Tuesday, September 30, 2008

Sarbanes Oxley fallout

Here's a good piece by a fellow accountant on one thing the feds could do to ease the fallout of the credit crunch. Suspend the Sarbanes Oxley provisions dealing with mark to market.....
Why should America attempt an expensive, controversial, and possibly ineffective bailout strategy for the current financial crisis when a virtually costless and simpler change could solve much of the problem?

We accountants don't like publicity. Fortunately, we don't get much. Most of the public remembers Enron, but fewer remember Arthur-Andersen, the big accounting firm that went down with them. Questionable accounting was a big part of the reason for Enron's failure. I think accountants may be behind the scenes again in the current financial crisis. Are there any of us bean counters in those meetings? If there are, my bet is that they are sitting on their hands and keeping their mouths shut even though they might know about a much better (and cheaper) solution. Accountants, after all, don't talk much; and they don't like to admit errors.

Pouring 700 billion of our money into failing financial institutions seems akin to throwing spaghetti against the wall. Keep throwing until something sticks. They tell us that credit will dry up if we don't inject cash. No credit would be disastrous for the economy, but they have not explained well enough why the banks have failed so suddenly and drastically that emergency room surgery is required. Knowing why would help us poor taxpayers feel better about how the problem should be solved. Ever wonder how many other bank failures are out there waiting behind the curtain to take their bows? Are we going to throw even more money at them too?

Should we consider a solution that requires no money, or at least a lot less? Here's one. Have the SEC suspend the accounting rule called mark-to-market. By a relatively simple accounting adjustment, troubled banks' assets and capital could be increased and credit kept available. Accounting purists, cover your ears. Eyes glaze and minds wander when I say balance sheet, so let's use the acronym BS, a more appropriate description. BS's have two sides: assets on the left, liabilities and capital on the right. Banks are required to maintain certain levels of capital (the difference between assets and liabilities) in order to make loans. When assets shrink, capital shrinks. When the ratio of capital to assets drops to a certain level, (think ten-to-one), banks are not allowed to make loans. And if it drops too low, they can be classified as insolvent. This can happen overnight, and it did.

Why? Wall Street is essentially driven by emotion and the news of the day, so when nobody wants a particular security, the price falls fast and hard. Do I believe in efficient markets? Yes, eventually, but markets are often wrong for periods of time ... think years. Therefore, we are marking assets down to near zero based on markets that fluctuate wildly from minute to minute. The media have hammered us with news about drops in home prices and increases in mortgage delinquencies to the point that nobody wants to own these assets. A few rotten apples have spoiled the whole barrel. Sub-prime loans and the securities they are bundled into have plummeted in value, sometimes to zero, because nobody wants to touch that barrel, even if most of the apples are still good. Banks marked them to their current value, billions in capital disappeared with the stroke of a pen (excuse me, stroke of a key.)


The introduction of Sarbanes-Oxley has been largely overlooked as a cause of the current crisis but it created a scenario whereby much capital left the New York market for London to avoid many of the provisions of Sarbanes Oxley.

One more mess the government now has to clean up from its own creation.

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