Predictably Irrationality and Corporate Governance

In the video presentation, Dan Ariely, author of "Predictably Irrational", attempted to provide some insight to what is now called behavioural economics. Using findings in social experiments he conducted (these findings are better detailed and explained in his book), he explained, in very rational way, why human behaviours are sometimes irrational- and predictably so.

He went on to apply the findings in explaining the possible reasons why Enron, and by extention other corporate failures, collapsed.

Perhaps some lessons here for instituting good corporate governance?

The Paradox of Re-defining Marked-to-Market accounting

In February 2009, U.S. Treasury Secretary Timothy Geithner announced the setting up of a Public-Private Investment Fund (PPIF) (in which both government and private entities contribute capital) to provide financing in buying up toxic assets from the banks. With these assets off the their' balance sheet, it was envisaged, banks can then proceed with the path of rebuilding its profitability and regaining the public confidence.

Also, with a well-capitalised entity holding these distress assets (mostly securitised papers back by mortgages or other loans), it can unwind these securities in a orderly fashion thereby averting a volatile downward vicious cycle in the values of these assets.

It was reported today that he will soon provide more details on the plan.

It was also reported in the past week that Federal Reserve Chairman Ben Bernanke had suggested that the 'Marked-to-Market' accounting policy should be revised, but not repealed, as "current rules did not lead to accurate valuations in times like these."

Subsequently, FASB (Financial Accounting Standards Board) announced that it will soon publish new guidelines to the application of 'Marked-to-Market' accounting.

I wonder if the soon-to-be-refined accounting standard will interfer with the Treasury's effort in cleaning up banks' balance sheet.

Let's assume that, following the implementation of the new accounting guidelines, banks need not write-down the toxic assets to their market values, what then is the bank managements' incentive to unload these assets to PPIF? Assuming that PPIF will only pay market prices for them, the banks will incur losses if they were to offload them to PPIF.

Indeed, even if banks are able to sell at or above the assets' carrying values, it will serve their interest to adopt a wait-and-see approach rather than rushing out and unload the distress assets. By doing so, they are hoping that PPIF's effort in buying up the toxic assets (from other banks) will be successful in stanbalising the credit market. With the return of order, they have a good chance in then unloading their own assets at even higher prices. In any case, even if PPIF fails to clear the clog and market prices remain depressed, no downside risk is perceived now that 'Marked-to-Market' need not strictly be adopted.

As a result, banks may continue to hold onto the toxic assets until they deem it to serve their serlf-interest to sell them- at a profit (!!!) and not necessarily to PPIF. What then is the point in setting up PPIF in the first place?

Hence, paradoxically, the redefining of Marked-to-Market accounting, which is supposed to help stabilise the financial market, may post a barrier in the receovery path to a sound financial system.

Updates on 30 March:

Bloomberg reports on the pending revision by FASB.

Profit Flaunting

Following Citigroup's statement in an internal memorandum (it was obtained by the media) that it was profitable in January and February 2009, the U.S. market rallied. And a day later, JPMorgan Chase's CEO also made a similar statement.

It is not normal practice that U.S. listed companies provide updates on profitability on a monthly basis. One wonders if the unusual acts were meant to provide confidence to the nervous investors holding on to their shares.

More importantly, now that two of the big banks had flaunted their interim profitability, who is next? Or more pointedly, for companies that see their share prices under pressure, who can afford NOT to provide the market with updates that they too are profitable, lest investors think otherwise?

Updates:

17 March: Standard Chartered Had 'Strong ' First Two Months

16 March: Barclays Says ‘Strong Start’ to 2009

12 March: Bank Of America Joins Parade, Says Sees Profit This Quarter

Alpha Male vs Beta Female

"Would the world be in this financial mess if it had been Lehman Sisters?"

The question was raised at the WEF in Davos and reported in an article titled "Where would we be if women ran Wall Street?" that appears in 2 Feb 2009 edition of International Herald Tribune.

Indeed, if all those alpha-seekers were more wary of the levels of risk undertaken, the state of the finanical system might not have been as bad as it is. So, as we usher in the year of the ox, it is perhaps time to leave behind alpha which, ironically, refers to the bovine species in ancient Greek and embrace its sister, Beta.

The Politics behind Accounting Standards

The article, titled "Accounting Standards Wild Under Pressure", in Washinton Post details how quickly we, the accountants, change our stance. And we are suppose to issue independent opinions?

Origin of Crisis (Part 4)

Act III

As the politicians are busy deregulating the financial sector, the dotcom bubble (touted as historical proportion at the time) was forming throughout the mid-90's (perhaps one can date the beginning with the NASDAQ listingo of Netscape) and reach a fever pitch in Year 2000.

Then it burst. The NASDAQ index plunged from its height of 5,000 level (reached in first quarter of 2000) to below 2,000 points within a year. Events that took place subsequently, though each deserves an Act of its own, happened too quickly that a montage in bullet points might be best employed in laying them out:

1. The trouble at Enron that brought itself to bankrupcy (filed for Chapter 11 in July 2001) and also led to the collapse of its external auditors, Arthur Anderson;

2. Conflict-of-interest scandals within the investment banks and stock-broking houses. Among which are those involving Henry Blodget, an Wall Street analyst who was recommending Hi-tech stocks to clients while privately rubbishing the same stocks, and Frank Quattrone, an investment banker who was allegedly allocating IPO stocks to his clients or prospective clients as favours in exchange for business engagements.

3. The September 11 Attack that depressed the stock markets further and ensured a prolong U.S. recession that began in March 2001, as later confirmed by the National Bureau of Economic Research.

4. The full weight of the events above trigger further corporate collapse and, along with the downfalls, more corporate scandals. The more prominant ones are:

Global Crossing Ltd (filed for Chapter 11 in January 2002);
Worldcom (filed for Chapter 11 in July 2002);
Tyco International (recorded US$9 billion losses in Fiscal Year 2002).

5. The Outbreak of SARS epidemic in November 2002 further depressed economic activity in Asia.

The confluence of events in Act 3 led to a notion that the global financial markets were collapsing and world economy is slipping into a severe recession. Additionally, manufactured goods coming out of China at ever decreasing prices was driving home the point that had there not been any intervention, not only was the world entering a recession, it would be coupled with deflation. It was further argued that deflation, once fully entrench, is even more difficult to get out of using monetary policy.

To slay the beast with dual heads (recession and deflation), US Federal Reserve promptly slashed interest rate at historical pace and kept real interest rate at near zero level for a long period of time. The rate was cut from 6.5% at end of 2000 to 2% by the end of 2001. By July 2003, it was already at (then) historical low of 1%. It was kept at that level for close to one year before the rate was slowly brought up from middle of 2004 to above 2% in beginning of 2005.

Reflecting on historical inflation data of the 3 years between 2002 and 2004 collected monthly, US inflation has fluctuated between 1.07% and 3.73%. Over the same period, Fed Fund Rate was managed within 1.0% and 1.75%. i.e. real interest rate during the 3 years was mostly in the negative region.

Not missing out the opportunities to push for his political agenda and win votes, President Bush launched two major tax-cut packages in 2001 and 2003.

Mark-to-Market: The debate continues

It seems odd that in the environment of continuing loss of income, employment and wealth in the real economies, discussions on the arcane accounting treatment are still festering. In the past week, I came across two separate news articles that reported views and comments by some of the most senior regulators and executives in the business world on the subject of Mark-to-Market accounting.

SEC head says accounting rules must be neutral (Associated Press; 8 Dec 2008)

Behind Schwarzman Spat With Wasserstein Lies FASB Rule No. 115 (Bloomberg; 8 Dec 2008)


Granted, the issue was not fully resolved by the accounting bodies which, after intense lobbying and protest, allowed certain exemptions from the application of the treatment. But that was two months ago- a long time by 2008 standard (Obama was elected barely a few weeks ago but it seems he has been acting as president for months ). Between the two months, the crisis has spread from wall street to main streets around the world.

And we are still debating how we post a number to a balance sheet that was read by less than a fraction of a percentage of the world population?