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Capitalism kills itself

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Capitalism has been victimized by a lack of regulatory oversight and its own relentless greed.

As I write, the financial sector is literally disintergrating, with many banks' stock prices collapsing. Desperate to stop the contagion effect, the Federal Reserve has made a $85 billion loan to American International Group, to prevent that multi-line insurance company from defaulting on its loans.

Insurance companies need to maintain a strong balance sheet to pay claims. State regulators typically monitor the type of investments insurers make to make sure risks are not too high. This could explain why New York State Governor David Patterson tried to intervene on AIG's behalf. Should an insurer fail, state government is typically on the hook.

Insurance consumers might have reason to doubt that their insurers will honor claims, a precarious situation that would resurrect memories of the Great Depression, when insurers failed, leading to a myriad of state and federal laws and regulations meant to re-establish public confidence in the industry.

New York State and other entities clearly lacked the ability to make a loan of sufficiently large size to prevent a worst case scenario of a general default or bankruptcy. The Federal Government, on the other hand, seeks to insure the national marketplace for financial products, so losses associated with subprime debt, credit derivates, and other exotic investment vehicles have been socialized in order to stem a broader contagion effect.

The true value of the financial asset is determined in a healthy marketplace. Buyers must have the capital. And buyers are hard to find. After all, if something (a company or the debt it carries) cannot be sold at a given price, it isn't worth that price. The absence of buyers for AIG shows that the company may be worth little, if anything, and AIG certainly isn't the only company in need of more capital.

Unfortunately, our government has chosen to absorb the losses of AIG, after nationalizing Freddie Mac and Fannie Mae. The loan made to AIG may never be repaid, but if the company were fairly valued, no private entity would have bought it. In other words, our government has determined that saving AIG would help more than letting it fail. This can be in no small part due to the speed of the devaluation of bad debts.

Valuations decline rapidly

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Within a period of just a few months, huge write-offs like those taken by Merrill Lynch simply couldn't keep pace with the disintegration of the market value of debt securities held in their portfolio.

Merrill Lynch was just sold to Bank of America for about $50 billion, a fraction of that company's stock value just a few months ago. At $20/share now, the company's total market cap is about $29 billion, so BofA bought at a premium. Still, Merrill had been worth at least $60 billion as recently as June, so the company lost in excess of $10 billion in market value, even on the heels of a series of very large write-downs over the past year, which sucked some $25 billion off its balance sheet even before the sale was negotiated.

The decline in Merrill Lynch's market capitalization signals that the write-downs were inadequate and the losses even higher. Trying to free itself of bad debt--by openly admitting and writing them off--actually worsened the company's prospects to resolve the crisis by adding more capital. The more shaky a company's assets are believed to be by the rating agencies, the harder it is to attract new investors and capital. The temptation to understate the problem is therefore very high.

The less transparency provided, the less investors know about a company's situation. Government has a responsibility to counteract the temptation to grease the books. Should a company be able to avoid admitting problems on its balance sheet, the consequences can rapidly snowball, shaking investor confidence about just how much financial companies in the broader market are really worth.

Adequately imposed, transparency prevents investment banks and brokerages from hide facts that might diminish the allure of the financial products they sell. Regulatory efforts--undermined by the laissez faire approach of the Republicans--intend to bring out in the open avoidable mistakes and conflicts of interest, which if kept secret could end up undermining the system of issuing stock and debt itself. The markets are meant to be kept orderly, a process that depends on rigorous adherence to GAAP--generally accepted accounting principles, a set of uniform accounting procedures integral to standardizing investments.
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Apparently Lehman Brothers, which declared bankruptcy on Monday, was less willing to write down its bad loans. While on the surface, this avoidance of losses might make the company look good, the lack of transparency ended up masking the scope of the problem until such time as the company's liabilities exceeded their assets.

Write-downs are an important part of cleansing bad loans off the books. The Japanese, who suffered from an extended deflationary period from 1993 to 2001 or so, struggled with this problem. Banks were reluctant to abandon bad loans, in part due to the close relationships between lenders and the banks. By writing the bad loans off, the Japanese economy could have recovered more quickly.

If a huge corporation like Merrill couldn't handle the devaluation of its debt holdings, it's a good bet that the entire financial sector suffers from rapidly declining valuations as well, and will suffer additional losses that could further speed the decline in valuations, making even more companies suffer under tightening credit conditions and dwindling capital reserves.

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http://johnbpeebles.wordpress.com

The author lives in Colorado, photographing the natural beauty of the Rocky Mountains. He has a pair of blogs currently active. Topics covered include social, political, and economic issues.


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