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Unruly Accounting


Haphazard, irrelevant rules must be changed now.

Rules have consequences - sometimes unintended consequences. If I told you the US government was going to give multiple tens of billions of taxpayer dollars to hedge funds and private investors, you'd justifiably not be happy. In fact, I think the word "angry" would come to mind.

But that's exactly what's happening, as a result of rules that were written for a time and place seemingly long ago and far, far away. Further, we're looking at potentially much larger sums being lost in the bank bailout (can we say hundreds of billions?), a reduced lending capacity at banks, and in general, a worsening of the very problems at the core of the crisis.

The good news is that it can be fixed, but the authorities need to get a sense of urgency. As Steve Forbes writes today in the Wall Street Journal, Obama is continuing with the worst of Bush's policies, making the crisis far worse than it should be. It's as if we're giving all 13-year-old kids an "F" in math because one kid failed.

Today's letter will look at some rather obscure rules that are having major unintended (and negative) consequences - and what can be done. Then, if we have enough time, we'll look quickly at Japan, unemployment and a few more statistical predictions of when the recession will end that you should be very wary of. It's a lot to cover, but it should make for an interesting letter.

Unintended Consequences

Let me state at the outset that I'm going to oversimplify this story to keep it from getting too long and technical, because I think it will make it far more readable and understandable to the majority of readers.

Let me note that while I'm talking about rules that don't make sense, this in no way should be seen as a criticism of the regulators. It's their job to enforce the rules, not make them. The authorities at the top (including Congress and the administration) should be taking action.

In the beginning, there were ratings agencies, and they rated corporate bonds from the very highest of credit quality (AAA) down to junk (CCC).

Now AAA means that the chances of losing money are very, very low. With each level of increased incremental risk comes a lower rating. If a corporate bond was at risk for losing just $1, it was rated all the way down to junk. And that was fine. Everybody knew the rules of the game.

But then investment banks asked the agencies to rate a large group of home mortgages in a pool known as a Residential Mortgage-Backed Security (RMBS). The investment bank would divide the pool (the RMBS) into various tranches. The highest-rated tranche would be given a rating of AAA. Let's say that the AAA tranche was 92% of the loan pool. The AAA tranche would get the first 92% of all monies coming into the pool before the other investors were paid (again, really oversimplified, but that's the net effect). That would mean the pool could have 16% of the home loans default and lose 50% of their value before the AAA tranche would lose even $1.
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