The U.S. banks are asking for more bailout money – and Congress is resisting (read article here.) Most people don't understand why banks are failing, and lots of them are ready to say "let them fail." But why they are failing is important – because the solution has to be linked to the diagnosis, don't you think?
Back in the old days of hyper-inflation (think 1970s) corporations developed a perverse problem. They had buildings on their balance sheet for $1million, but inflation had made the land, buildings and other assets worth $10million (or $20million). The corporations weren't allowed to mark up their assets to market value. So the banks couldn't lend them more money. As a result, fellows like T. Boone Pickens created a new business opportunity. They simply went to banks and borrowed money based on the real value of the underlying assets, and bought the corporations. Having no desire to run these companies, they often sold off the assets to pay off debt and kept the profits and the companies (and their employees) went away. They were called corporate raiders. And their existence could be traced to accounting.
When banks lend money they are required to have reserves which back up the loans. Banks can lend multiples of their reserves. They have leverage, because every dollar of reserves can create several dolalrs of new loans. As the reserves go up, they can loan more money. If they raise reserves by $1, they can loan out, say, $6.
But today, the bank loans already on the books (not new loans) - especially real estate loans – are going down in value (it's more complicated than this because of various bond offerings and insurance products on the mortgages, but the idea is pretty close). There is an accounting rule which says if a loan goes down in value, the bank has to estimate the new value of the loan and mark the loan down to market value (mark-to-market accounting). So, as real estate tumbles, the loan value tumbles. Every dollar of loan value comes straight out of reserves. This is called reverse leverage. Because if a loan goes down in value by $1, and $1 comes out of reserves, suddenly the bank has to reduce its total loan portfolio by $6 – get that? Instead of one loan being affected, suddenly a lot of loans are affected. Because one loan has to be marked down, in order to cover its reserve requirements, the bank may have to call up the local retailer and ask her to cut her inventory loan by 30% – because the bank no longer has sufficient reserves to cover all her debt. Ouch!!! One bad apple sort of starts spoiling the barrel – to use an old expression.
Suddenly, the reverse of the T. Boone Pickens opportunity happens. A few write-offs eliminate the reserves, making new lending impossible and actually (because real estate has cratered so badly) causing banks to call in perfectly good loans to cover their reserve requirements. (By the way, miss your reserve requirement and, by law, you go into default and the regulators take over your bank.) "But," you might say, "this means perfectly good debts are being called, and perfectly good loan opportunities are being ignored, just because of an accounting convention." And you would be right.
How far would you like the economy to stagnate because of an accounting convention? Sure, there was good reason for this rule. It was intended to keep banks from making questionable loans. But not many banks – not many economists – and not many accountants – expected real estate to drop 20% in value across the U.S.A.
The Japanese came across this problem in the middle-1990s. Their economy exploded in the 1980s. Real estate in Tokyo became the most expensive in the world. Ginza retail property was worth $1M per square foot! And middle-class Japanese discovered homes they had purchased for $80,000 were worth $1M! Young Japanese families buying new homes spent the $1M, and went deeply into debt. Then, the Japanese economy cooled. And real estate values tumbled.
But Japanese regulators would not let the banks write off these loans. They said "either this loan is repaid, in full, or you must write down your reserves." Banks quit lending. The Japanese economy nosedived into recession. And it has still not recovered. Stock prices, real estate prices, prices of everything have remained stuck. And the economy has not grown. After more than 12 years, the Japanese are still in a recession. You may not care, after all you don't live in Japan. But if you live in Japan you've struggled for a raise, you've struggled to pay bills, and if young you've struggled to find a job for 12 years. There are thousands of stories of highly qualified young Japanese college graduates who have never been able to find a job, thus never married – effectively never started their adult lives. Stuck. Families stuck by an extended recession as old debts are slowly, painfully slowly, repaid.
So what should America now do? Should we stick with the old accounting rules? Should we mark down loans, creating bank reserve problems? We know this means banks will ask for bailout funds – to get reserves back up. But we don't want to cover those reserve requirements – for fear the money will be spent on private jets and big bonuses. Maybe, just maybe, we should change the accounting rule.
By the way, I'm not the first with this idea by a long shot. Steve Forbes, a noted conservative, is one of the leaders for this change. He spoke to it on Meet the Press yesterday. This isn't really a hard question, is it? Why would anyone extend a recession, or create a depression, when an accounting rule is very close to the center of the problem? Something as easy to change as an accounting rule.
The issue is Lock-in. Our old enemy of the stuck corporation. Lock-in to past practices that causes the company to keep doing what it always did – even though everyone agrees there has to be change. Lock-in keeps the company on a path to sure destruction. The old accounting rules were based upon what used to be true. Thirty years ago, it was rampant inflation that gripped the U.S. economy. Double digit inflation screwed up everything business leaders and regulators had ever been taught. At one point, in 1978, President Carter went through 3 heads of the Federal Reserve (that's Bernanke's job) in under 1 year! Old accounting conventions were turning business upside down, and destroying healthy corporations. And mark-to-market (rather than acquisition cost), which allowed companies (and banks) to bring assets to "current value" was critical to a healthy economy and the management of healthy businesses.
But who's more Locked-in than economists and accountants? Not exactly known as a "progressive" group of people. Yet, the future for America is totally clear if we keep doing what's been done in the past. The government and industry forecasters have a trend that's very predictable. Without change, liquidity remains hampered, the economy remains on a downward tilt, layoffs continue and problems worsen. Something fundamentally needs to change.
So, using The Phoenix Principle, we know what's needed. Firstly, we can learn from our competitors. The Japanese situation has been studied to death, and the results are well documented. Universally, economists have demonstrated that Lock-in to old practices has hampered the Japanese economy dramatically. As the other developed countries struggle with falling real estate, the first to take action will come out the big winner. The first to find a way to move forward gets an advantage.
We now need to Disrupt! Someone has to help us stop and realize that more of the same has a clear future – and that future is not pleasant. Something has to change. Then we need to create White Space. Instead of changing the rules for all banks, we need to carve out some healthy but jeapardized banks in which to test the practice. We need to allow them to change their accounting, and watch the results. If it works, we can learn and replicate. Don't test on Citibank and Bank of America, which are huge and possibly unable to survive. Test where we can learn what works, and FAST.
Nobody wants another depression. And most people don't want to keep putting tax dollars into banks shoring up reserves. So maybe, just maybe, we should try something new. Like changing the accounting rule. Let's give it a shot, test it with some banks that are strong but struggling, and see if we can't figure out how to apply changes in a way that can get the economy going again!