Client Update -- September 30, 2009

The New Gold Rush!

California was the home of the original gold rush in 1849 and Wall Street is now the cause for the new gold rush in 2009. The first rush was fueled by greed after the discovery of gold, providing opportunity to improve one’s lot in life. This new gold rush is being fueled by fear that our lot in life will diminish unless we own gold. This fear is rooted in the hundreds of billions of dollars being printed by our treasury and thereby putting our currency at risk.

How did we get into this mess? Contrary to media reports, capitalism has not failed us. No other political/economic system has ever produced so much freedom and opportunity while improving the standard of living for so many people. The terrible economic crisis that hit us in 2008 has crippled the reputation of capitalism, even though the crisis was caused by our government’s actions. We all know that printing too much money is not a good thing, but our government did it anyway starting at Y2K with concerns about our economy and the new century. This led to the tech stock boom, and during the subsequent bust our government created even more money to save us again. This led to the housing boom (the money has to go somewhere!), and now we’ve just gone through our second bust this decade. How has our government decided to fix this one? By giving the addict more drugs!

History does not repeat itself, but it rhymes. Had the Federal Reserve not created so much money and kept interest rates so low twice this decade, this current crisis would not have been able to develop. All that money needed a home, and it eventually found one in home prices. For capitalism, this is merely the failure to handle all the money that government recklessly created. The three largest economic disasters—the 1930’s Great Depression, the 1970’s Great Inflation, and the 2000’s Great Recession—were all caused by government economic policy mistakes, but played out in the capital markets, and thus capitalism undeservedly received the media’s blame and the public’s scorn.

All of this begs the question, what works well in a world of falling dollar value and uncertain economic times? First and foremost is protection in the form of assets that should retain their value and even profit in this environment: foreign government bonds, commodities such as gold along with other natural resources, and higher growth areas like technology. Areas that may seem safe but could lose value include US treasuries and utilities. Second is vigilance. Most advisors won’t admit it, but the days of buy and hold are over. As we’ve always done for you, we will constantly watch over your portfolios, making strategic changes in investments as conditions warrant. Opportunities present themselves every day, but so do threats. It is just as irrational to believe that every investment opportunity is bad, as it is impractical to think that there is not risk in them.

We will continue to find investments where we can reasonably assess the risks in this dynamic and ever changing environment. Please call if you have any questions about your portfolio.

Market Update

Stock markets around the world have rallied strong from their March lows, retracing about one-half of their losses. While this is better than the alternative, it is also very typical of a bear market rally, so it does not necessarily mean we're out of the woods.

One year ago, the most adamant bears were predicting the S&P would sink to 1,000 and it dipped into the 600's. Six months ago, the most adamant bulls were predicting a rally to 1,000, and now we're there! Just as it overshot on the downside, it may overshoot to the upside, with the reasonable answer somewhere in between.

Looking in the rear-view mirror, let's assume first that the March lows were too low and merely the final panic sell-off created by the economic meltdown last year, and second that the market is now fairly priced for our current economic circumstances. If this is the case, then the market will only make progress from here if our economy makes true progress going forward. However, since our economy is at the epicenter of the world's troubles, it has many more economic issues to work through before solid results are consistently achieved.

Thus we are also looking elsewhere for opportunities. While other stock markets around the world sold off along with us during the panic stages, they do not face our troubles going forward and may offer better returns. Economies such as India, Brazil and Turkey to name a few, are experiencing internal growth and favorable economic and demographic trends that will allow them to prosper even as America suffers through some tough times. We expect to add incremental exposure to such overseas markets as their conditions continue to improve.

Overall, we would continue to characterize our outlook not as optimistic or pessimistic, but merely opportunistic. Our economy is in uncharted territory. While we hope for the good times to return, we must be ready for some difficult times as well and try to take advantage of what develops along the way. Thus far, our theme of getting paid (i.e. owning more bonds than usual) while we wait for the recovery is working quite nicely, and we do not expect substantial changes in the near term. In fact, several bond market indices have more than doubled the stock market indices this year.

We continue to monitor the economic landscape to assess a prudent path through these difficult times.

Client Update – July 15, 2009

Our current view is more cautious than optimistic. Because the drop-off was so severe, there is certainly a likely case for a short-term recovery. However, the unwillingness of lenders to take on even typical risks will throw a road block in front of any potential recovery. So, where does that leave us? Probably with an economic and financial roller coaster for the next several years! A sustained vibrant economic expansion needs free-flowing credit. Until that occurs, the odds favor a sub-par recovery. The massive amount of credit taken on by consumers this decade needs to be unwound at the very time that banks already have too many loans on their books and are in no hurry to boost lending – especially given the rising trend in delinquency rates. The Fed has boosted excess reserves in the banking system, but banks are not using this to increase lending – they would rather hoard the cash and safely make money for themselves and not take the risk of lending it to others.

The initial stock market enthusiasm this Spring seems to be giving way to more realism. Historically, deep recessions are followed by strong recoveries. The thought is that with higher corporate growth rates, both profits and equity prices will rise. However, this financial crisis is far from typical, and we can not safely rely on past cycles to predict how this will turn out. Could stocks surprise on the upside in the coming year? Of course they could! Since there is still a lot of cash on the sidelines, earning virtually nothing, those investors are under the pressure to raise their stock exposure. Further, the economy could rebound more strongly than generally expected. Although these outcomes are all possible, we give them a lower probability and are staying with a strategy that places a higher weight on capital preservation than normal.

The viciousness of this economic and financial meltdown has frayed nerves, and left many investors deeply skeptical about the timing, strength and sustainability of a recovery. These concerns are justified since lurking just over the horizon is the threat of another economic/financial crisis—inflation. We do not believe the government will be able to remove the current extreme stimulus (see chart) in a timely and controlled manner without creating a devaluation of the dollar and consequentially higher inflation. The market dysfunction has, and will continue to create opportunities at the stock- and bond-picking level. This has helped many of our active equity and fixed income managers generate high levels of outperformance during this recent period.

As is often the case, thoughtful, active management is experiencing a period of outperformance. What is encouraging is the evidence that these periods can last several years when following a time of market dysfunction. Data and manager feedback suggests that valuation discrepancies still remain and that it should continue to be a good environment for our management philosophy for some time.

To conclude, the financial nature of this cycle will have lasting repercussions and it will be a difficult climb back to any semblance of normality. The outlook is highly uncertain, and that argues against taking on too much exposure to stocks. Therefore, our preference is to remain focused on the varied opportunities we continue to find in the fixed-income markets around the world. We are working diligently to continue to find great opportunities amongst the markets’ wreckage.

Real Estate Moves

Six months ago, the real estate market appeared mortally wounded. Today, however, many sellers are receiving multiple offers on their homes; lower prices make this a great time to be a buyer or get your property taxes reduced; and low interest rates make this an ideal time to lock into a great long-term mortgage. Whether you’re an owner, buyer or seller, there are several factors to keep tabs on in today’s rapidly changing local real estate market.

Property Tax Reduction
If you own real estate, this may be the easiest time ever to obtain a property tax reduction. If the market value of your property (residential or commercial) is less than the property tax assessment value, then you may be able to reduce your property taxes. The closer to the top of the market you purchased, the greater your savings could be. Properties are valued by the county assessor every January 1 and the reduction filing period runs from July 2 to November 30 based on that value. You will need evidence to support your proposed valuation, but you may only use sales price data prior to March 31 to refute the Assessor’s January 1 value.

Your appeal can be submitted in two ways: via an application for a formal hearing or via a mail-in appeal. If you live in a neighborhood with similar homes, the sales price data is usually easy to compute and a mail-in appeal is generally sufficient. However, the more custom your home or location, or if the property is commercial, a successful appeal can be more difficult, but also more significant. Currently, due to the large number of appeals, it may take 6 or more months to secure a hearing date, and you’d better come prepared. At the hearing, you’ll be up against the Assessor’s office, and it will be your data versus their data. In this type of situation, I highly recommend using a professional service to represent you. However, be wary of the many scams that are surfacing requiring upfront payments followed by little or no work to obtain your property tax reduction.

It’s a Lender’s Market
Most real estate cycles are described as either being a “seller’s” or “buyer’s” market depending on whether prices are rising or falling and who is in control of the transaction. Today’s environment, however, is neither…it’s a lender’s market, because more than at any time in the past 50 years, it’s tough to get a mortgage. It’s more difficult to secure a mortgage now because of all of the cumulative abuses of recent years. The pendulum has swung the other direction—likely too far—and it will eventually swing back. However, most all the current problems would have been avoided had we just honored some simple lending requirements: Everybody should have to put 20% down and use either a 15- or 30-year fixed mortgage with reasonable and verified debt-to-income ratios. To secure any other type of alternative mortgage, the buyer should have a higher credit score and better debt-to-income ratios than those necessary for a traditional mortgage. But this is not the world we live in so many mortgage options are available, even to those who shouldn’t use them.

George Savile, a 17th century English statesman, once said “A prince who will not undergo the difficulty of understanding must undergo the danger of trusting.” Americans have become too trusting of their mortgages. To understand the various types of mortgages and when to use them is not rocket science, but it takes some time and is best done in context with your own personal situation. What tends to happen is the buyer goes out and finds a house they want. They then use a lender (who is generally not financially savvy and does not know enough about the buyer’s personal financial situation and goals) to find a loan that allows them to qualify to purchase the house. However, just because the buyer can “qualify” doesn’t mean it’s the wise thing to do! Caveat Emptor—this famous Latin phrase meaning buyer beware—applies all too well to mortgages. What has generally been necessary to make the numbers work are alternative mortgage products such as ARMs, Convertible ARMs, Option ARMs, Interest-Only, etc. While these alternative mortgages often make it easier to qualify for a loan, they can lead to unaffordably high future payments.

Fixed or Adjustable?
I must admit that I’ve never been a fan of adjustable mortgages. My business partner, on the other hand, has been very successful over the years just using adjustables, but he works at it and his timing has been good. However, we have been in a period of generally falling interest rates for the past 25 years so it has been easier to refinance at better rates every few years. While this has worked for both fixed and adjustable mortgages, it has been really good for adjustables. At some point the trend will reverse and it will be difficult to impossible to pull off what has been so easy in the past. Going forward, fixed rate mortgages may well be the better way to go.

If you already own your home, now is a great time to refinance and get rid of that adjustable loan and lock into great long-term fixed financing. If you are looking to buy, begin working with a lender before making an offer so that you understand your financing options. Currently, the fixed mortgage market is split into two camps. First, for larger loans over $1,000,000 your best place to start is a large institutional lender where jumbo, fixed rate loans are available. Second, for loans under $750,000, a good place to start is with an independent mortgage broker. If your loan amount is in between, you may need shop between the two in order to determine the best source.

Time to Buy?
History doesn’t repeat itself, but it does rhyme. So, I believe it will be helpful to look at the last LA/Ventura County housing bubble to gain some insight on the current situation. The last bubble started in 1985 and ended in 1989, with prices rising about 40% over 4 years. It then took almost 6 years (1995) to bottom at 1985 prices and another 3 years (1998) before it began to move back up. That’s 9 years from the market top to the point where we could feel the market moving up again. This current bubble started in 1998 and rose steadily through 2001, where it reached the previous 1989 peak, and then rose very sharply through 2005, with prices going up 125% over 7 years. Prices have been much quicker to drop this time, already falling back to 2001 levels in many areas by December 2008. Prices would still need to fall another 25% to reach the previous lows of 1985 and 1995.

Recent data still shows home prices continuing to decline, but the volume of home sales is finally on the upswing. A stabilizing of consumer confidence; government programs slowing foreclosures, providing tax credits, and modifying loans; along with record low interest rates (with government help) have all worked together to bring buyers back to the market. However, given the strength of this recession, and the fact that real estate markets don’t turn on a dime, we’re still likely to see more price declines, mixed in with several years of leveling off before prices eventually gain traction and begin to rise again. Further, all of the current government programs will be hard to sustain, creating more downward pressure on prices as these programs are terminated or modified. It may be 3-5 years before we see a more normal real estate market.

So, is it time to buy? In my opinion, only if you plan to keep the house for 5 or more years and you can get a 15- or 30-year fixed mortgage, then it may be a good time to buy. Interest rates will likely be higher in the future, so now is not a great time to use adjustable mortgages hoping to refinance at better rates in the future. A year from now, prices may be lower, but rates may be higher, and we could easily find ourselves just half way through a long, drawn-out recovery period. You won’t miss a big recovery by waiting a year or two, but you might miss out on an incredible foreclosure deal, your perfect dream home at a reasonable price, or historically low mortgage rates. So, be a selective buyer and use a traditional fixed mortgage to protect yourself.

Next Steps
Now is a great time to lock in great long-term financing or reduce your property taxes. Given current lending conditions, certain lenders are better for jumbo loans and others for conforming loans. My office maintains a list of trustworthy and skilled professionals who have been successful in helping our clients in today’s real estate environment. Please call if you would like a confidential referral.

Seven Steps to an Affordable College Experience

Find the school that’s truly a “best fit” for you, and the school will find more ways to make it affordable. Most students, however, go about the process backwards. With all the focus on getting in, few focus on getting out without significant debt. First, they find the school they want to attend, and then their parents scramble to find a way to pay once they’re admitted and offered limited financial help.

The good news for affluent and middle-class families, especially those that have not set aside enough money for college, is that those who receive the most financial aid are not always the ones that need it. Even if you have a large income, or have significant assets, there are many ways to cut college costs if you know the steps to take.

Qualify for Quality Aid
There are two types of financial aid: need-based and non-need-based. Even if you do not qualify for need-based aid at a less expensive school, you may qualify for it at a more expensive school. For example, if you’re expected to pay $20,000, and a state school costs $15,000, you might be expected to foot the entire bill. However, at a private school costing $45,000, you might qualify for $25,000 in need-based aid.

Furthermore, even if you don’t qualify for any need-based aid, many schools offer great non-need-based aid including grants, scholarships, tuition discounts, and merit money. To keep things simple, we’ll call all of these forms of free money “grants.” However, regardless of your financial situation, every student needs to complete a FAFSA (Free Application for Federal Student Aid) to be considered for both need- and non-need-based aid.

Step 1: Go to FAFSA4caster.ed.gov and click on “Begin Now” in the “Use the FAFSA4caster B” box to estimate your Expected Family Contribution (EFC).

Begin with the End in Mind
A successful approach is to target schools where you will be a best-fit student. To be a best-fit student, you should be in the top one-third of their freshman class, possess the characteristics and qualifications that make you the type of student they are looking for, and exemplify the school’s mission. A little known bonanza of detailed information known as the Common Data Set is a goldmine of admission and financial aid information.

Step 2: Using Google, type in the college name and “common data set” and find Part C to analyze the school’s stated admission criteria, including GPA and SAT statistics. Also, view Part F2 to locate programs and activities in which you participate. Finally, review the school’s mission statement. Does it resonate with you? Focus on those schools that are a best fit for you.

Four on the Floor
One of the biggest ways to cut the total cost of a college education is to graduate in 4 years. You’d be surprised at how difficult that can be at many schools. Few schools advertise their 4-year graduation rates, and many schools’ published rates are actually 6-year numbers. The average 4-year graduation rate for all colleges and universities is only 40%, versus 60% in 6 years. Private universities’ average 4-year graduation rates are 70%, versus 30% for public universities.

Step 3: Go to www.CollegeResults.org/search_basic.aspx and select the school, then click on the “vital statistics” link to see 4 to 6 year graduation rates for your best-fit schools.

Get the Grant
For most students, admission to a respectable college where they will thrive both academically and personally is not the real problem, it’s affordability. Many schools tout that they meet 75-100% of students’ financial need, but when you dig deeper you’ll often find that the need is met with loans. This could leave a graduating student saddled with significant debt. Therefore, your search should focus on schools that provide the largest portion of their financial aid in grants, not loans. You also want to verify that the school does a good job in continuing to provide grants during years 2-4.

Step 4: Use the Common Data Set, Part H, for each of your best-fit schools to analyze its total financial aid package. To find the average grant dollars go to Part H2 line (k) for need-based or line (o) for non-need-based students. Further, line (e) and line (n) tell how many need- or non-need-based students received grants, respectively. With a little basic math, you can glean valuable insight into how each school awards financial aid. Then, further focus on those best-fit schools that offer the amount and type of aid you’ll need.

Dollars for Diversity
Admissions officers are all striving for diversity. The term means something slightly different to each college, but regardless, it can be used to your advantage. For example, most engineering and technical colleges are male dominated, so they are looking for more female students; and most schools are filled with in-state students, so they are looking for students from far-away states. Find the schools that want, but lack students like you, and they’ll find you more grant money.

Step 5: Use the application, admission, and enrollment numbers found in the Common Data Set, Part B2, C1, C7, and F2 to your favor by applying to schools that are looking for students like you. Further, apply to distant schools (Common Data Set, Part F1) who will be excited to receive an application from outside their region.

Application Angles
Aside from the proper completion of the application, it is helpful to apply early, visit the schools if possible, and stay politely in contact with them so they know you’re interested. In addition, there are a few more subtle steps that can increase your financial aid. If you are truly a best-fit for the school, they will not want to lose you to a competitor, especially one in their region. Therefore, consider applying to a known rival school where you’d also be a best fit, and to a reputable, in-state public school where they know you could attend for less. How will they know where else you applied? You filled out the FAFSA in Step 1 and listed the schools you wanted it sent to!

Step 6: Go to CollegeBoard.com, select your best-fit schools and use the “Find Similar” tab to locate at least one nearby rival school for each of your best-fit schools and apply to them as well. Respectfully mention the competing schools when discussing your financial aid package with your preferred schools.

Funding Fears
Most parents overestimate how savings, retirement, and 529 accounts will cost them financial aid. FAFSA doesn’t even ask about home equity, retirement accounts, or a non-custodial parent’s assets to determine need-based aid. Parental assets, including 529 accounts, only reduce need-based aid by 6% of their value. Parents also underestimate how much flexibility many schools have in awarding grants to their best-fit students, especially if the family’s financial situation has changed. Admissions officers can be very accommodating when they feel they are dealing with reasonable people.

Step 7: Use 529 plans to save for college and convert traditional custodial accounts (UGMA & UTMA) to 529s. Calmly appeal the financial aid package you’ve been awarded. Don’t treat the discussion as a heated negotiation and don’t oversell the student – admissions officers have seen and heard it all before. Be specific as to the number you’d need to make it work, mention any situation they could empathize with, and offer documentation to support your case.

Competition among students and schools has created a focus on admission to schools with big brand names and impressive rankings. However, if you’re not a best fit for one of these schools, your financial aid package will likely be miserly. Instead, increase your odds of receiving the financial aid you need by following these seven steps to an affordable college experience.

Client Update – April 15, 2009

Cashing In on Closed-Ends: The first three months of this year saw the seventh consecutive quarterly loss for the major stock market averages. From 2009’s peak to trough (January 6 to March 9), the stock market dropped nearly 30%. However, amidst the continued carnage, there exist some very interesting securities. These securities are very misunderstood and this allows a patient and careful investor to take advantage of the current environment. What makes them a real value is that their higher volatility is due to other peoples’ fear and panic and not reality. When you understand how they work you will be more comfortable with the volatility and realize how profitable these securities can be, when purchased as others panic.

They are unusual, so stick with me and I believe I can explain them. First, on Monday, March 9, 2008, the stock market was down nearly 4%. One of these misunderstood securities, Eaton Vance Limited Duration Income (symbol EVV), was also down 3% in price. However the actual value of this security increased by 0.2%. Further, from February 1 to March 9, EVV’s price fell 20%, but its value fell only 4%. So, while the stock market may move its price around, its true value is much more stable. How can this be?

A little history is in order! At this point my kid’s eyes usually glaze over, but please stick with me. This type of security is called a closed-end company and there are many hundreds of them. They’ve been around since 1822 when King William I of the Netherlands first authorized and used the concept. They are the predecessor to today’s mutual fund, which were created in 1924 in response to a “flaw” these securities have; a “flaw” that can be exploited. Where mutual funds only price at the end of the day and everybody gets in and out at the same price, closed-end companies are traded all day long at varying prices. So they are basically mutual funds that trade on the stock market, or to think of it in other terms, a stock/company whose sole business is managing a portfolio for its shareholders. There is an important difference (as noted above): Closed-end company stock prices can move differently than the true value of the portfolio they manage for you. This perceived “flaw” led to the creation and popularity of mutual funds and their pricing fairness. However, the “flaw” can be used to your advantage when there is sufficient fear in the market.

Both mutual funds and closed-end companies have a Net Asset Value (NAV) which is their true value and a market price they trade at. The NAV is the value of the stocks or bonds that the fund holds. Where a mutual fund’s NAV (value) and price are always the same, only a closed-end company has a price that can be different from its NAV (value). Thus, while EVV’s portfolio of notes and bonds fell only 4% (from $11.77 to $11.30 due to panic and mass selling around the world in early March), your fellow investors were in full panic mode and selling everything they could, driving its price down 20% in a few short weeks.

So, while most investors were reacting to its 20% price drop, we were comfortable with EVV’s 4% value drop and felt certain it would correct quickly. By March 31, EVV’s value was up 5% (from $11.30 to $11.87), recouping all its drop incurred during the 30% market sell off, and its price was up 17%, almost recouping all its 20% drop. But, we care more about its value for gauging safety and real progress. For the first quarter of 2009, EVV’s value was up 7% while the stock market was down about 15%. Did I mention that it pays 1% per month in dividends? So, EVV’s year to date return was actually 10%, based on value. Based on price, the return was about 9%, but with more volatility, which I’m suggesting you ignore as long as the value is holding up.

I have attached a chart that shows its movements since December 31, 2008. Please use the left scale in dollars for Value and Price and the right scale in percent for the Discount. You can see the green Value line has remained quite steady. If EVV were a mutual fund, its NAV (the green Value line) would have made it a steady performer in the recent 30% sell-off. In contrast, the blue Price line has moved quite a lot. The yellow Discount line tracks the difference between the Value and Price. For example, at March 9, EVV’s value was $11.30 per share, but you could buy it for $8.89 per share, a 21% discount. That’s nothing but fear!

On top of that, I should explain how we can find a bond portfolio yielding over 12% per year. Well, it was a bond portfolio yielding about 8% last August that has fallen 25% in value from roughly $16.00 to $11.87 and its price dropped even further to $10.51, causing its yield to go from 8% to 12%. Thus, EVV’s income producing securities are trading at a 25% discount to their maturity value, and you are able to buy the fund itself at a discount. A discount on a discount and 12% per year in dividends while waiting for it to go back up could be a good thing. We just need to tolerate the price volatility (while we closely monitor the value) to be sure this gem continues making real progress.

EVV is just one example and over the coming months we plan to continue researching and acquiring other deeply discounted closed-end securities as opportunities arise. Thank you for your patience and I hope this helps you understand more about the unusual opportunities available in this confusing market environment.

Client Update – April 2, 2009

Why today may have been significant to our economic future! We would like to share with you an article written by Steve Forbes, Editor and Chief of Forbes magazine. Mr. Forbes writes about the unnecessary regulations and new accounting rules that have brought on many of the problems surrounding our financial crisis: In particular he discusses the so called “mark-to-market” accounting rules that make companies and banks recognize prices for assets that are not realistic but have a profound impact on our financial system. This rule has forced many whose operations are profitable to appear as if they are losing money or insolvent. To the credit of this administration, this rule was greatly changed yesterday, and the stock markets around the world have reacted by going up significantly.

Although many good financial lessons were learned during the Great Depression, unfortunately many of the laws passed at the time to stabilize our financial system have been undone in the past few years: mark-to-market accounting, short sale uptick rule, naked shorting, and the Glass-Stegall Act to name just a few. This article was written about a month ago and he clearly lays out the problems being caused by mark-to-market accounting. Our hope is that it will help you understand the benefits of changing the rules back to where they had been. We don’t need more regulation, we just need to go back to what has worked fairly well for the last 70 years. Here’s the article:

By STEVE FORBES
What is most astounding about President Barack Obama's radical economic recovery program isn't its breadth, but its continuation of the most destructive policies of the Bush administration. These Bush policies were in themselves repudiations of Franklin Delano Roosevelt, Mr. Obama's hero.
The most disastrous Bush policy that Mr. Obama is perpetuating is mark-to-market or "fair value" accounting for banks, insurance companies and other financial institutions. The idea seems harmless: Financial institutions should adjust their balance sheets and their capital accounts when the market value of the financial assets they hold goes up or down.
That works when you have very liquid securities, such as Treasury bonds, or the common stock of IBM or GE. But when the credit crisis hit in 2007, there was no market for subprime securities and other suspect assets. Yet regulators and auditors kept pressing banks and other financial firms to knock down the book value of this paper, even in cases where these obligations were being fully serviced in the payment of principal and interest. Thus, under mark-to-market, even non-suspect assets are being artificially knocked down in value for regulatory capital (the amount of capital required by regulators for industries like banks and life insurance).
Banks and life insurance companies that have positive cash flows now find themselves in a death spiral. Of the more than $700 billion that financial institutions have written off, almost all of it has been book write-downs, not actual cash losses. When banks or insurers write down the value of their assets they have to get new capital. And the need for new capital is a signal to ratings agencies that these outfits might deserve a credit-rating reduction.
So although banks have twice the amount of cash on hand that they did a year ago, they lend only under duress, or apply onerous conditions that would warm Tony Soprano's heart. This is because they know that every time they make a loan or an investment there is a risk of a book write-down, even if the loan is unimpaired.
If this rigid mark-to-market accounting had been in effect during the banking trouble in the early 1990s, almost every major commercial bank in the U.S. would have collapsed because of shaky Latin American and commercial real estate loans. We would have had a second Great Depression.
But put aside for a moment the absurdity of trying to price assets in a disrupted or non-existent market, of not distinguishing between distress prices and "normal" prices. Regulatory capital by its definition should take the long view when it comes to valuation; day-to-day fluctuations shouldn't matter. Assets should be kept on the books at the price they were obtained, as long as the assets haven't actually been impaired.
Mark-to-market accounting does just the opposite. When times are good, it artificially boosts banks' capital, thereby encouraging more investing and lending. In a downturn it sets off a devastating deflation.
Mark-to-market accounting is the principal reason why our financial system is in a meltdown. The destructiveness of mark-to-market -- which was in force before the Great Depression -- is why FDR suspended it in 1938. It was unnecessarily destroying banks.
But bad ideas never die. Mark-to-market was resurrected by the Financial Accounting Standards Board and became effective in the fall of 2007 (FASB rule 157) to the approval of the Bush administration, its Treasury Department, and the Securities and Exchange Commission. Even as FASB 157 began to take its toll on financial institutions last year, Mr. Bush refused to kill or suspend it. When Congress voiced displeasure last fall, the administration and regulatory authorities made some cosmetic changes, but the poisonous essence remained.
If the president really takes Roosevelt's legacy seriously, he should suspend mark-to-market accounting rules, restore the uptick rule, and enforce the prohibition against naked short selling. If he doesn't, historians will look back in utter amazement at Mr. Obama's preservation of Mr. Bush's worst economic policies.