BAILOUTS, BALANCE SHEETS AND B.S.

The steep fall in stock markets around the world during October is troubling news in nearly every respect. Despite the efforts of central banks and individual countries to come to the rescue of banks and other lending institutions, the crisis continues to spread and deepen. No financial institution seems willing to lend substantial amounts of money to other institutions, though conservative banks in the U.S. and abroad have used their strong capital positions to take over failing institutions. Unfortunately, in the midst of this financial free-fall, the United States is engaged in a highly partisan political debate that only occasionally focuses on the problem at hand.

It was certainly unwise for Secretary Paulson to allow the proposed $700 billion rescue package to be characterized as a bailout. To an extent, it certainly was a bailout of investment banks and other financial institutions that had accumulated large amounts of worthless mortgage backed securities on their balance sheets. Allowing these entities to pawn off this "toxic waste" was certainly one way of rescuing these wobbly lending institutions that could neither lend nor repay monies from a weakened capital base.

Yet, in the political discussion leading up to Congressional approval of the revised bailout package, now laden with special sweeteners, some Republican representatives decried accounting rules as one cause of the distress. Mark to market accounting had led financial institutions to mark down the value of mortgage based securities and derivatives once it became apparent that there no longer was a market in this financial inventions. Mark to market markdowns were thus not a cause, but a reflection of the loss of value that any financial institution holding such junk had experienced. In order to fairly reflect this loss of capital on the balance sheet, these mortgage based securities were reduced in value.

To advocate, as many Republican representatives attempted, the suspension of "mark to market" accounting in favor of some alternative - mark to make believe - might have rescued some balance sheets, but would have worsened the crisis in confidence that has led to the seizure of various credit markets. Balance sheets must reflect accurately the present value of a company or corporation. To game the balance sheets or to allow questionable transactions to remain off-balance sheet items will not save the system, but merely hasten its demise.

If Enron taught us nothing at all, it should have warned us that playing fast and loose with accounting rules and resorting to off-balance sheet accounting to hide losses and inflate profits does not eliminate problems, it merely postpones them. Then, when the deceit can no longer be maintained, the collapse is inevitably short, swift and brutal.

In the current crisis, the root cause is the frivolous waste of capital on mortgage loans that could not be repaid by those agreeing to interest free subprime mortgages and the like. Once, the default rate in the subprime market exploded, it caused lenders to pause with respect to refinancing teaser lows. When those holding mortgages in need of refinancing in order to avoid the balloon payments inherent in interest-free mortgages could no longer find refinancing, they too joined the chorus of mortgage defaults.

Unlike the past, many financial institutions were not directly impacted by the increased rate of defaults in the housing sector. Most of the original mortgages, especially the questionable ones involving subprime, Alt-A and option ARM mortgages, had been sliced and diced and packaged with other mortgages in order to spread the risk. At a certain tipping point, however, no matter how much repackaging had been done, the level of risk had to increase.

At the ground level, of course, foreclosures in one community reduced the property values of all surrounding homes. This led to negative equity scenarios that afflicted even reasonable mortgages. Once the mortgage value of the house exceeded the market value, even honest people were put in a bind. They could continue to pay the mortgage, even though they were paying more than the house was presently worth, and hope for an upturn in the housing market to bail them out. They could seek to refinance their mortgages at a better rate. Or, they could walk away from the negative equity by refusing to throw good money after bad. Unfortunately, many chose the latter.

The cascading of defaults on mortgages put pressure on the lenders. Ameriquest and Countrywide were the first large lenders to go under. Indeed, Countrywide burned through a loan from Bank of America in such short time that Bank of America had to buy Countrywide in order to have any hope of recouping its investment. Later, WaMu and Wachovia, a savings and loan and commercial bank respectively, were taken over as the burden of bad loans brought down their value.