Wednesday, March 11, 2009

Why historically based valuation can lead to taxpayer looting

Comment to Arnold Kling's Econlog "William Isaac is Wrong on Market Value Accounting":
[ Kling referrs to George Akerlof and Paul Romer paper "Looting", and links to this New York Times writeup ]
> Historical-value accounting was an invitation to bankers to loot.
> OK, why? You can obviously have any sort of value accounting scheme without the looting of taxpayers.
If I understand, it is because with historical-value accounting, players make absolutely no claim about future returns, and so the players can take on all kinds of business that no one can defend as being sustainable, as that business grows and grows and grows.
The usual analogy is jumping off of a 50 story building.  When you reach floor 20, you have 30 stories, historically, of fine results.  But nobody could defend your continued descent as sustainable.
The politically enabled players take on all kinds of business, for short-term gain, then walk away before the inevitable crash, for the taxpayers to pay far, far above the total sum of the payday of the players.
If the players have to defend a future value to the marketplace, they have _some_ responsibility to demonstrate sustainability, as they take on more and more and more business.
What leads to looting of taxpayers is: (1) not having to defend *any* reasonable story about future returns (2) politically enabled players taking a short term payday on a huge amount of unsustainable business (3) with the players knowing somebody else will pay for the ultimate massive shortfall, a shortfall much more massive than the monies actually looted.
[ Additional comment ]
> Right, but make banks defend this to investors, not regulators. So if we should make Mark to market a requirement for banks to disclose to investors looking to put in capital, but not for capital requirement ratios.
Mark-to-market requirements can have different objectives.  If one of the objectives is preventing the looting of taxpayers, then we are most definitely talking about capital requirement ratios.
Because, as we are currently experiencing, the buck stops with the taxpayer.  Investors in banks have no ultimate responsibility to pay for all bank shortfalls; the worst that can happen is the complete devaluation of their investment, which in this case is small compared to the loss.

No comments: