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How To Fix the Broken US Economy (Part 1)

Posted on Saturday, Apr 18th 2009

By Guest Author Bill McGinnis, CFA

[Many of you have participated in the debate I have encouraged in my series on Capitalism 2.0. It’s important to keep the discussion going and work together to offer solutions. To that end, over the next two weeks guest author Bill McGinnis will discuss two practices he believes must be changed: short selling and mark-to-market accounting. Bill begins with a more general background on what has gone wrong and what the US government must do differently.]

The following piece was sent as an email to numerous politicians and select media on September 24, 2008.  Recipients included both the Obama and McCain campaigns.

Good afternoon,

I work nationwide and internationally as an expert in investments and securities. I previously worked as a portfolio manager and investment analyst in the securities business – most recently for Robert W. Baird. I am writing to provide some perspective and assistance with the very difficult issues in front of you.

The financial tangle we are in is more complex than anyone can fathom. It is unprecedented and much too intertwined to allow for knee-jerk reactions. Simply throwing taxpayer money at the issue certainly isn’t the answer.

In assessing some of the proposals outstanding, I’d like to suggest that some combination of the following makes the most sense to me.

1. Suspend mark-to-market accounting for five years.

2. Allow the government to buy distressed securities, but require that the sellers provide equity ownership in their company to the government equal to at least 125% of any losses realized in the sale of such securities. In such cases, the government should also be put in a position ahead of debt holders of the companies.

3. Reinstate the short-sale uptick rule which was eliminated in 2007. There is no need to provide aid to the homeowner because the above measures will take pressure off declining housing prices, lower interest rates and make credit more available for refinancing.

Why are these good solutions?

1. We do not really have a $700 billion problem. The problem is real, but it is much smaller than it appears – it has been exacerbated by mark-to-market accounting. Mark-to-market accounting forces companies to reflect investment securities on their balance sheets at current prices, not at their real value. In theory, the current price and value should be equal, but this relationship disintegrates in times of financial crisis.

If you go to the grocery store and a $1.00 can of corn is on sale for $0.50, it does not mean that the corn is no longer worth $1.00. The corn is simply on sale. That’s why we buy 12 cans at once while it is on sale, because we know it will be $1.00 again next week. However, no one is going to pay $1.00 for it as long as there is $0.50 corn available. The price is $0.50, but the value is $1.00.

We have a similar situation in the credit markets today. Many securities that deserve only a small price reduction have exceptionally low prices today … because there are no buyers, but many sellers. The reasons are many fold, but most of them circle back to mark-to-market accounting. There aren’t any buyers because of fear and a significant reduction of capital in our financial markets. Much of the fear is unfounded, but it has decimated the prices of credit securities.

Mark-to-market accounting forces the current artificially low prices to be reflected on the balance sheets of every company that owns such securities. Thus, a $10 million security that may eventually repay the entire $10 million, may have to be reflected on the balance sheet at millions less than $10 million. Going back to my corn analogy, there can be a significant difference between price and value. Mark-to-market accounting reflects price, not value.

Suspending mark-to-market accounting would allow the markets to stabilize and for prices to realign with value. It sounds simple. It is simple. AND it costs nothing. The realignment could take a number of years, but the positive impact on the financial markets would be immediate.

The problem is $700 billion only if we do stupid things today. A bailout adds significant liquidity to the system (i.e. it pumps huge amounts of money into the economy), but this does not make the companies themselves solvent. The crisis won’t be abated until we have solvency. In addition, adding liquidity increases inflationary pressures and decreases the value of the dollar.

A rational approach will result in a much lower cost and less disturbance to our economy.

2. There are some securities that truly are severely and permanently impaired. Allowing the government to take these off companies’ balance sheets would free up capital and allow for renewed investment by these companies. This will keep the economy moving forward.

However, these companies bought these securities in the first place. They were bad investment decisions. It is not the government’s role to bail them out. The companies, and thus their shareholders, should carry the burden of these mistakes. That is why I suggest that the government receive equity investments equal to 125% or more of every dollar lost by the government in taking over these securities. In some cases, there may not be enough equity to make up for the government’s losses. In providing the service of taking over impaired securities, the government should also take a position ahead of debt holders of such companies. All losses should be calculated on a company-by-company basis and not on a pooled basis.

An important point here, however, is that the government cannot move swiftly to sell these securities. It is swift sales in turbulent markets that cause and continue pricing disruptions. These disruptions flow through very quickly to the housing market and the rest of the economy. This needs to be a long-term solution (possibly 5 to 10 years).

3. In the last month, we have lost several major financial institutions to bankruptcy, buyout or takeover. I am confident that in at least some of these cases this was unnecessary. The combination of pressures from mark-to-market accounting, combined with huge short-selling pressure, drove these leading companies out of business. Had they made some significant mistakes?

Undoubtedly. However, they weren’t significant enough to have warranted their decimation. Across our stock markets, we have seen significant short selling (selling shares you don’t own) in recent months. This puts downward pressure on the share prices. Again, we have that difference between price and value. However, with the fear that exists, there have been very few buyers. I believe we will eventually learn that much false information and malicious rumors were planted by the very same people who were shorting the shares (they hope to repurchase the shares in the future at a much lower price). This has always happened in our stock markets and has received too little attention from the SEC. However, until 2007, there was an uptick rule for short sales that said you could only sell shares short on an increase in price. Thus, it was nearly impossible to drive the share price of a company into the ground simply by short selling. That rule was inexplicably removed in 2007 and this year we have witnessed the result.

The uptick rule needs to be reinstated for all stocks immediately. It is another simple change that costs nothing.

4. Companies that bought securities that have gone bad assumed that risk upon purchase. They should suffer the consequences. That’s how things work in a free economy. The same is true for individual homeowners. Too many people bought homes they couldn’t afford. They made the mistake of believing that housing prices would go up forever and turn a bad idea into a good one. Freedom can be hard.

However, the homeowner certainly will benefit from the first three suggestions due to stabilizing housing prices, lower interest rates and more credit availability. Millions of homeowners will benefit within the first year.

Without a doubt, some homeowners were subject to illegal acts related to their home purchase and/or financing. These illegal acts need to be prosecuted to the fullest extent possible. Predatory practices are not something that should be tolerated in any way. Anyone who bought/financed their home as a result of fraud/deception will be protected in this way.

This is heady stuff. Even with decades of training, it is difficult to comprehend the situation, let alone have any idea what to do in response. The information above is still a relatively complex presentation. I can make it much clearer, but I wanted to keep this short.

If you or your staffs would be interested in discussing these matters, I will make myself available. If you would like assistance in your office assessing the proposals that are before you, I can be available for that as well … and likely could bring other local professionals with me. These are very difficult times and the actions you take in the next several weeks will change people’s lives immeasurably.

Please let me know if I may be of assistance.

Sincerely,

Bill McGinnis, CFA

This segment is part 1 in the series : How To Fix the Broken US Economy
1 2 3 4

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Comments

This was a very good proposal, though it seems
apparent that Congress then and now, along with the Administrations then and now, quietly ignored Mr. McGinnis’s sound advice. Surely, he
is the kind of person with the proper business
acumen, who should have, at least been
consulted, on our economic issues. Perhaps it’s
not too late for them to call on his services.
Let’s hope they do.

Popham of Boston Saturday, April 18, 2009 at 7:22 PM PT