In Defense of Gambling with Borrowed Chips, Part II

My recommendations, in Gambling with Borrowed Chips, are as follows:

1)      That  the U.S. government must repeal its legal tender laws, allowing Americans to find our own money.

2)      That there ought to be a simple and complete abolition of the Federal Reserve System

3)      That we must learn to let failures fail, without Greenspan or Bernanke “puts” and, finally,

4)      That “we need as a people to accept an important cultural change – we need to learn greater respect for the profession of accounting and for its independence.”

That’s the list as I presented it in my conclusion and as Gravelle considers it. In this blog, I propose to reverse the order. Starting with number 4 then, my reviewer plainly thinks this the runt of the litter. She isn’t “sure what Faille specifically proposes” in this line, so she won’t comment on it.

Well, perhaps in the PowerPoint sense I don’t “specifically propose” anything. It is hard to reduce a critical cultural shift to a list of specific proposals. It isn’t a matter for departmental white papers.  It is a matter of focus.

But I’ll dwell on this point today because recent newspaper accounts of JPMorgan and its billions of dollars lost on portfolio hedges tell a story that may assist with the needed cultural shift if anything can. These losses have stiffened the resolve of advocates of the “Volcker rule,” and of a stern construal thereof, and have at the same time confused those who have been trying to rejigger that rule to allow some flexibility, so this incident may end up having a lot to do with the future of investment banking in the US.  

JPM’s CEO, James Dimon, has said that "affiliated but asymmetric accounting" may have contributed.

Does this bore you, dear reader?  Are you saying, “oh, no, a discussion of accounting.” I suggest you resist the impulse to say that. That is all I “specifically propose” in such matters.

The problem in this case may have been that (a) derivatives on credit default swaps are marked to market – their value is constantly re-adjusted under existing accounting principles, but (b) the value of a bank’s outstanding loans are not marked to market – they are carried at original value, and adverse market condition are acknowledged through the creation of a reserve. If derivatives are used to hedge risks inherent in the loan portfolio then, as the “Heard on the Street” column in the Wall Street Journal has recently noted, the derivative can distort apparent earnings, and distort the bank’s own managerial processes.

I would certainly hope that bankers will correct this asymmetry by marking loans to market, and that the professional (private sector) bodies that maintain accounting standards will press toward this end. Prospects for that are not good at the moment, for reasons that were foreshadowed by the discussion in chapter eight of my book.  The leaders of the standards-setting bodies have been spineless and various politicians have introduced demagogy into accountancy issues over the years, cowing the spineless into indecision when the bases for sensible decisions were fairly clear.

If the politicians were to stand back, the accounting profession would hash out its own issues. And if the public were informed, if there was a general cultural acceptance of the importance of independent integral accounting standards, the leaders of that profession might exhibit the necessary backbone. Then we wouldn’t need a Volcker rule to do their work for them.

Equity and Prop Desks

Below is a brief passage from what may become the third chapter of my proposed book as represented in the table of contents I provided on December 10, 2010.

This complements materials I've provided for the two previous chapters, and we will continue our march in a measured pace.

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3. Equity and Prop Desks

The distinction between equity and debt is critical to any serious discussion of modern finance. It is also, not coincidentally, critical to the understanding of corporate liquidations or reorganizations. We will begin there, and soon enough we’ll be discussing corporate governance, government regulation, and the mysteries of federalism.

Think of a newly bankrupt corporation as a see-saw with a much heavier weight on the left and a lighter weight on the right. The right end, then, is up in the air. The left end (the equity) sits on the ground. The fulcrum is in the middle.
In terms of the right to receive a payoff, the most senior debt has first dibs. This is the airiest part of the see-saw. After those debts are paid off, payments follow in a sequence defined by contract and law. In time, the liquidators of the estate come to the fulcrum – the point at which what remains to be distributed is the good will of the ongoing enterprise.

Let’s assume that there is some such value (if not, we’d be dealing with a liquidation rather than a reorganization). On this assumption, the holders of the “fulcrum security” will be reimbursed by the transformation of their securities into the equity of the reorganized company. The classes of security that are lower than the fulcrum security, including the holders of the old equity, will get nothing.

One quick way of expressing all of this is to say that the holders of the equity of a company are the ones who bear the “residual risk.” They are the ones most certain to lose out in the event of liquidation. Thus, their interests are aligned with the interests of the corporation as a continuing, sustainable, entity.

To use a serious maritime image rather than the frivolous playground imagery above, we might say this: it is because the captain would go down with the ship, in accord with maritime tradition, that the captain is the best one to entrust with the task of steering the ship safely. Passengers with secure access to a rowboat in the event of a mishap are less suitable for the task.

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A footnote in there may refer to “Chapter 11 Reorganization Cases and the Delaware Myth” by Harvey R. Miller (2002), an article that sought to rebut the widespread impression, the “myth” that “there is something fundamentally wrong, even reckless, with the reorganization process as it is practiced” in the federal bankruptcy court in bellwether Delaware.

A further theme of the chapter as it develops will be the critical role of speculation in uncovering the real value of assets. Specifically, the equity markets (and their speculators) reveal the value of an ongoing enterprise as its market cap. The difficulties caused by regulations that obscure that process, thus hiding the true value. Prices as data. Leonard Read’s pencil.

From there to the role of shorts, a return to the Enron scandal, what Skilling called a certain short. Hedge funds and the prop desks of banks.