Op-Ed: Catchphrases Blur Changes on Wall Street

By Tom Kaufman and Christian Hudson

Originally Published in the Santa Cruz Sentinel: 06/22/2008

Financial SWAT teams, increased power and more regulation are just some of the catchphrases currently volleying back and forth between Wall Street and Capitol Hill. Although it's clear change is coming, its silhouette is still as blurry as whether we've reached the bottom in the credit crisis.

The debate will certainly intensify, but before we lose the proverbial forest through the trees, what's important to remember is that there are options available that won't strangle innovation, force firms to move overseas and won't cost taxpayers more money.

Consider one question: would you eat at restaurant that first got to interview the health inspectors, then got to pick who got the job? Oh, and if the restaurant didn't like the report, it then got to make sure the inspector never came again. Reservations anyone?

That's what Wall Street gets to do. In fact, Wall Street calls it a beauty contest when the Big Four accounting firms by that we mean Deloitte & Touche, Ernst & Young, Pricewaterhouse Coopers and KPMG show up to interview with one of the venerable banks or investment houses for the job of auditor. It stands to reason that if an accounting firm hopes to get rehired, then the product might look more like what the client wants to hear than what you or I need to hear. Can anyone represent the true public interest and yet be selected by the company being reviewed? Benign neglect anyone?

Even better, consider that both the rating agencies and our current regulatory system use the numbers from the auditors. So even if the government creates aggressive new financial SWAT teams filled with Crouching Tiger Hidden Dragon-style fighters wielding laptops and calculators, how good are they really going to be if the information is still a product of a conflict of interest?

What to do? Kill the beauty contest and replace it with a lottery system.

Let the Securities and Exchange Commission or whatever marble government building ends up as last man standing after Treasury Secretary Paulson shuffles the deck determine the selection. If you think that institutionalizes the Big 4 as a monopoly, then here's a headline: Status Quo Results in Fewer Accounting Firms. Still, a test to lottery entry for accounting firms aspiring to bigger clients can certainly be written.

If you are a politician who thinks the Fed's move on Bear Stearns was a bailout, then you should like this plan because it helps all parties shine the flashlight on the fancy math. And, say, if you're a politician who thinks the market should be left alone, then you should like this because the lottery system doesn't step on Wall Street's most dynamic and innovative minds.

Now, if you are reading this saying, "Yeah but won't this result in the Big Four phoning it in?" Well, if you don't do your job, then you're out of the lottery or get a reduced share. How's that for motivation? And, if you're the Big Four, the good news is that you get the jobs, maybe more respect, and maybe more protection from litigation for doing your job.

Lastly, many of you may correctly point out that this is similar to what the British do and they didn't dodge the mortgage bullet either. That's true, but if you look at the reports, the finger is pointed at how the government regulators actually regulated companies -- not the auditors.

Our suggestion doesn't necessarily replace the other ideas floating about. We just think without it the other ideas don't really have a chance to do what you think they'll do. Apply this idea to rating agencies, too? How simply revolutionary.

Tom Kaufman is the Capital Markets Committee Chairman for the American College of Real Estate Lawyers.

Christian Hudson, a former Santa Cruz resident, now practices law at Hunton and Williams LLP in Washington.

Today's Two Great Stories Help You Get Smart: Homes Sold for .30 to .40 Cents on the Dollar? And the Bear Sterns Story You Should be Reading.

As we predicted yesterday, the Bear Sterns' emails would draw the sexy headlines (and deservedly land on the front page). But, again don't let the headline bury the lead. It might be A1 in the NY Times, but the most important story related to Bear Sterns is C1 of the Times' business section. It is about asset valuation. Boring you say? Why you care is because that simply means how banks and investment firms decide what their portfolio is really worth. In other words, the toughest part for a Bear Sterns is trying to decide what a bundle of mortgages are really worth when the market is gyrating like an amusement park. It is more magic math, and the rest of Wall Street has the same struggle.
Out West, the LA Times has a terrific and instructive piece on buying foreclosure properties that you might miss but shouldn't. The sexy headline here is how investment firms have been buying homes at .30 to .40 cents on the dollars from homebuilders. That's the wow factor. Why you care is the reporting on what it takes to buy a foreclosed home and the pitfalls. As finance and real estate attorneys we say bravo to this type of reporting especially the warning about stepping into the original owners' shoes and finding yourself faced with the liens and mortgages that sunk their boat.

Don't Miss the Lead Because of the Headline

Normally we like to highlight just one story that we think is overlooked and deserves your attention. But, today is different because the real story is how:

1) The indictment of the Bear Sterns fund managers...
2) Treasury Secretary Paulson's push for a stronger Federal Reserve regulatory role...
3) Banks' use of magic math can make a balance sheet look attractive to investors...
4) UCLA's prediction that economic angst and pain will continue until 2010...

...are really all moving parts of the same story.

The story is whether regulation or prosecution will rule the day as a way to restore investor confidence and market stability. AND, will it happen fast enough to limit more pain?

Why do you care? You care because if you can understand this then you'll have a sense as to how things are going to play out for the next year.

First, the Wall Street Journal's excellent reporting on the Bears Sterns indictments points out that prosecutors like to go with their best case first. That's the headline because if this sticks, then you'll see more prosecutions. But if the indictment is tossed out, then you're not likely to see much else. The email details may be delicious, but what matters to your home value and 401k is whether prosecutors chose the right case.

Second, Treasury Secretary Paulson's push for a stronger regulatory role for the Fed is the flip side to the indictments. Basically, it is the government doubling down to play two hands. A judicial hand in pursuing criminal prosecution, and a regulatory hand in the hopes of not having to play the court card in the future. Why do you care? You care because neither hand holds a scalpel, instead each holds a cudgel. On the one hand picking the wrong case to prosecute runs the risk of further undermining investor confidence that is hungry for accountability. On the other hand, any regulation (even appropriate and effective regulation) runs the risk of unintended consequences. What's the mean? That means mortgage mess fallout regulation will try to walk that line between safeguarding from another credit crisis and soothing jittery investors with making sure it doesn't grip too tightly and squeeze business out of Wall Street and into London.

Third, the Wall Street Journal did everyone a favor in deftly explaining how banks can legally move assets around (or simply redefine them) so that their balance sheets still look good to investors. This story goes directly to whether investors will feel good about jumping back in and the challenges for Paulson and the Fed.

Fourth, most predictions have things turning around in 2009, but UCLA contends it is going to be a slow burn all the way to 2010. Readers and viewers today will understandably be distracted by the sexy headlines of indictments in the Bear Sterns case and the details of the email exchanges, etc. But what shouldn't be missed is how decisions made today on the judicial end, and the debate and ultimate conclusion on the policy end are really going to leave their mark next year. And, that will be when we are in the midst of another year of teeth gnashing. Right when everyone is hoping the markets find their footing. Reporters and producers have a chance to put the parts together now into a digestible snacky piece so that come next year there's a collective sense of how we got from here to there. Oh, by the way don't you feel a bit more confident when you understand things?

And the Answer to Rocketing Oil Prices and Sinking Home Prices is... Offshore Oil Drilling?

Rarely do you get such an easy bouncing ball to follow as to how a business issue (rising oil prices) becomes a consumer issue (rising gas prices) that boomerangs on the economy (suburban homes already on the brink of foreclosure become even less attractive due to the expensive commutes) so that it turns into a political issue (Pres. Bush, Sen./Republican party presumptive presidential nominee McCain, and Florida Gov./potential VP pick Crist now support offshore oil drilling). Why do you care? You care because if the solution to gas prices is offshore oil drilling, then what about energy research? What about consumer pressure on the auto industry for more fuel efficient cars? On the other hand, you also care because if you live in the burbs lower gas prices mean more in your pocket on your daily commute, not to mention your neighborhood starts to looks reasonable again as a bedroom community for your town. And you really care because mortgage applications are at a new low for the year. Politically, we wonder if the political bank shot goes something like this: Given that McCain and Obama are so tight in the polls among independents, is the McCain campaign betting that gas prices/wallet issues will trump environmental issues among independents? Seems like a smart political reporter with access to his/her news organization's polling archives could answer that in a solid piece.

The Link: Gas and Land Values Part II

While the Wall Street Journal puts the gnashing of teeth over what the Federal Reserve will do next in terms of rates (nothing or raise them over inflation inflammation), we decided that we already flagged that for you last week. So instead we thought it better to return to one of our favorite story lines - the link between home values and gas (as seen in our prior post The Link: Gass and Land Values). The Atlantic Monthly some months back did a terrific piece arguing that the McMansions of today's suburbia may be the slums of tomorrow. They have a compelling argument. (We just wish it was easier to link to for you on their website). As we've shown you before, housing markets across the country are not equally taking the hit. Instead, consider who is: Often times it is the burbs. Why do you care? Because even if oil is experiencing a bubble, gas isn't likely to return to the levels that commuting in a Hummer is viable. Thus, my city row house looks pretty good. Today's LA Time's story shows how Southern Californian commuters are experiencing price reductions in the housing markets furthest out. The story is about Los Angeles, but we think it might as well be about any big city. I could substitute LA and Pasadena for Washington, D.C. and say... Fairfax City, Virginia?

Save This Link and Save Your Financial Life.

Reading the business pages and blogs today and last week gives one the sense that the sky is falling. So instead of highlighting a must read article like today's NY Times' story on how almost half of Wall Street's bank profits have - POOF - vanished, and that Goldman Sachs is supposed to report tomorrow with Morgan Stanley on Wednesday... Or, suggesting the Washington Post's feature installment on the Mortgage Mess. Nope, instead, we think you should check out CNN's bevy of financial calculators. Why do you care? Want to see how your retirement is going, or perhaps look at a new mortgage while taking advantage of a down market, or maybe just pick a mutual fund? CNN has all the calculators right here. SAVE THIS LINK, and forget having to Google for these calculators. Right now is the perfect time to create a plan that takes advantage of a down market.

Why Your Town Can't Seem to Fix Anything

You pay your taxes, so why isn't that road fixed? Why hasn't the city finished off building the new park, or police station? Why? Because cities generally use bonds to get those done. You can imagine when Wall Street is on a lending diet that gets even more difficult for cities, and it couldn't be a worse time since defaulting mortgages also mean property taxes are not getting paid either. So why you care about bonding ratings is because it can help your city get better access to money and keep the projects going during lean years. And of course when the cities have to pay less, there's less reason to raise taxes. Most people's eyes glaze over when you say "bonds" much less "bond ratings" but this story really is about the quality of your life in your community. Now that you have that background, click here to read the New York Times' report.

Collision Course of Inflation and Adjusting Mortgages?

Unclogging the mortgage mess' drain meant the Federal Reserve was willing to lower rates in order to increase the amount of money institutions were willing to lend. More money being lent means more projects getting built (thus more jobs), and of course, more things getting purchased (from cars to homes). But, and this isn't new, from the moment that all the financial wizards agreed there was a problem in the market most news stories have had a cautionary paragraph at the end of their report which noted eventually increasing that cash flow would spur inflation worries. Guess what? Fed Chairman Ben Bernanke is getting more full throated about inflation concerns. Why do you care? Because when those other adjustable rate mortgages (ARMs) reset come next Spring we just might be at the point where the market it still stalled but inflation will mean no help in the rate cut. Result? Who really knows. But, we'd like to see more news stories explore both of those concepts colliding. If I were buying a house now, I'd be thinking about locking in a rate, but at the same time I couldn't be sure that prices wouldn't go down further. Especially given next Spring. If I were selling a house, I'd worry about next Spring. It puts a lot of pressure on brokers and sellers this Summer. In the meantime, check out CNN's solid coverage today on this.

The Double Whammy: Home Credit Line Crunch, and Looming 2009 ARM Reset Wave

You probably missed these two articles from the end of last week and Sunday's paper. But, you can't afford to. Why you care is because one explains how that home credit line you thought was there for a rainy day, may have gotten washed away. The other explains why those in the real estate business are bracing for Spring of 2009. Think of it this way. If the Mortgage Mess was a tsunami, when all those ARMs reset come next Spring it will feel like the second set crashing down on you. Why you care is because you can either ride the wave or get crushed by it. Read on.

Basic Math on Fixing Your Mortgage

CNNMoney.com has an excellent primer on the basics of fixing a mortgage that's in deep trouble. Included in the story are two things we always point out to people when they ask why can't all the mortgage problems just be fixed. First, as reporter Les Christie writes, "what's best for a borrower isn't always best for the lenders". That's absolutely true, and that's the struggle. On the other hand, there's something in the favor of the home owner - and that's the second point: A foreclosure costs a bank about $50,000 per home. Thus, why you care about that number is whether your mortgage can be fixed under that bar? Maybe so, maybe not. Still, this article is a great first step in understanding the process.

Slouching Toward Reform while Lehman seeks another Brother, or a Sister

While everyone is talking about the end of the primary season you can bet Wall Street and Capitol Hill banking types are more focused on two stories today. First in the Wall Street Journal's, "Lehman Is Seeking Overseas Capital" and second the New York Times' "Rating Firms Seem Near Legal Deal on Reforms". Why you care about these two articles is because it shows that while Wall Street is acknowledging that those who rate investment companies and products for potential investors are getting played off one another by the very people they are supposed to be evaluating. This, of course, is something we have been focusing on here for a while and most recently on our post, "Is this the U.S.' Plan to Prevent the Next Wall Street Meltdown?". Fixing the problem will eventually bring confidence back to Wall Street which is good for your pocketbook and 401k. Meanwhile, the Lehman Brothers story is a reminder that we are not out of the woods yet. If you read two financial stories today, these are them.

Building the Perfect Beast?

The Wall Street Journal has a good short article on defaulting construction loans. Why you care is because defaulting construction loans make lenders less likely to lend, and stopping up the market instead of fluidity makes your stock portfolio under perform. The other part of the story here that you care about is that construction means jobs, and even if you aren't a part of that sector, you need all portions of the economy doing reasonably well so that people have money in their pockets and bank accounts to look toward the future. What we'd love to see, and what would be most useful to you, is for the Wall Street Journal to take the next step and do this story but in a market by market analysis. We'd love to see San Francisco compared to Washington, DC - so on, and so forth. Until then, check out Lingling Wei's article "After Mortgages, Construction Crisis May be Building". (Wei's editor gets a nod for the headline).

Credit Crisis Kills Your Kid's College Loan

How is that for a reason as to WHY YOU CARE about the business pages? Lending institutions feeling the pinch are now deciding to not lend to some four year colleges and community colleges. Result? Well, for example, say you are an honor roll high school graduate in California that can get into pretty much any school you want but decides to do two years at a community college knowing you can then move on to a UC and come out with thousands upon thousands of dollars of less debt at graduation... Now you are going to have to get a second or third job while you are at that junior college because you have no access to a loan. This, like the mortgage crisis has been percolating for a bit. The business pages might not be the front section of the paper or the lead on the local news, but at the end of the day it is the difference between owning a home or not. Going to school or not. Making more money or not. Having healthcare or not. The New York Times' Jonathan Glater deserves credit for not only writing about this, but writing about it for a general news audience. You need to read this. There's going to be more on this, and this article is an excellent starting place.