"How do you value these damn things?" was the most memorable line from Fed Chair Ben Bernanke in remarks tonight at the Economic Club of New York. He referred to complex financial instruments, responding to a question from Henry Kaufman.
The answer amplified a theme from an otherwise studious and sober speech putting current US economic challenges in context. The formal talk's theme was hidden somewhat by its dryness. But an important point seemed to be that the sub-prime crisis was not a cause but a trigger of recent deterioration in market functioning.
The real cause is the proliferation of financial technology manifested in instruments that no one is really sure how to value. The Chairman politely but firmly criticized investor reliance on rating agencies as a substitute for doing their own risk and valuation assessments. He emphasized that investors who make bad or ill-informed decisions have, will and should suffer economic losses from doing so.
The Fed's job is limited to promoting stable prices and maximum sustainable employment, he repeated. It has to take into account the effects that financial markets can have on those goals when setting policy. But investors have to make judgments for themselves and mustn't expect ex post bailouts from the Fed or other governmental agencies.
People at my table agreed that the speech itself was a competent if dull account of the present situation and that the Chairman's answers to questions after that showed a vibrant, astute and engaged man commanding historical perspective, economic learning, and good common sense.
Kaufman's question and Bernanke's answer do underscore two points of special interest to me: (1) investors have to do a better job of valuing securities and not rely on ratings and (2) accounting standard setters need to be cautious moving toward "fair value accounting" when valuation of trillions of dollars worth of assets today is an uncertain art at best.
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1. Posted by Jake on October 15, 2007 @ 20:59 | Permalink
Nothing to disagree with here. On Larry's two concluding points, to be fair, the trend toward "fair value" accounting, like it or not, is not a new phenomenon.
Might it be possible that more aggressive standard setting on "fair value" accounting could give investors an added incentive to do a better job of valuing securities?
Finding an organization with an appetite for aggressively setting accounting standards, alas, is not easy.
2. Posted by Lawrence Cunningham on October 16, 2007 @ 15:52 | Permalink
Once again, great points, worthy of serious debate. And, sure, fair value notions are long part of traditional accounting, including US GAAP. But this is usually in pursuit of asymmetric recognition of losses compared to gains (e.g., the lower of cost or market principle and other symptoms of conservatism).
The vogue in prevalent discussions takes an interest in using market values or, when no actual market values exist, managerial estimates of market values (the so-called mark to market method). This movement jettisons notions of conservatism, including asymmetric recognition of losses.
It may be fine doing so when there are actual markets and market values, although with many difficult-to-value instruments even that proposition is uncertain. The deeper trouble is that for a vast range of instruments there is no market and no market value. The net result is proliferation of the mark to myth method (popularized by the geniuses at Enron Corp.).
3. Posted by Jake on October 16, 2007 @ 22:58 | Permalink
Again we agree. I would observe that "difficult-to-value" instruments could be better described as expensive-to-value instruments -- to anyone but the purveyor, who always has a proprietary valuation model for whatever atypical financial product he is peddling. Reconciling MTM accounting with the conservatism principle is a matter I must reflect on....
4. Posted by notaneconomist on October 17, 2007 @ 7:49 | Permalink
So, let's say I'm an investor.
Let's say I'm a bank, and I lend money out to people and they pay me interest. Let's say I'm that kind of an investor.
Let's further say that, as an investor, I invest my money in loans to non-citizens who can leave my legal jurisdiction at any time. Further, that I advertise that I haba Espanole. Further, that I don't need them to prove to me that they are legal citizens of my jurisdiction. Further, they don't even require proof of a job. Or a license. Or income.
Let's say I invest this way. And lets say that the Federal Reserve and the rest of the banking system OK these activities in the form of regulations.
Is Mr. Bernacke telling me that I should then suffer the financial consequences of my actions?
Or is he saying that someone else should take the consequences. Those who were sold worthless securities based on these underlying investments made by the very banks that he regulates?
What an incredible ponzi scheme this guy runs.
5. Posted by JorgXMcKie on October 17, 2007 @ 8:33 | Permalink
Let's say I'm dumb enough to entrust my investment resources in a shaky borrower who shows neither reason nor willingness not to disappear with the resources. Let's say the Fed and the govt don't pass regulations saying "don't be dumb and do dumb things and make dumb investments." When I do make an incredibly dumb investment (see above), who *should* pay besides myself and those even dumber who invested with me?
Are taxpayers required in the Constitution somwhere to rescue the stupid?
6. Posted by sharinlite on October 17, 2007 @ 9:53 | Permalink
JorgXMcKie, yes according to the read of the Constitution by tinfoil hatted leftist loons who run 75% of this country in one way or another. Today, being stupid, dumb or whatever label one uses is accepted and rewarded in a myriad of ways.
7. Posted by the razor on October 17, 2007 @ 11:51 | Permalink
Would a robust market for shorting CDOs and other similar vehicles provide the market signals that would allow for better (and cheaper) market-based valuations? I've not heard of such a market, but is one available and if so how well does it function?
There seems to be an imbalance between the large possible returns for investors and managers who are bullish about these types of investments, without a corresponding mechanism for similar returns for bears.
If I'm right, this could act a like a pricing ratchet with a built in bias toward rising prices until great downward pressure breaks the mechanism. this is especially true if the most aggressive actors can raise money with the help of express (FDIC insured deposits) or implied (Fannie Mae; after-the-fact) capital infusions should a steep asset price drop lead to an institution's failure.