Nouriel Roubini was the keynote speaker this morning at the CBOE Risk Management Conference in Laguna Niguel, California. I was there listening attentively.
Roubini has become the icon for economic gloom and doom in the world economy. Professor Roubini (NYU Business School) has been gloomy a long time. In 2004, he made a famous talk at the Davos summit predicting a world financial collapse and so it came to pass. What does he say now? More of the same.
According to Roubini, the aggregate US banking system is "insolvent." If by "insolvent," he means liabilities exceed assets, then that certainly is not the case currently. Could it become true? The answer depends upon the way in which accounting rules are applied. As they are now applied, there is that possibility.
Let me give you a simple example. Imagine that there only two banks in the entire world, banks A and B. Suppose the assets of each bank consist of a $ 100 billion loan to the other bank and $ 20 billion of cash. Now suppose the market price for each loan falls by 25 percent. Now each bank is insolvent: assets equal $ 75 billion for the loan, marked to market, plus $ 20 billion in cash minus $ 100 billion in liabilties. Each bank is now insolvent with a net worth of minus $ 5 billion. Suppose you combined the banks into a single bank and simply cancelled the two $ 100 billion loans between themselves. Then instead of two minus $ 5 billion banks, you now have one bank worth $ 40 billion. Does that kind of accounting make good sense? Don't think too long to answer that one.
This, in a nut shell, is what is wrong with mark-to-market accounting. The liabilities don't get written down, only the assets. In the aggregate, they balance one another, so that in a true aggregated balance sheet it is ridiculous to argue that the entire banking system is insolvent. But, bank by bank, with absurd accounting rules, it can, in principle happen, with the current regulatory regime.
Got any ideas? How about changing the current regulatory regime?
By the way similar nonsense occurs when you require the expensing of stock options, as almost all S&P500 companies have learned. If the options are never exercised, you still have to reduce earnings by their existence. So when they expire worthless, nothing has ever happened. It is exactly as if the options were never issued in the first place, except that reported earnings have been reduced for every single year that the options existed (they are typically amortized). Does this make sense? An event that turns out to be exactly the same as if nothing had happened at all has a major impact on the income statement of most companies? Again, don't think too long to get to the answer to this one.
It is not the "absence of regulation" that leads to the above absurdities, it is the existence of an overbearing and irrational regulatory regime.