Frank Holmes, CEO and chief investment officer at U.S. Global Investors, writes in the Daily Reckoning
The cure [for the financial mess on Wall St] is not more regulation – in fact, the current rules are a big reason why we’re in this dire situation.
Almost a year ago, an accounting rule known as FAS 157 went into effect. This rule has been called the “fair-value rule,” but it’s not working that way. FAS 157 is forcing companies to write off tens of billions of dollars in debt-related investments.
That’s because of FAS 157′s requirement of a “mark-to-market” valuation on these investments each quarter. Mark-to-market essentially means the value of these investments if they had to be sold immediately. Current uncertainties and liquidity issues have chased away just about all of the buyers for many of these investments, so the markets are distorted. When there are no buyers, under FAS 157 the value has to be marked down, sometimes to zero. This is the case even for securities that could be sold in the future at face value once they reach maturity.
This is not a blind defense of the companies that have invested heavily in derivatives that Warren Buffett called “financial weapons of mass destruction” in 2002. In the next six years, these financial WMDs grew by 500 percent to more than $500 trillion. The sheer size of these derivatives has greatly increased the risks of catastrophe, and the danger is further elevated because of FAS 157 and Sarbanes-Oxley.
Because global financial markets are woven in a complex web, turmoil in one sector is felt elsewhere. Some wounded financial companies are desperately selling healthy stocks to raise capital to stay afloat, and this heavy selling pressure is forcing down the price of these stocks. The same is being done by leveraged hedge funds that have been hurt by their investments in financial stocks – they need to raise money for shareholders who want out of their fund, so they are selling good stocks to get cash.
What Frank writes seems to make sense at first glance. But if you stop to think about it – why shouldn’t companies be made to “mark-to-market” any of their investments? Aren’t shareholders supposed to know where they stand every quarter? What is to stop companies from misrepresenting their assets and misleading investors? If there are any “securities that could be sold in the future at face value once they reach maturity”, the market knows that the “losses” and write-offs or mark-downs declared by banks are only notional, and the stock price will not tank. But the reality (in the sense of social construct, in other words, market determination of prices) seems to suggest that a lot of these securities are worthless. There is no market to determine prices.
I see the chart depicting a derivatives market of $516 trillion. What does that even mean? I cannot comprehend numbers like this at all. If these derivatives start to “unwind”, “un-hedge”, what does that mean? That seems to be the scenario that Henry Paulson and Ben Bernanke are afraid of. I guess.
