Fallout from the Financial Crisis

Perhaps the most important take-a-way from the Financial Crisis has been deflation – professional deflation. Let’s face it, the establishment didn’t see the financial crisis coming, were stunned when it arrived and can only recommend ‘the same old, same old’ going forward. Unfortunately, like Humpty Dumpty, the financial system and all the kings men have had a great fall.

The problems we face are huge but essentially rooted in the collapse of the Efficient Markets Hypothesis (“EMH”), the demise of which has shattered an entire belief system about the reliability of markets and the purity of market forces. With this loss, key ideological foundations underpinning the global financial system have been yanked out throwing the system into turmoil. Politicians in company with a bevy of heavyweight economists have been hard at work – ever since – to find a replacement for the ‘leave it to the market’ philosophy.   

In financial markets during the past couple of decades or so, market purism based upon the EMH became a kind of religion. Adherents of this faith believed strongly that markets were frictionless, perfect, and as a result markets (all markets) delivered real time, reliable asset valuation signals. Like many theoretical considerations in economics, EMH was controversial and applied carefully within the profession; while outside in the world of finance and business it was swallowed whole: hook, line and sinker.

Mark to Market Accounting 

Nothing proves this point quite so emphatically as the rise and fall of Mark to Market (“MtM”) accounting. MtM accounting establishes the value of assets on the basis of (present) market prices, allowing balance sheet values to reflect current market conditions. Emerging strongly in the last few decades MtM fed the near universal desire around the financial world to escape from the more conservative historical cost methodologies for asset valuations (asset values recorded on balance sheets at original purchase price instead of being adjusted for present market values). In time MtM became a pillar of the SEC (US Securities and Exchange Commission), FASB (the US Financial Accounting Standards Board) and the IASB (International Accounting Standards Board) ‘fair-market’ valuation standards.

In the past Mark to Market accounting was very welcome for a variety of reasons. First and most obviously in bull markets MtM valuations were generally higher than historical cost valuations allowing much greater scope for leverage (this was particularly true for investment banks). But more importantly, MtM and the bundle of idealized market assumptions that accompanied it were a gold mine for leveraging earnings and individual bonuses.

Enron, A Lesson to us All

How many companies celebrate the adoption of a new accounting system with champagne? Well, there’s at least one that I know of, Enron. On January 30, 1992 Jeff Skilling was so delighted at the SEC’s decision to allow Enron to use MtM accounting in the natural gas industry that he and 50 or so senior managers celebrated into the wee hours. With mark to market accounting Enron would be able to spin straw into gold, i.e. turn newly signed contracts (visions) into immediately bookable earnings, and then covert those (imaginary) earnings into higher valuations, stock prices and personal bonuses. Ironically it all makes sense if you live in the idealized world of frictionless markets. In such a belief system there are no impediments to market dynamics – all risks, immediate and unforeseen, are assumed to be incorporated into present market pricing. Nothing to worry about, the market is always right.  Of course with the benefit of hindsight we know how this story ends, with very subjective (and often manipulated) valuations, unrecognized bubbles and financial disaster.

The collapse of Enron a decade ago shook the world and brought down accounting giant Arthur Andersen, but Jeff Skilling did not invent Enron’s accounting system out of thin air, he modeled it on established Wall Street norms; practices which existed on the Street then as now, practices that have been mercilessly exposed in the recent financial crisis but not altered or changed.

Well functioning markets and the free interplay of market forces are vital to the modern global economy, but as we have seen idealized fantasies played a significant role in generating the crisis in the first place, and are a continuing part of the problem today. Unfortunately there is no quick fix for this foundational problem, no readily available alternative that can replace the existing system. 

 Things to Think About

1. We’re all going to have to come to grips with this reality. The system is not automatically self regulating; anticipate more financial disruptions as well as over-reactions by governments, regulatory bodies and the public. It will contribute significantly to increased uncertainty and financial volatility in future.
2. The Holy Grail for investors and the accounting profession was (and is) objectivity, certainty that the numbers that appear on our spreadsheets and financial statements are valid and reliable. Valuation objectivity may be the biggest victim of this crisis. As most market players know well, values are subjective by nature, depending as they do upon a variety of irrational factors including our collective perceptions about future growth. Knowing how markets really work (or not) is vital for business leaders today – it’s a pragmatic reality that is going to get more and more important in the years to come.