Not enough regulation, too much regulation, bad regulation and bad acts are among the allegations blitzing media reports. Integrally related are regulatory environments, political settings, tax regimes, incentives and behavior. One can succinctly tell the story by pondering the answers to a series of questions, all of which reveal the not-too-invisible hand of government.What happens when money is persistently available at less than historical risk-free rates and the government co-opts over half of the housing lending market traditionally serviced by the private sector?
After centuries of historical cost accounting, with disclosures associated with market values, what happens when regulators insist on displacing historical basis with fair market basis during rising markets?
When politicians pressure to avoid accurate reporting of stock-based compensation arrangements within the face of the income statement, along with tying tax deductibility to market performance, why is anyone surprised that managers are pre-occupied with secondary markets, rather than the core of the primary business in which they operate?
When political insurance is garnered through hybrid organizations known as government-sponsored entities, whereby everything good is claimed by government and everything bad is blamed on markets, why is doublespeak unexpected?
The answers to these questions explain the quagmire at hand. Many other extraneous factors contributed to the setting. Economists and financiers taught the theory of perfect hedging, downplaying the systemic factors that rear their head on occasion. Whether Russia's treatment of its own treasury bonds or America's handling of Long-Term Capital Management should have been warning enough, their messages apparently went unheeded.
A tendency to embrace and follow regulators' and legislators' guidance, no matter how ill-conceived, meant a deterioration of professional conduct. What politicians want may not be worthy investments. Prior to government domination, business practices required lending at less than 80 percent of collateral value. Down payments were required, as was an ability to pay back. These are stalwart realities. Only a belief in government purchase or bailout could explain market participants' aberrant behavior. Regulatory pressures to extend unmerited loans to promote a social policy of homeownership undeniably are now a part of history.
Certain watchwords are used as subterfuge. Whenever I hear the words, "It's complex," I know that is likely a euphemism for that fact that the person speaking does not understand whatever he or she is about to describe. Complication must not excuse intractability. Whatever is designed and then marketed should require both a seller and investor to understand that which they are exchanging. Yet, just as we purchase computers that we could not build, investors purchased securities the construction of which they failed to understand. Trademark names of the largest companies gave them comfort, as did the façade of regulatory structures.
Now comes the paradox. If all manner of risk can be priced and exchanged in free markets, then why are those who have earned unusual returns suddenly surprised that they have incurred unusual losses? The primary flaw in political intrusion to the marketplace is the sense of protection that rears its head whenever massive losses are witnessed. If the credo is, "You win, you keep it, but if you lose, I bail you out," then the incentives produce exactly what we have been witnessing.
The billions and trillions of dollars under discussion all stem from one reality. Today's market is skittish, uncertain whether regulators and politicians can restrain themselves. This is an era when political candidates have promised everything from taking all profits of a single company, to onerous taxation of the healthiest of economic enterprises. No wonder that more are sitting by the sidelines, rather than venturing onto the field. A shortage of buyers means that prices will fall. The fair market value guesses in today's setting have little to do with the contractual commitments made on paper.
The worst steps the government could take would be to abrogate contracts. The best steps would be to return to historical cost accounting, with fair market value disclosures, and then let the market clear. Let us know the actual investment an entity has tied up in an investment, relative to what someone is willing to pay for that commitment today. That will help sort out fact from fiction. One of my favorite analogies is one in which you imagine betting $10 at roulette and being so lucky it becomes $1 million. However, hesitant to stop winning, you continue to play until you are left with $100. The headlines then blitz that you have lost almost a million dollars. Is that anywhere close to reality?
Do not panic as to the potential loss of a purchase arrangement that pays 50 percent discount or less of face value commitments. That loss can only result if the contracts are abrogated or politicians use the fund for social programs or political earmarks that are unrelated to the core issue at hand. In truth, if, rather than selling the instruments, they are held and collected over time, then little reason exists for profits not to accrue.
The problem, as usual, is analogous to what happens when a business goes bankrupt. Too often, customers believe that they no longer have to pay a company that has disappeared. They view themselves as winning. That is not the case. The debts for past services are still owed. The calamity will be if all borrowers listen to the political rhetoric about now that government is in control, foreclosures will cease. Such an abrogation of contracts will indeed lead to a very expensive bailout.
Those responsible for financial reporting face the troublesome fact that changes in contracts where all parties fail to be represented call into question intrinsic values. Contractual cash flows are suddenly subject to second-guessing due to uncertain governmental action. Legal cases are being spawned as one party or the other sees their rights abrogated.
When entities pen their disclosures on risk, care has to be taken to consider how the "exigent circumstances" vehicle for circumventing corporate governance, ownership and contracts could affect the reporting entity. As though the government-sponsored entities of Fannie and Freddie had not caused enough havoc and uncertainty, novel proposed and existing "bailout" arrangements are problems, rather than solutions. Bankruptcy and restructuring within the legal system have been designed to provide seats at the table to all contractual parties, whereas various ill-specified, nontransparent, politically controlled alternatives increase uncertainty not only as to outcome but also as to process.
Wanda A. Wallace, Ph.D, is the John N. Dalton Professor of Business Emerita at the College of William and Mary, and has served on FASB's Financial Accounting Standards Advisory Council and the Comptroller General's Government Auditing Standards Advisory Council.
