A Dash of Insight

Political Power: Who Makes the Call?

Last week saw the FASB proposals for some modest adjustments in the mark-to-market rules.  We were on the road for a campus guest lecture, trying to do a little giving back.

The coverage of this was amazing.  Seeking Alpha had a block of stories, all Editors' Choices. They all were very opinionated and critical about the decision.  Apparently Seeking Alpha could not find anyone who thought it was a good decision, since there were no Editors' Choices in support.  Bloomberg and other MSM sources bemoaned the "political pressure" on FASB.

These commentators all need to go back to school.  We have so many blogging economists now.  Why can't we get some help from some blogging political scientists or public policy types?

There is no subject where the gap between the self-perception of knowledge and the actual understanding is so great.

Let us try some examples.

How Experience and Education Colors Advice

Let us take a problem like environmental policy.  Let us further suppose that you had our job, teaching young people about these issues.  Your team included an economist, a scientist, and you.

Would it surprise you to learn that the economist favored a free-market solution with minimal regulation?

Would it surprise you to learn that the scientist thought that all pollution was bad?

The public policy problem is one of reconciling competing viewpoints and finding outcomes that generate something good for society.  (Defining this is difficult, so books are written about it.  Defining the public interest is beyond our scope.  For the moment, let us just accept that there is a  broad public interest, and it would be good to find it.)

On the environment, the solution might be a recognition that driving pollution to zero is too costly.  We might recognize that some firms can improve more readily than others.  The trading of "pollution rights" was an idea from the 70's and we are still debating it now.

Please note well that there is no criticism of either the economist or the scientist.  They are very intelligent and have great knowledge.  They are smarter and know more than most of those pundits evaluating their comments.  They are good!  The problem is that they see the world through their own experience.

We need a broader viewpoint.

Let's try another example, one that is familiar in the decision-making literature - the Cuban Missile Crisis.  Briefly put, the US discovered that the Russians were building missile bases 90 miles from our shore.  It was a challenge that could not be ignored.

A team of advisors presented information and options to President John F. Kennedy.  For those of us who are old enough to remember, this event was the closest we came to nuclear war.  It was important.

(An aside -- Art Cashin uses this as a training story, since he was then a rookie trader.  The question was how to trade the crisis.  The answer was to buy, since if it was not solved, trading longs would not matter!)

The Air Force advisors recommended a "surgical air strike."  Further evaluation showed that the strike might not be as precise as hoped.

The Army thought that an invasion of Cuba was called for.

The Navy recommended a blockade, preventing further delivery of missiles and material.

The State Department sought a political solution.  They thought that the Russians were bargaining about Berlin.  They suggested that we might give up our Turkish missile bases, something that was no longer really relevant for US strategy.

Political advisors thought that a quid-pro-quo in Turkey would be a sign of weakness.  If we did this, it should be through a back channel.

Please note that all of these advisors were very intelligent and had great knowledge.  They were all good -- very good!

The public policy problem was to reconcile the differing advice.  The actual decision -- a "moving blockade" giving Khrushchev time to respond and to allow the back channel to work --is hailed as an example of excellent Presidential decision making.  We did not go to war, and the missile bases were removed.

Implications for FASB

So what does this have to do with the Financial Accounting Standards Board (FASB) and the mark-to-market decision?

The first thing to understand is that the SEC, which has the decision about where to vest accounting rules and oversees FASB, is not a branch of government, like the Supreme Court.  It is an Independent Regulatory Commission.  There is insulation from normal politics, since it is not wise for routine politics to govern accounting rules.  The SEC must have at least two members from each party in a five-member commission.  The President has the power to appoint, but not to fire members.  There is significant insulation from routine politics, but it is not like the Supreme Court.

The Problem

The mission of FASB is accounting.  The intelligent and expert members of this group make very good decisions, but they look at the world from the perspective of accountants.  They want to force companies to reveal information to investors.  It is their mission, and they do it well.

The current problem is that FASB instituted FAS 157 at the worst possible time.  It was a new rule and probably a good one.  The implementation of this rule led many accountants to take the most conservative view of assets held by financial institutions.  While the rule provided some flexibility in implementation, most accounting firms in the post-Enron era chose a conservative course.  Many had the government-dictated death of Arthur Andersen and the loss of accumulated partnership interests at the forefront of their thinking.  Why take such a risk?

Meanwhile, the problem was much broader than the accounting question.  The new rules might have been implemented quite safely a few years ago.  Accountants could learn the rule and also the exceptions.

Instead, the implementation came at the worse possible time.  The forced write downs of assets contributed (did not cause, but contributed) to a death spiral.  Capital was subtracted from firms faster than the government could add TARP money.  Private capital was frightened away by the threat of further write downs.

Some misguided pundits and bank analysts have seized upon the continuing losses as evidence that they were right.  In fact, the rules were designed to make them right.  Had the rules been addressed in a timely fashion, the death spiral might have been stopped.

Enter Congress

Many in Congress noted that there was a wider public interest, something extending beyond the strict notion of accounting rules.

Congress, as part of the original TARP legislation, mandated a study of these rules within 90 days.  Former SEC Chair Christopher Cox and company conducted the study.  There was plenty of evidence, including some from us.  The Cox group made a finding, just before the door hit them on the way out.  Their conclusion was that the FAS 157 rules were not that important for bank failures.  This conclusion, an official finding by the SEC, is rightly viewed as biased by many of us.  It is nevertheless cited by many in supporting the current rules.

Unhappy with this outcome, a sub-committee of the House Financial Services Committee held hearings and expressed some displeasure.  There was some tough questioning of SEC and FASB leaders.

Is this political pressure?  Of course.  It is a completely appropriate exercise of Congressional oversight, warning FASB that their viewpoint was too narrow for the circumstances.

There is absolutely nothing wrong with this Congressional action.  There was not even any legislation -- just some nudging in a public hearing.  This is precisely what Congress should do -- focusing attention on the broad public interest.

The Outcome

The result of this political "pressure" was a very modest tweak to the FAS 157 interpretation, much less than many thought was needed.

The pundit reaction to this has not been accurate.  Various opponents of change claim that FASB caved in to political pressure.  This is an easy story for journalists to write and for pundits to criticize.  None of them exhibit any understanding of how the American political system works.  They are writing to a receptive audience, which shares their pre-conceptions about how government should work.

We are still awaiting the actual new guidance from FASB, but it seems to be pretty tame.

The delay in addressing this issue has been a failure of the political system, which moves slowly and must deal with those in power.  Had the issue been raised eariler, or if the crisis had come later, the outcome might have been quite different.

Takeaways

We have had many emails from accountants.  Please note what we are not saying. Accountants are  intelligent and serving their mission.  Like the Air Force in the Cuban Missile Crisis they are good -- very good!

The problem is that their perspective is too narrow.  We need rules that provide information to investors without crippling the US economy.  Since concern about declines in regulatory capital is not their defined mission, they do not make it part of their decision.

FASB is not elected by anyone.  FASB should not run the economy.  That is what we mistakenly allowed to happen.

Market Curiosities

So many issues -- so little time.  Let us try a few quick takes on some current issues.

Selling the GE News.  We watched with some wonder as selling ensued on the basis of a the announcement by S&P of a negative outlook for GE's triple A bond rating, perhaps in two years.  Surely the issue was widely known, as is Jeff Immelt's determination to avoid this outcome.  If investors doubt his plan, why wait until the S&P announcement?

Additionally, when did everyone suddenly decide that the ratings agencies "got game."  At one moment they are the villains of the CDO fiasco, but now they know better.  Were we alone in this reaction?  No, we see that the astute team at Bespoke Investment Group is on the story.

Bush Delay on Auto Companies.  When the Senate failed to pass legislation to help the auto companies last week, there was some interesting bargaining and speculation.  The measure had majority support, but a procedural vote brought to the floor by Majority Leader Reid showed that the votes were not there to block a filibuster.  In the aftermath, there was widespread speculation that conservative Republicans held firm because they "knew" that President Bush would come to the rescue.  Others speculated that the UAW held the line because they had the same tip.

In short, the parties did not want to negotiate a solution in haste, preferring to sit around a table with a few months to reach a solution.  Now that everyone sees the effect on car sales (see Calculated Risk on Chrysler) and the Bush delay, we wonder if there are any second thoughts.  We still expect action, but it not have the form expected by the parties last week.

Gaius Marius is on this case, discussing the problems with the bankruptcy alternative.

Our take.  The government role should be to create the right incentives for the needed bargaining and let the parties work it out.  This means a firm deadline and some guidelines, but not a dictated solution.  Sen. Corker seemed to be making some headway on this.  The goal should be to achieve the restructuring without the stigma.

Warren Buffett.  In our introduction of the concept of Wall Street Truthiness we noted recent criticism of The Oracle of Omaha, including suggestions that he has "lost it."  Regular readers know our preference for the long term and real data versus an incident or two.  Mebane Faber has a great analysis of the Buffett record, including data and simulation tools.  The results had some surprises, even for those of us who are Buffett fans.

Fed Policy Moves.  It took less than twenty-four hours before the punditry decided that the Fed moves were going to be inflationary -- or ineffective --- or both.  This pattern of market reaction has been typical for months.  Policies that take many months to implement and get traction are declared worthless in the absence of instant results.  Many of those leading the critics, including the CNBC "devil's advocates" do not have much background or expertise on the subject.

Why not look to someone who has both the knowledge and experience?  Readers should consider Bob McTeer's viewpoint.  He has been a practical voice of reason for many months.  Since he is a courteous man, and not a loud and fast talker, he seems to get shouted down on these programs where they put up six or eight talking heads at a time.

Our Take.  There will be time to move from fighting deflation to fighting inflation.  Readers who are not familiar with the importance of the velocity of money should bone up.  You are going to be hearing a lot about the concept.

Wall Street Truthiness: A New Series

Here at "A Dash" we are always interested in things that become part of the conventional wisdom with little supporting evidence.

To find the right terminology for this concept, we turned to a leading source, Stephen Colbert on "truthiness."  Here is the Wikipedia definition:

Truthiness is a term first used in its current satirical sense by American television comedian Stephen Colbert in 2005, to describe things that a person claims to know intuitively or "from the gut" without regard to evidence, logic, intellectual examination, or facts.

It is important at the outset to be very, very clear about our intention.  We are not saying that the CW is wrong, just that the evidence does not support the conclusion.  Also, the CW is not totally bereft of facts; it is more the lack of a true scientific method.

As always, evidence might not matter.  The CW drives the market, and the market often becomes the reality.

Eventually, of course, truth will out.  But in the long run, we are all dead.

Having exhausted our set of pithy quotes, we are confident that you have the drift.  Our objective will be to do the following:

1. Identify a widely-held belief or conclusion where supporting evidence is sketchy;
2. Raise this topic for further discussion and analysis;
3. Consider what facts, if any, might prove the conclusion to be incorrect.

Reader Participation

This is a game that is open to all.  We do not necessarily disagree with the propositions advanced, but obviously we lean that way.  Anyone can join in with evidence, but it must be real evidence, not just an opinion.

Starting Agenda

We have a few topics in mind.  Here are things that we hear almost every day.  The "truthiness indicator" hits the red zone when some TV pundit sounds off on the following:

• The recession is already a year old, so it is nearly over.  Look at the last five recessions.  (Our short take - -not enough cases in the universe.  This recession could last much longer.)
• We have many years of economic distress in front of us.  It will not be a "V" recovery.  (Who can know this?  Some programs will kick in and attitudes will change.  How long?)
• Hank Paulson dumped the original TARP idea because he learned that all of the financial assets held by major institutions were worthless.  (He does not know, you do not know, and neither do we.)
• The economists at the NBER, the official recession-dating group, are clueless bozos.  They are way behind all of us smart folks in knowing that there was a recession.  (Their mission is different.  Traders do not understand research purposes.)
• Warren Buffett has lost it.  (Get real.  When something very unusual -- a black swan -- intervenes, normal metrics are thrown off.  It does not mean they will not be proven right.  Think about long-term records).
• The Baltic Dry Freight index is in a multi-year funk, with little hope of recovery.  (Who knows?)
• None of the government "bailout" initiatives have worked, and none will.  (This is complicated.  Bernanke tried to explain it, but no one was believing).
• President Obama will hike taxes and kill the economy.  (There is some good evidence of moderation for those trying to be objective).

Conclusion

For each item, we want to identify the conventional wisdom and the evidence.  The list is open for nominations.  Please join in!

We will take up each in turn with more detail, and revisit as indicated.

It is important for everyone to realize that this is a time of extreme stress, and therefore a time of opportunity.  The point is to look forward.  This is difficult to do when no investment seems to work.

A strong approach would be to examine the propositions with a view toward what information might provide a refutational catalyst.  Our preliminary assessment is that the catalysts are still many weeks or months in the future, but more study is needed.