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MAKING CENTS OUT OF THE NEWS
Blog #10
(September 20th, 2008)
RULES GONE WRONG
By Tom McAllister, CFP™
As the Music Man would say, "We've got trouble, trouble, trouble". Much of the trouble in the U.S. financial markets has been attributed to the sub-prime mortgage meltdown. But, as a financial planner and stock market observer for more than four decades, I know that at least two other factors are weighing very heavily on financial stocks now. Both these factors have to do with rules. In my opinion, one set of rules is too strict, the other too lax.
The first set of rules relates to banks, requiring them to do “mark to the market” accounting. These rules, launched just a few months ago, force banks (both investment and commercial banks), on their quarterly statements, to show all assets, including long term holdings, at current market value. That means that even long term home mortgages on which payments are current must be priced quarterly (as if the homes were being sold right now!). Of course such long term assets were never meant to be priced quarterly, and since home prices in general have fallen, the mortgages show up as losses on income statements. The irony is, no cash losses have occurred, because the mortgage payments are up to date and the homes are not all being sold right now! The same unreasonable rules apply to commercial real estate holdings by banks. The new regulations (part of the Sarbanes-Oxley legislation) that require this "mark to the market" are triggering unintended consequences by making the financial statements of investment banks and commercial banks appear to be in much worse condition than they truly are. In my view, Congress should immediately pass legislation suspending these “mark to the market", pending review and modification of accounting abuses. This set of rules is too strict and is hurting, not helping matters.
Just as Sarbanes-Oxley rules are "too strict", a second set of rules, this set perfectly sensible and effective, was changed last July by the SEC, regulators of the stock market. Now we have a situation where the rules are too lax, inviting some of the abusive practices that are helping drive stock prices down. This second set of rules has to do with "short sales" of stock. By way of background, a short sale is one made by a person or entity with borrowed stock. The seller borrows shares from a broker and delivers them to the purchaser's broker. The seller is betting the price of the stock will go down. (If I'm a short seller and ABC stock is now selling for $50 per share and I believe it's headed downward in price, I sell borrowed shares at $50, with the intention of buying shares at $45, delivering them to cover my sale and keeping the $5 per share profit.)
Until July of last year and going all the way back to the Great Depression, short sales could be made only on a “up-tick.", meaning at a price higher than the last transaction price. This rule kept short sellers from driving down the price of a stock by repeatedly selling it short. In the year since these very effective restrictions were removed, hedge funds and other speculators have deluged already troubled financial stocks with continued and repeated short selling. In my opinion, Congress should immediately pass legislation reinstituting the up-tick rule. In fact, as proof of what I'm saying about the need to limit short selling, just a couple of days ago the SEC put a temporary ban on short selling (whether on an up-tick or not!) on 799 different financial stocks.
Yes, we've got rules, rules, rules. Some are unreasonably strict, some overly permissive. And, my friends, maybe that's the reason we've got troubles, troubles, troubles….
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