3 Right-Now Economic Remedies (Financial System)

[Indiana Oracle]

Although a majority of America is invested in the stock market, its mechanisms are often not well known. One reason is that most folks own managed mutual funds under 401k plans.

But these are unsettling times and concrete, right-now, effective economic solutions from Washington for the financial system (the lubricant of all global economies) seem to be in very short supply, to put it kindly.

With the widespread public outrage over the nature and use of spending package(s) being contemplated by the Congress, there is good news: concrete ideas are now being discussed and something approaching considered debate is showing signs of life.

Here are three very important items to understand as this debate unfolds:

1. Ban Naked Short Selling [fixed]
2. Reverse Mark-to-Market asset accounting [not yet fixed]
3. Reinstitute the Uptick Rule [not yet fixed]

Naked Short Selling is Now Banned

A good thing from the SEC in 2008 to help bring more order to the markets.

Washington, D.C., Sept. 17, 2008 — The Securities and Exchange Commission today took several coordinated actions to strengthen investor protections against “naked” short selling. The Commission’s actions will apply to the securities of all public companies, including all companies in the financial sector. The actions are effective at 12:01 a.m. ET on Thursday, Sept. 18, 2008.

Short Selling: When short sellers borrow shares of stock so as to sell them in anticipation that the price will fall. If the price drops, they buy the cheaper actual shares to cover the borrowed ones, pocketing the difference. No harm, no foul.

Naked Short Selling: When sellers do not borrow existing shares and speculate outright, looking to offset their positions shortly after the sale. Such activity, when well-financed or in low trading volume situations, can allow manipulators to drive what is known a “bear raid” on a stock. The price can quickly fall to unjustified levels from which it may not recover for a protracted period due to the psychological effect the drop had on normal investors. There is no question that a lot of this have been going on since 2007.

Reverse Mark-to-Market Bank Asset Accounting

It can be well-argued that Mark-to-Market (MTM) was yet another Washington idea with good intentions (presumably) that has gone wrong in practice. MTM accounting rules have forced banks to recognize billions of dollars in losses on mortgage-related securities. Debate on this topic is finally taking place.

What is MTM

Mark-to-market accounting sets the value of (or “marks”) assets on balance sheets to reflect their market sale prices.

Loans and securities make up the bulk of a normal (vs. investment) bank’s assets. Thus, the method used to establish values for this securities affects shareholders’ equity. (Shareholders’ equity = assets – liabilities) That, in turn, has an effect on a bank’s profit and loss statement. From there we develop a perception of the bank’s financial health.

For public companies using the MTM method, there are three methods of pricing stock shares (securities being one type of asset):

• Level One is where the stock is actively traded; a normal stock, such as GE.
• Level Two stocks do not have market prices due to their not being actively traded and are priced using the Fed model which bases pricing on similar stock prices.
• Level Three is an estimated market price; Level One or Two cannot be used (where most toxic back assets are right now).

Does MTM Work

Not effectively.

When the markets are booming, the assets are over-valued which can lead to unintended consequences. When it is in crisis MTM overstates negativity since stocks are sold for distress reasons and in some cases stop trading altogether.

The Bank for International Settlements (basically, the central bankers’ central bank) has suggested:

…applying mark-to-market accounting to today’s triple-A-rated subprime mortgage securities, could overstate expected total losses by as much as 60%.

In this testimony of William M. Isaac, (Chairman, the Secura Group of LECG, Former chairman, Federal deposit insurance corporation; before the Subcommittee on Capital Markets, Insurance, and Government-Sponsored Enterprises: U.S. House of Representatives Committee on Financial Services, Washington, DC, March 12, 2009), he argued:

MTM accounting has destroyed well over $500 billion of capital in our financial system. Because banks are able to lend up to ten times their capital, MTM accounting has also destroyed over $5 trillion of lending capacity, contributing significantly to a severe credit contraction and an economic downturn that has cost millions of jobs and wiped out vast amounts of retirement savings on which millions of people were counting

I agree with the thesis, that TARP was an unnecessary expenditure and did and has so far not addressed root problems in the banking sector – one of which is MTM accounting.

Reinstitute the Uptick Rule

What is the Uptick Rule

The Uptick Rule is a Securities and Exchange Commission (SEC) trading rule used to regulate short selling in the financial markets. The rule limits the timing of short sales. It mandates, subject to certain exceptions, that a security can only be sold short (speculating it will fall in price) above the preceding price. There are nuances, but that is the gist of it.

It was put in place in 1938. In 2004 as the market was rising out of 2002, it was eliminated. Another monument to the fallibility and fallen nature of man. Calls for its reinstatement have been coming for some time now.

Reinstating the Uptick Rule, will not stop markets from falling. But it will make huge downside runs less frequent and probably less extreme, thereby mitigating against the bear raid mentioned previously. The point of reinstating it is to bring a more order to the markets.
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[editec]

I've been trying to wade though the arguments for MTM for some time now.

On one hand, if a bank is assessing the value of its bonds inappropriately and lending based on those dubious claims, it certainly does make sense to limit their ability to lend based on false values.

OTOH, that's EXACTLY how this banking crises started, too, wasn't it?

As long as we all pretneded (or imagined) that the American people can afford to pay (on average) four times their annual median incomes for the median home, those bonds (based on those mortgages taken out on those overpriced homes) had value, hence the banks were solvent.

As I understand things now, if we impose MTM on the banks they're pretty much ALL insolvent, so we're guaranteeing (to the bond holders) that we'll cover the difference between what the bonds owe, and what they're actually worth.

And it is my understanding that the difference is NOW estimated to be somethig in the neighborhood of $9 TILLION.



This whole problem REALLY stems from the fact that the median price of real estate has run out of kilter with the median family income.

If the median family income is about $57,000 (as it was) then the median home price should have been not more than about $78,000.

It was, last I heard, more like $200,000.

So American borrowed foolishly, and banks let foolishly, and the Moddy's and Standard and Poor rated bonds incorrectly (given the rish inhernet in this lopsided incomes to home prices for4mula, I mean) and the whole god damned thing collapsed when the NINA loans (that should never have been given to begin with) showed us ALL what just how badly the thing had gotten our of kilter with reality.

Have I about got it right as you understand it, Indiana?

 

[wimpy77]

Although a majority of America is invested in the stock market, its mechanisms are often not well known. One reason is that most folks own managed mutual funds under 401k plans.

But these are unsettling times and concrete, right-now, effective economic solutions from Washington for the financial system (the lubricant of all global economies) seem to be in very short supply, to put it kindly.

With the widespread public outrage over the nature and use of spending package(s) being contemplated by the Congress, there is good news: concrete ideas are now being discussed and something approaching considered debate is showing signs of life.

Here are three very important items to understand as this debate unfolds:

1. Ban Naked Short Selling [fixed]
2. Reverse Mark-to-Market asset accounting [not yet fixed]
3. Reinstitute the Uptick Rule [not yet fixed]

Naked Short Selling is Now Banned

A good thing from the SEC in 2008 to help bring more order to the markets.

Washington, D.C., Sept. 17, 2008 — The Securities and Exchange Commission today took several coordinated actions to strengthen investor protections against “naked” short selling. The Commission’s actions will apply to the securities of all public companies, including all companies in the financial sector. The actions are effective at 12:01 a.m. ET on Thursday, Sept. 18, 2008.

Short Selling: When short sellers borrow shares of stock so as to sell them in anticipation that the price will fall. If the price drops, they buy the cheaper actual shares to cover the borrowed ones, pocketing the difference. No harm, no foul.

Naked Short Selling: When sellers do not borrow existing shares and speculate outright, looking to offset their positions shortly after the sale. Such activity, when well-financed or in low trading volume situations, can allow manipulators to drive what is known a “bear raid” on a stock. The price can quickly fall to unjustified levels from which it may not recover for a protracted period due to the psychological effect the drop had on normal investors. There is no question that a lot of this have been going on since 2007.

Reverse Mark-to-Market Bank Asset Accounting

It can be well-argued that Mark-to-Market (MTM) was yet another Washington idea with good intentions (presumably) that has gone wrong in practice. MTM accounting rules have forced banks to recognize billions of dollars in losses on mortgage-related securities. Debate on this topic is finally taking place.

What is MTM

Mark-to-market accounting sets the value of (or “marks”) assets on balance sheets to reflect their market sale prices.

Loans and securities make up the bulk of a normal (vs. investment) bank’s assets. Thus, the method used to establish values for this securities affects shareholders’ equity. (Shareholders’ equity = assets – liabilities) That, in turn, has an effect on a bank’s profit and loss statement. From there we develop a perception of the bank’s financial health.

For public companies using the MTM method, there are three methods of pricing stock shares (securities being one type of asset):

• Level One is where the stock is actively traded; a normal stock, such as GE.
• Level Two stocks do not have market prices due to their not being actively traded and are priced using the Fed model which bases pricing on similar stock prices.
• Level Three is an estimated market price; Level One or Two cannot be used (where most toxic back assets are right now).

Does MTM Work

Not effectively.

When the markets are booming, the assets are over-valued which can lead to unintended consequences. When it is in crisis MTM overstates negativity since stocks are sold for distress reasons and in some cases stop trading altogether.

The Bank for International Settlements (basically, the central bankers’ central bank) has suggested:

…applying mark-to-market accounting to today’s triple-A-rated subprime mortgage securities, could overstate expected total losses by as much as 60%.

In this testimony of William M. Isaac, (Chairman, the Secura Group of LECG, Former chairman, Federal deposit insurance corporation; before the Subcommittee on Capital Markets, Insurance, and Government-Sponsored Enterprises: U.S. House of Representatives Committee on Financial Services, Washington, DC, March 12, 2009), he argued:

MTM accounting has destroyed well over $500 billion of capital in our financial system. Because banks are able to lend up to ten times their capital, MTM accounting has also destroyed over $5 trillion of lending capacity, contributing significantly to a severe credit contraction and an economic downturn that has cost millions of jobs and wiped out vast amounts of retirement savings on which millions of people were counting

I agree with the thesis, that TARP was an unnecessary expenditure and did and has so far not addressed root problems in the banking sector – one of which is MTM accounting.

Reinstitute the Uptick Rule

What is the Uptick Rule

The Uptick Rule is a Securities and Exchange Commission (SEC) trading rule used to regulate short selling in the financial markets. The rule limits the timing of short sales. It mandates, subject to certain exceptions, that a security can only be sold short (speculating it will fall in price) above the preceding price. There are nuances, but that is the gist of it.

It was put in place in 1938. In 2004 as the market was rising out of 2002, it was eliminated. Another monument to the fallibility and fallen nature of man. Calls for its reinstatement have been coming for some time now.

Reinstating the Uptick Rule, will not stop markets from falling. But it will make huge downside runs less frequent and probably less extreme, thereby mitigating against the bear raid mentioned previously. The point of reinstating it is to bring a more order to the markets.
______

nice article indiana. the uptick rule and i believe mtm both will be taken care of.

 

[Indiana Oracle]

The points you are making are part of the overall story to be sure. MTM, however, generally has a different thrust and is more easily viewed at a higher level of abstraction.

Leaving aside (for the purpose of this) that many banks with financial instrument trading operations became involved in bank asset derivative trading and what followed from that, most of a bank's core assets remain loans of various types, and a large majority of these are "performing", i.e. they are being paid as and when scheduled.

However, these performing assets were bundled in derivatives in many cases. Due to in large part to the collapse of the bank asset derivative market (the reasons for which I am not covering here), a bank's good loan assets are now considered Level Three whether they are performing or not. On the basis of MTM, as long as this continues there is no way to establish a value for them. Hence, bank profitability and financial health is distorted negatively and artifically.

What is being discussed at present regarding MTM is to replace that with a cash flow-based valuation approach. In the case of banks this should work effectively since their cash flow is the interest paid on loans. This does not directly result in the unwinding of the derivatives, but it will restore the balance sheet of the banks and further add to the performance of the economy. Bank operations are the lubricant of any capital-based economy.