January 30, 2009

The Defibrillator is on the WRONG patient

Why Obama’s Advisors Need Triage Training

By: Dr. David E. Martin, Executive Chairman, M∙CAM Inc. and Fellow at the Batten Institute of the Darden Graduate School of Business Administration, University of Virginia


The government bailout of AIG failed to attract the notice that it deserved for good reason. Few economists and fewer informed citizens have any clue about the complex role the insurance industry plays in the global financial scene. This lack of visibility may cost tax payers in excess of the combined Obama Administration stimulus plan plus the carelessly constructed TARP legacy of the Bush Administration. Why? The answer is quite simple. Every pension fund in the United States, most corporate bonds and debt, and a huge amount of commercial product and service flow relies on its credit rating and performance insured by little understood credit guarantees. Take these guarantees away or impair the companies that issue them and no retirement account in the U.S. could maintain its codified obligations for investment grade assets. And, by the way, if rating agencies in the U.S. actually rated risk inclusive of the balance sheet risks of these guarantors, we would already have a rating crisis equal to, or larger than Japan’s 10 year ratings draught.

The International Credit Insurance & Surety Association or ICISA may have painted the happiest industry consensus growth statement of any industry association in the past 3 quarters when, in their November 18, 2008 press release they stated, “By insuring payment risks and guaranteeing the performance of third parties we support our policyholders in maintaining and growing their business.” For an organization whose membership carries over US$2 trillion in exposure, this was certainly a cheery message. This press release came on the same day that Market Watch reported Hartford Financial Services Group, Genworth Financial Inc. and Lincoln National applying for capital support from the Office of Thrift Supervision begging the question, if the risk performance professionals can’t manage their own risk, what are they actually selling to their clients?

A review of ICISA members’ balance sheets and 4th quarter earnings reports reveals a more troubling observation – one that has missed all but the subtlest of media attention. The Chairman of one member stated in his interim report to shareholders the fall of 2008, “The crisis on international capital markets intensified in the third quarter on a previously undreamt-of scale.” Investment income was halved and earnings in some members fell by over 90%.

FDIC Chairwoman Shelia Bair – head of a distressed insurer in its own right – has been promoting the “bad bank toxic asset purchase” solution for good reason. If the FDIC actually had to do what insurers are contracted and paid to do (yes, the FDIC is paid premiums to manage risk), the financial crisis would be seen in its full glory and that would be calamitous at best. Get the paddles where they belong Mr. President and Secretary Geithner. The manikin never was alive and the patient is dying!

Bailout Solutions Use the Wrong Economic Model:
Correctly Valuing “Intangibles” the Solution to the Crisis

Dr. David Martin, Executive Chairman, M∙CAM
Fellow, Batten Institute, Darden Graduate School of Business Administration, University of Virginia

Let’s review a few simple facts that our policy-makers are missing. The current credit crisis is not a real estate mortgage crisis. The banking liquidity problem is not caused by collateralized mortgage obligation devaluation. And pumping large amounts of taxpayer dollars into a ‘bailout’ will not solve the problem. Why? Neither consumer goods purchased using home equity second mortgages nor inflated “goodwill” premiums paid in leveraged M&A commercial debt transactions reflect collateral value. Congress and the Treasury are ignoring tools that they used less than 5 years ago to save the U.S. taxpayer $10 billion and in so doing are risking an engine failure of our national economy. By enabling regulated financial institutions to monetize the value of existing General Intangible Liens which exist in all forms of credit agreements, taxpayers will be spared unnecessary, and economy threatening bailouts.

First the ‘main street’ crisis: heralded as a real estate bubble casualty, the current explosion in defaults on both mortgage and the pooled investment vehicles built thereon has very little to do with the housing market. Encouraged to bolster the economy by using their home equity for consumer credit (to buy cars, appliances, TVs, and other goods) in response to the market confidence collapse following September 11, 2001, consumers created an aberration not previously seen in the real estate market. In a market where default statistics are measured against 30-year mortgages collateralized by homes, banks and credit rating agencies pretended that second mortgages were just like first mortgages. The problem is that consumer credit defaults spike in 18 to 24 months – not in 10 to 15 years. When home mortgages are rated using 30-year real estate default statistics (much longer onset and much lower incidence) rather than consumer credit default statistics (much shorter onset and much higher incidence), you see a recipe for disaster created by the perfect application of the wrong model. “Fixing” the real estate market would require deleveraging consumer behavior with home equity – a message that is not mentioned because it requires a potentially unpopular call for fiscal accountability during an election. Using the personal bankruptcy reform initiatives passed by Congress in 2005 linking means testing to consumer debt, cessation of credit card and real estate equity pooling would avert further instability.

The same lack of collateral adequacy is causing the Wall Street crisis: The lack of banking liquidity today has virtually no linkage to junk mortgage securities and their non-performance. The real problem is that reserve accounts (the money a bank needs to hold to be capable of issuing credits) are calculated based on a long-forgotten concept of collateral. Rating agencies have been allowed by Federal and international banking overseers to misstate asset values and investment performance when measuring the leverage for bank and insurance reserves. The collapse of the mortgage-based securities triggered a drop in ratings catalyzing a chain reaction.

In 2000, the Financial Accounting Standards Board (FASB), influenced by hearings lead by Senator Phil Gramm (R-TX), required companies to modernize their accounting for merger and acquisitions. When one company purchased another, they were required to immediately write off the premium paid for the purchase and only report the value of the actual assets they had acquired. Many of the assets which led to the premium price are so-called intangibles (contracts, trademarks, copyrights, patents, franchises) which are not adequately reflected on balance sheets. While this accounting change attempted to add transparency to shareholders, it created a conflict of interest for banks. In leveraged debt acquisitions, the acquired company’s value has both a purchase price and a much smaller booked value. The difference between the price and the book value frequently represents over 50% of the gross transaction leaving the acquiring company’s balance sheet both asset poor and debt burdened. On the one hand, banks knew that immediately following a debt offering, the book value of collateral would collapse. However, they also were incented to inflate the value of transactions to maximize commissions. When the bank then had to assess its own lending capacity, it now must measure the financial risk of the loan based on payment history and collateral (which in most cases doesn’t include the intangibles purchased in the company) thereby immediately leading to a greater perception of debt risk. Neither the FASB nor any other oversight body actually defined how to recognize the true value of intangible assets. This is not a small point: these assets are estimated to be over 80% of the actual value of acquired companies. The result of all of this is that banks have vast sums of commercial credit issued where the recognized collateral assets represent less than half of actual market value. It is collateral insufficiency, and the associated reserve costs, which are freezing the credit markets – not real estate. When something which costs $1 billion only produces half a billion in collateral, and that in turn damages the rating of the bank that loaned the money, something is wrong.

Tragically, what is missing from the furor over the current “crisis” conversation is an honest assessment of the problem. By failing to recognize the intangible assets that can serve as additional collateral for credit using the General Intangible Asset Liens existing in every credit agreement, Congress and the Administration are failing to see the problem clearly and making the solution much more difficult.

This solution has already been legislated and the financial tools necessary already exist in law and accounting standards. The Treasury has made use of this solution in the past. 5 Years ago, when corporations were taking advantage of IRS loopholes by fraudulent donation of intangible assets, the treasury recognized that it was unable to properly evaluate these intangibles and sought the help of private sector expertise to do so. They put to work a methodology that properly evaluated intangibles and enabled them to recover or retain over $10 billion dollars in revenue. Despite this experience, the Treasury Department has failed to apply the same solution to the current crisis, which is also caused largely by huge numbers of intangible assets not being properly accounted for. The solution for stemming the tide of bank failures is to allow for immediate, ratable recognition of the value of intangible assets, and to establish oversight to insure appropriate rigor in the process. The immediate consequence of rating actual intangible collateral in commercial debt portfolios would more than adequately infuse confidence into bank reserve accounts making costly taxpayer financed liquidity unnecessary. It would be a shame for historians to reflect on 2008 and lament that, though we had all the technology of our modern markets, we were still using accounting tools last innovated for levying taxes in the Napoleonic Wars. The problem is clear, the solution is available. Let’s hope that the Congress and Treasury have the wisdom and courage to use it.