prevent the economy from sinking deeper and deeper into the abyss. Again, understand, the core issue here is an accounting issue, not a true fundamental economic issue.
I remain opposed to the government socializing our insurance and banking industries, but I think I better understand WHY we are here and HOW we can get out of the death spiral we are in.
Again, everything above might be wrong. I will endeavor to investigate this futher and post my finding here.
Now McCain is trying to take the high road. He is going to postpone the debate so he can work on the financial bailout. He has not been involved involved in the discussions before. He is trying to pretend he knows something about economics. I have really lost a lot of respect for the man in the last 4 weeks.
The venture capitalists have a lot of gain if the bailout happens. It is not really as simple as they make it out. A lot of people made loans that they should not have made. A lot of companies decided since the house prices were going up there was no risk to those loans and decided to insure them to make some “free” money on premiums. I am not an accountant but most of the loans are sold to investors so the banks do not have them assets anyway so they do not follow under those rules.
I would like to see the bailout happen with a package to include new regulations. GW is not known for following through on his plans to overhaul the system. I am not saying there has to be a ton of regulation but when you are loaning money to people without proof of income — that is criminal and should not be rewards. I had to have tax returns and check stubs when I applied for my loans.
Actually, I have been doing research on this. The current foreclosure rate is not nearly as high as we have been lead to believe. The current rate is around 2% and it has been as high as 3.5% in the last 20 years.
I certainly agree that the banks should be penalized for loaning money irresponsibly, however if you really dig into the detail of FAS 157, it is pretty clear WHY the banks are being forced to take huge write downs. BofA did not have billions of dollars in loans default, BofA’s portfolio was devalued due to FAS 157.
I am hesitant to drag McCain into this (frankly, I did not catch the news last night). He is a part of this, but he really has no more power than 99 other senators at this point.
As far as the Venture Capitalists are concerned, since most of their money is in private equity, a bailout does not have a direct correlation with them except they own private companies that will be impacted by a financial downturn (just like everyone else in the country)