Bill Fleckenstein

Contrarian Chronicles8/27/2007 12:01 AM ET

How regulators fed the credit mess

Obscure accounting rules approved last year made it easier for over-leveraged financial institutions to get ever more creative and cover up shaky numbers.

By Bill Fleckenstein

I have written plenty over the years about how financial firms have been allowed to essentially make up their numbers. But on Wednesday, a Bloomberg story by Jonathan Weil ("Wells Fargo Gorges on Mark-to-Make-Believe Gains") makes it appear I have not been skeptical enough about the ability of these firms to create illusions.

Officially blessed fudging

Kudos to the Financial Accounting Standards Board (FASB) for creating this fiasco last September, when "it approved a new, three-level hierarchy for measuring 'fair values' of assets and liabilities, under a pronouncement called FASB Statement No. 157, which Wells Fargo (WFC, news, msgs) adopted in January," as Weil reported.

He counted the ways: "Level 1 means the values come from quoted prices in active markets. The balance-sheet changes then pass through the income statement each quarter as gains or losses. Call this mark-to-market.

"Level 2 values are measured using 'observable inputs,' such as recent transaction prices for similar items, where market quotes aren't available. Call this mark-to-model.

"Then there's Level 3. Under Statement 157, this means fair value is measured using 'unobservable inputs.' While companies can't actually see the changes in the fair values of their assets and liabilities, they're allowed to book them through earnings anyway, based on their own subjective assumptions. Call this mark-to-make-believe."

Weil succinctly summed up the situation as follows: "There's the kind of earnings investors can take to the bank. And then there's the kind the bank can show to investors."

If it's murky, suspect malarkey

So in addition to what we already know -- that the murky world of structured credit had thrived on a mark-to-model fantasy -- we now learn that financial institutions leveraged to the eyeballs enjoy the ability to mark themselves to whatever they theoretically think they ought to be allowed to declare. It's a variation of the accounting treatment Blackstone (BX, news, msgs) was lobbying to utilize before becoming public – bookkeeping that Blackstone subsequently decided against -- whereby it would have been granted permission to predict its future gains based on its past gains and then amortize that into income.

Essentially, the accounting conventions in this country have devolved to the point where financial statements for financial institutions are worse than useless. Allowing this nonsense to pass for an honest assessment of reality has created the credit predicament we're in now -- which has caused the Fed to ride to the rescue -- just weeks off the stock market's high and with the market still up on the year.

Obviously, it didn't take them long to return to the playbook well established by then-Fed chief Alan Greenspan. For about a week, it looked as though the Fed was trying to behave responsibly for once -- by reducing moral hazard and removing the Greenspan "put" while surgically attempting to increase liquidity in the banking system.

Stepping back to its recent scheduled meeting, I thought that when the Fed didn't lower the federal funds rate, it was probably because it didn't understand the situation. Apparently, the Fed now understands it a bit better. Thus, the Fed will do what it has done over and over for 20 years: opt for the blank-check bailout, the game it has perfected and which has created so many imbalances in this country.

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As for those folks who might quibble by saying that the Fed only cut the discount rate, the truth is that the liquidity it provided has had Fed funds trading below its target for nearly two weeks. So it has been a de facto ease. In any case, the Fed's rate cuts cannot solve the bad-debt problem left in the wake of the real-estate/credit bubble.

Macho men crying 'Mommy'

One final comment about the financial world: It's populated with rich, hypocritical whiners. Wall Street, the hedge-fund community and their lap dogs in the news media continually brag about how much they love capitalism and free markets.

Yet when the creative-destruction component of capitalism rears its ugly head, they want the central planners to bail them out immediately, before they take any pain. And the ones clamoring the loudest are the very same folks who behaved the most irresponsibly.

At the time of publication, Bill Fleckenstein did not own or control shares of any of the companies mentioned in this column.

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