Two sorts of regulation

In a recent article in Financial Director, Robert Bruce, warns of the danger of politicians knee-jerk reactions to financial crises. He takes as his text a recent ICAS publication by Laura Spira and Cath Gowthorpe, as 'tres formidable' a pair of academics as one could hope to meet. Their report Reporting on Internal Control in the UK and the US: Insights from the Turnbull and Sarbanes-Oxley Consultations compares experience of the UK Combined Code with American reactions to the Sarbanes-Oxley Act passed after the Enron scandal.

Bruce thinks regulations set in the heat of the moment, like SarbOx, are likely to be poor ones and cautions against political interference in the aftermath of the current crisis. I'm not so sure. At least something is done and the current crisis is an almighty failure of the City's traditional approach of self-regulation.

With one bound, Jack was free.

The option to reclassify some financial assets from 'available for sale' to 'held to maturity' has been seized by two European banking groups Schroeders and Deutsche Bank. In the case of Schroeders this turns a £50m loss into a profit.

If this is being treated as a change of accounting policy, prior year figures should have been restated.

[The title is taken from a story about writing in weekly comics in days when comics included tales told in episodes from week to week. According to the story, the hero of a tale had been left bound to a tree and surrounded by hostile savages at the end of one week's episode. Unfortunately the writer had gone sick and no one could think how to get the hero out of his predicament. Eventually the writer returned to work, took up his pen and started the next week's instalment with the words, 'With one bound, Jack was free'.]

Do falling corporate tax rates lower the tax yield?

A recent EU paper gives the first impression that, although corporation tax rates have fallen across Europe, the tax take has not declined because the total proportion of corporation tax to GDP has not fallen. At first sight this would seem to give some support to versions of right wing economics that claim cutting taxes increases income. The authors of the study find this is not the case; what has happened is that economic activity has been shifted into companies to take advantage of the low tax rates.

Click on the title to go to the paper.

Short selling corner

Every now and then someone successfully 'corners' the market in a security or commodity. A well executed corner is a thing of elegance and beauty, even if it results in financial mayhem for some. In this case, short sellers have somehow managed to sell short more Volkswagen shares than are available for trade, because Porsche has acquired rights to a large proportion of the shares. The result is that the hedge funds and others who have sold shares they don't own now have to buy them in at almost any price. Click on the title link to go to an article that explains what has been going on.

Dynamic provisioning

In its recent bi-annual stability report, the Bank of England has called for measures to improve the financial stability of banks. One of these measures is called 'dynamic provisioning' which involves building up 'reserves against future losses in the good times, which they could then draw on when times were tough'. What a good idea! This used to be called 'prudence'. Admittedly, in the past banks kept these reserves hidden in the form of secret reserves and there is everything to be said for keeping them transparent.

The FT, in another article about the same report, says the Bank blames the crisis on 'shareholders' for failing to supervise their companies and 'marking to market'. As a shareholder in Lloyds TSB I shall chastise myself severely for failing to attend their AGM and point out to them the error of their ways. I'm sure that would have made all the difference. But it is interesting that the Bank explicitly cites marking to market as one of the causes of the crunch.

We are beginning to need a new name for the 'credit crunch', which was fine when the problem seemed to one confined to interbank lending. Something more indicative of the scale of the problem would now seem more appropriate: something like 'Global Financial Meltdown'.

The Wonder of Woolies

Older readers will remember the slogan with which Woolworths used to market itself. The company is a useful case study in corporate decline having lost around 90% of its value over the last five years. Today we hear that lenders have appointed there own accountants to look at the company's plans and budgets. Normally such an announcement would cause a huge drop in share price, but in a turbulent market it seems to be just one more bit of glum news.

More Credit Crunch Humour

Accountancy Age misdirects[1] me to a splendid satirical offering thedailymash whose recent articles in the news/business section include 'Leprechauns are stealing our gold, claims Darling' and other gems.

[1] The URL in their article is wrong.

Stewardship in the ascendant?

Despite the accounting standard setters' determination to downplay the importance of corporate governance and the control of directors' potential excesses, the current crisis is focusing minds on the need to make companies accountable for the resources entrusted to them. Most recently Gordon Brown's article in the Daily Telegraph in which he calls for greater attention to the stewardship exercised by companies. The BBC reports him as follows:

The markets must reflect society's values, including "fairness, stewardship and co-operation," he said.

Mr Brown said he wanted to uphold these three key ethics in public policy and across the public arena, as "markets work best when underpinned by an ethic of fairness".

This is a "defining moment for our emerging global society", he added.

"The ethic of fairness means we reward hard work, thrift, enterprise, effort and responsible risk taking, but refuse to condone or reward irresponsible or excessive risk taking," he said.

Also, the "ethic of stewardship must restore to all financial institutions their public purpose.

If the IASB and FASB take this as a prompt to rethink their objectives for financial reporting, it would be a small step in the right direction.

Should Corporation Tax be Voluntary?

According to a House of Commons select committee a quarter of Britain's top companies pay no corporation tax. These may be the ones who are investing and taking advantage of tax incentives to ensure future prosperity. On the other hand they may be using off shore tax havens and managing their affairs to avoid contributing to the economy and to society. I think we should be told.

What's all the fuss about marking to market?

On Sunday European heads of government discussed accounting standards. That's pretty unusual. On Monday the International Accounting Standards Board (IASB) had an emergency meeting. On Tuesday Trustees of IASB had a conference call to suspend the IASB's due process. On Wednesday the Accounting Regulatory Committee of the EU met to consider the IASB's proposal. Such haste is unusual. What was all the fuss about, and why is accounting intimately involved in the solvency of banks?

It all comes down the technicalities of an IASB accounting standard IAS 39 on Financial Instruments. Financial instruments have been a problem for financial reporting because a lot of people think that historical cost accounting doesn't do a good job of reporting them. For one thing you can acquire financial instruments without laying out any immediate cash, so the cost is zero, and for another the value of the things can fluctuate wildly and may not bear any relationship to the cost, if any. IAS 39 tries to solve this problem by classifying financial instruments into several boxes - I won't go into the details.

The main importance of which box instruments get classified into is that some boxes allow the instruments to be valued at 'amortised cost' on the assumption that the company will hang onto them until the end of their lives. Other boxes require the instruments to be valued at 'fair value' - which is mostly market value. This is what is called 'marking to market'.

Now one of the main effects of the credit crunch has been that the market price of many instruments, especially collatoralised debt obligations (CDOs - rights to the cash flows from sub-prime mortgages and similar things), have collapsed because nobody wants to buy them. If the holders of CDOs are required to value them at market value then that creates a huge hole in the balance sheet. And if the holder is a bank, that can mean that the bank either has to raise a lot of new capital, or reduce its lending drastically in order to maintain its required level of reserves.

What the banks want to do is to revalue the CDOs and similar on an amortised cost basis, which means they look at the likely payments that they are going to receive over the life of the CDO and value that stream of cash flows, using a net present value method. Since everyone seems to agree that, although currently unsaleable, most of the CDOs will eventually produce a respectable stream of cash flows, this will result in a much smaller balance sheet hole and make life a lot easier for the banks.

Sounds like a good idea? Well, yes, it probably is. But if it works in one direction it works in the other. That is to say, the reason that banks got into the current pickle is that they marked up the value of financial instruments when the market was valuing them above a realistic value, and the banks didn't complain then. In fact they declared record profits and paid their senior executives and employees mind-blowing bonuses.

My personal take on this is that marking to market always was a bad idea and encouraged market instability. Accounting should be providing a reality check on markets, not reflecting their errors back at them. The head of IASB has often defended market value by saying, in effect, that it is the only way of portraying reality. But that's a view that is rooted in a touching faith that markets can't be wrong. Users of financial reports want to know what the long term cash flows that they'll receive from various financial decisions will be.

Market prices reflect the value of those long term cash flows, but with an enormous amount of error. If the market gets the value of one bank's CDOs wrong, it gets the value wrong for all banks, so there is a huge 'systemic' effect. Moreover, if an upwards error in market prices is reflected in profits and bonuses, then banks buy more CDOs pushing up the prices still further and creating incentives to make more CDOs. When the error reverses, the herd instinct among investors, ensures that they all try to sell at the same time and prices collapse.

'Okay, clever clogs', I hear you say, 'what would you do?' Well, I'd use historical cost principles. Either, I'd treat the assets as 'held to maturity' and value them on an amortised cost basis. Or I'd treat them as trading items and value them at the lower of cost or net realisable value, as is the practice for inventory. For these purposes 'cost' could be zero for things like interest rate swaps which don't require up front payments. I'd also require extensive 'footnote' disclosures showing market values, but I wouldn't incorporate these in the balance sheet and income statement which form the basis on which contracts are written and solvency calculated.

For more on why marking to market is not such a good idea see John Kay's FT column of 14th October.

Vogon Poetry Award

Older readers will recall with affection a radio programme called Hitch Hikers' Guide to the Galaxy. HHGG or H2G2 to its friends[1]. H2G2 features the Vogons, a race of intergalactic thugs who tortured their victims by reading Vogon poetry to them. TG has recently come across a strong contender for what should be an annual award along the lines of the Ignobel awards. Both the Vogons and the Ignobel awards are covered in Wikipedia, if you need to find out more.

The writer of the poem is Guy Judge, an academic in the Economics Department at Portsmouth University. Guy's blog contains a raft of interesting stuff about Econometrics and Mathematics[2].

[1] Yes, it was radio before it became a book or telly series.
[2] For those who don't find 'interesting' and 'Econometrics' an oxymoron.

And now the lawyers ...

It's reported today in Accountancy Age that firms of accountants are likely to be sued for their role in setting up the sub-prime mortgages which many people believe were key to the start of the credit crunch. There must be some very nervous partners at the moment worrying about where the next holiday in Antibes is going to come from. One consolation for them is that they are all in the same boat; not all the big firms can be allowed to go bankrupt in hurricane of law suits that will follow the deluge of the crunch.

Remuneration policies partly to blame shock horror

Under the headline City bonuses may have worsened crisis says FSA we learn that the Financial Services Authority has come to the astounding conclusion that remuneration policies may have had something to do financial institutions taking unwarranted risks. Well my gob is smacked.

Tax havens for all

I've just bought a couple of bits of electronics from Amazon. Keen price, prompt service.

They both came from Jersey and so presumably evaded VAT. We are all likely to get caught up in the world of tax havens, whether we want to or not.

A modest proposal ...

Writing in today's Guardian, Richard Murphy and John Christensen argue that location of special investment vehicles in tax havens was one of the conditions leading to the present crisis and that global regulation is needed to cover the operations of tax havens. Not all of these are offshore. London is one of them.

[My title is taken from a notorious article by Jonathan Swift from 1729 proposing the eating of babies as a solution to an Irish famine. Swift was, of course, being satirical. It is likely that many in the financial community will regard Murphy and Christensen's proposal as equally outrageous, but at the time of writing the FTSE is off another 5% and less self-interested people may be beginning to realise that a root and branch rethinking of financial regulation is necessary.]

Credit crunch - beginners start here

There is an excellent piece on what has gone wrong; it's in the Economists' Forum - backpage of today's FT. Under the title 'The Fed must widen its focus' Thomas Palley explains how the unregulated 'parallel' banking system has boomed and bust and the role of mark to market accounting. Available at www.ft.com/econforum

Enron was an omen of dangers of fair value rules

A letter from Prof Mike Page of Portsmouth University in today's FT argues for suspension of the fair value rules. The letter stands out against the current of interested preparers and users striving to maintain the existing rules. IASB has promised to look at classification of financial instruments, but this is no substitute for a more radical reappraisal of the role of financial reporting in regulation.

From Prof Mike Page.

"Calls for the suspension of marking to market and fair value rules should be supported, not because the rules were the cause of the crash, but because they were the cause of the bubble that preceded it. In bending the knee before the illusory power of the market, accounting standard setters have ignored the unintended consequences. Marking to market was an invitation for operators in financial markets to make up numbers and pay themselves accordingly. Enron was a warning of what could happen. We know market prices are highly variable and accounting standard setters should now acknowledge that the role of accounting is not to mimic market prices but to provide a more reliable alternative.

Apologists for marking to market say there is no alternative, since it is impossible to calculate the intrinsic value of some instruments. If this is the case, what were institutions doing buying instruments for which they had no idea of the intrinsic value?

In the wake of this crisis the International Accounting Standards Board and US Financial Accounting Standards Board need to acknowledge, through their joint project to create a conceptual framework for financial reporting, that it is the function of financial reporting, not to pander to the markets' whims, but to create a sound basis for evaluating the stewardship of management and preventing opportunistic behaviour."

Credit crunch humour

The following was recently posted to the internet news group alt.usage.english

Dear American:

I need to ask you to support an urgent secret business relationship with a transfer of funds of great magnitude.

I am Ministry of the Treasury of the Republic of America. My country has had crisis that has caused the need for large transfer of funds of 800 billion dollars US. If you would assist me in this transfer, it would be most profitable to you.

I am working with Mr. Phil Gram, lobbyist for UBS, who will be my replacement as Ministry of the Treasury in January. As a Senator, you may know him as the leader of the American banking deregulation movement in the 1990s.

This transaction is 100% safe. This is a matter of great urgency. We need a blank check. We need the funds as quickly as possible. We cannot directly transfer these funds in
the names of our close friends because we are constantly under surveillance. My family lawyer advised me that I should look for a reliable and trustworthy person who will act as a next of kin so the funds can be transferred.

Please reply with all of your bank account, IRA and college fund account numbers and those of your children and grandchildren to wallstreetbail...@treasury.gov so that we may transfer your commission for this transaction. After I receive that information, I will respond
with detailed information about safeguards that will be used to protect the funds.

Yours Faithfully Minister of Treasury Paulson

To which a subsequent poster added - (to the Tune of Galway Bay)

If you ever go across the sea to Wall Street
Then maybe at the closing of the day
You will see a banker jumping from a window
As you watch the sun go down on Fannie Mae

Just to hear again the riffle of the dollars
And the brokers in the exchange making hay,
Just to sit and count your bonus by the million
And listen to the taxpayers as they pay.

For the cold wind that is blowing over Wall Street
Is all icy from frozen bank accounts
And ex-bankers, now are digging praties
for to creditors they all owe large amounts.

If you ever go across the sea to Wall Street
Then maybe at the closing of the day
You will see an evicted mortgage holder
As you watch the sun go down on Fannie Mae

[Pedant point on the original song - Galway Bay - the first verse is

If you ever go across the sea to Ireland
Then maybe at the closing of the day
You may sit and watch the moon rise over Claddagh
As you see the sun go down on Galway Bay.

But in summer, when the song is set, there is nowhere on land where you can both watch the moon rise (at about 12 degrees north of east) over Claddagh (a suburb of Galway) and the sun set (at about 12 degrees north of west) over Galway Bay.]

Shoulder to shoulder for marking to market

The accounting standard setters and the firms of accountants are becoming increasingly clamorous in their defence of marking to market. One of the latest examples is Ian Powell's letter in today's FT. Mr Powell wants transparency - but one can have transparency with footnote disclosures. Marking to market caused the problem on the way up when it was used for calculating profits and bonuses and it is doing damage on the way down as it takes away from balance sheets what it previously added.

Call me an old cynic, but there are going to many law cases in the wake of the crunch; anybody solvent who had anything to do with it is going to be sued. Suspending marking to market might just be an admission that the policy sanctioned by the firms and standard setters was not such a good one.

John Kay and the Halifax

A BBC podcast about the Halifax Building Society is well worth a listen. You can find it at

http://www.bbc.co.uk/worldservice/programmes/business_daily.shtml for Thursday October 2nd.

John Kay, (www.johnkay.com) who was a director of Halifax at the time of privatisation, makes the astute observation that financial engineering is a zero sum game. If you added up the value of all the CDOs and credit derivatives (look 'em up in Wikipedia), they should have come to no more than the value of the underlying securities. Did any of the auditors blythly putting their names to the accounts of financial institutions ever do a ballpark check? Did the accounting standard setters? It would have been revealing and have cast some doubt on the reliability of market values.

Aims and purpose

This blog is to add thoughts about current developments in the world of finance and accounting. The name is clearly a pseudonym, but those in the know won't find it too hard to work out who I am, so there is no big secret.