A Bearish Debacle

In 1907, John Pierpont Morgan coordinated a bailout of Wall Street in that era's financial panic. His modern day successor, JPMorgan Chase CEO Jamie Dimon, played a similar role by bailing out and subsequently buying rival Bear Stearns for the bargain basement price of $2 per share. That's an astonishingly low price -- about a quarter of the value of Bear Stearns' Manhattan headquarters of around $1.2 billion. As one JP Morgan banker pointed out to me yesterday, Wall Street's fifth-largest investment bank fetched less than what George Steinbrenner paid for Yankee baseball star Alex Rodriguez. Bear Stearns took down plenty of people with it. Last year, Forbes magazine ranked former Bear Stearns' then-CEO James Cayne as Wall Street's richest CEO, with $1.3 billion of assets. Today, his holdings are worth $13 million. British billionaire Joe Lewis lost a cool $1 billion on his 11 million share bet on Bear Stearns.

A Bearish Debacle: Revenge of the Accountants

It's been Annus Miserablis global investment banks. In the past year, they have recorded more than $180 billion in write-downs and losses since the onset of the credit crunch. Even worse, there seems to be no end in sight.

To both the banks and the outside observers, the size of the write-downs is both unexpected and perplexing. Yes, foreclosures are up. But media reports notwithstanding, hundreds of thousands of Americans are not yet spending their nights sleeping on the streets after being ejected from foreclosed properties. Indeed, some financial institutions are getting impatient with the accounting rules that are forcing them to write down massive paper losses in subprime mortgages.

The culprit, they say is, the concept of "fair value" -- or "mark to market" accounting. Valuing complex mortgages is a more difficult task than valuing, say, guns and butter. In the absence of a genuine, liquid market, most mortgage-linked securities are currently valued-based on the formerly obscure ABX index. Bankers are questioning whether this two-year-old index based on values of just 20 bond deals can be legitimately used for valuing an asset class approaching $1.3 trillion in size. By forcing banks and hedge funds to sell assets because of write-downs, inflexible accounting standards are actually making the crisis worse.

On its face, valuing mortgages according to what the market is willing to pay makes eminent sense. Traders have always marked their holdings to market prices. But when markets become dysfunctional, it's unclear whether "mark to market" accounting makes any sense. In the past, financial institutions have used different models for assets such as loans that they intended to hold until maturity. This allowed them to ignore irrelevant market fluctuations. In past financial crises – such as the savings and loan crisis in the 1980s – banks did not mark loans to market prices. That alone may have contained the S&L crisis until the crisis worked itself through the system. It's newfangled financial engineering that's to blame for banks' current problems. By packaging mortgages into more volatile securities, banks had swapped the credit risk of holding the loans for the volatility risk of any tradable financial instrument.

A Bearish Debacle: Policy Makers Perplexed

The meltdown of the huge mortgage-backed security industry puts policymakers in a real bind. In testimony before Congress, Fed Chairman Ben Bernanke has admitted that the inability to value such assets on the basis of actual trades is "one of the major problems that we have in the current environment. I don't know how to fix it. I don't know what to do about it." That's not Bernanke's failing. The instruments of monetary policy at his disposal are too blunt.

There are a couple of solutions. First, let the banks go bankrupt. After all, investment banks have been going bankrupt for centuries. In the 1870s, the John Jay bank -- the Goldman Sachs of its day -- went belly up. And there was not yet a Fed around to bail it out.

Second, emulate the solution to the Latin America debt crisis of the 1980s. In that instance, auditors agreed to ease off the banks for a few years to allow banks to work out bad loans. But Latin American loans were classified as being "held to maturity" -- which in effect gave auditors and banks more flexibility in how they could be valued. But replicating this solution with tradable securities spread across tens of thousands of investors may be a non-starter.

Finally, move the accounting goal posts to reduce paper losses. AIG, which recently wrote off $11 billion in the value of derivatives, has argued that fair value accounting has "unintended consequences." AIG instead wants auditors and companies to estimate maximum losses they are likely to incur and only book these losses in profits, with unrealized losses posted on the balance sheet but not recorded in earnings. In AIG's case, this method would have reduced the impact of the $11 billion write-down on fourth-quarter results to $900 million.

Accountants aren't lending a sympathetic ear. They point out that bankers were happy to describe mortgage securities as "tradable" at ever rising prices. Now, when things are tough, they want these same securities accounted for essentially as loans. And after the Arthur Anderson debacle, accountants are reluctant to take any step that might potentially expose them to Enron-style lawsuits.

A Bearish Debacle: The Cult of Modern Finance as Culprit

Whatever the eventual solution, there is no easy fix to the current woes. And contrary to the shrill critics screaming from the media peanut gallery, it's not because the former chairman of the Princeton economics department (Fed Chairman Ben Bernanke) and the former CEO of Goldman Sachs (Treasury Secretary Hank Paulson) have turned out to be incompetent yokels. That criticism is motivated more by either Schadenfreude or a Jonathan Edwards-style “Sinners in the Hands of an Angry God” idealism.

The real culprit behind the mortgage meltdown is the cult of modern finance. As Alan Greenspan pointed out in yesterday's Financial Times, Keynes' "animal spirits" have more to do with keeping markets liquid and functioning than any complex financial model could ever account for. The whizz-bang models of modern finance used as the basis of risk management systems in financial institutions across the world are unable to model effectively Nassim Taleb's "Black Swan" events or the psychology of financial mania. Nobel prize-winning modern financial theory suffers from an intellectual scotoma: if you can't model it in a mathematical equation, it does not exist.

Extreme market conditions always offer opportunities to make money. Investors who call the bottom of this market will make huge profits when it recovers. Only history will show whether in buying Bear Stearns for a pittance, JP Morgan just did.