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Author: Lawrence Cunningham

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The SEC’s Failed Cover Up

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SEC officials redacted extensive portions of the agency’s internal watchdog’s report exposing its internally documented failures overseeing failed investment bank, Bear Stearns. But an unredacted version is published by Senator Charles Grassley, Senate Banking Committee Member who requested the study.

The failed cover up is ironic for an agency charged with promoting transparency in corporate America. It makes a mockery of todays’s SEC roundtable on how the SEC can help investors by promoting corporate transparency.

Many of the failed deletions refer to internal SEC documents showing that the SEC knew of problems that it left unaddressed. Also deleted are judgments the inspector makes about SEC performance, including one concerning the existence of ignored red flags.

It is not obvious why it is appropriate for SEC officials to delete these materials. Indeed, Senator Grassley obviously believes there is no basis for doing so. Below I highlight differences between the SEC’s redacted version (available in full here) and Senator Grassley’s published version of the original (available in full here).

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Dick Pierce on Alaskan Energy Policy

[Poster’s Note: Alaskan energy policy is now a subject of national interest. Expert insight into that policy and its history appears in the following note by my colleague, George Washington University Law Professor Richard J. Pierce, Jr. A leading authority on law and public policy in a wide range of fields, including energy, Dick lived in Alaska for years in the 1960s, tried the case that authorized construction of a gas pipeline from Alaska to the lower 48 states in 1978, and more recently testified as an expert witness in cases involving the value of Alaskan oil and gas. Thanks to Dick for allowing me to post this note, which I’ve edited slightly for length.]

Alaska pipeline map.jpgEnergy policy in Alaska is much more like the United Arab Emirates than the United States. Almost all Alaska’s revenue comes from state taxes on oil produced at Prudhoe Bay. Every Alaskan citizen gets an annual state check for a share of oil revenue.

When oil was discovered at Prudhoe Bay in the 1960s, the reservoir contained lots of gas, plus oil. The producers began to construct both oil and gas pipelines to the lower 48. With difficulty, and at a cost ten times the original estimate, they built the Alyeska line to transport oil.

The gas line is more difficult. Laying a chilled, high pressure gas line in permafrost raises daunting geotechnical, metallurgical, and environmental issues that the oil line did not . A gas line would be some three times longer because of the difficulty of transporting gas by tanker. A gas line also requires a certificate of public convenience and necessity from the Federal Power Commission (now the Federal Energy Regulatory Commission) under the 1938 Natural Gas Act.

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More on Accounting as Policy Lever

Debate intensifies on the topic of my Monday post: accounting as a policy tool. (David Zaring captures divergent views.) The intensity shows in today’s NYT column by Floyd Norris, a columnist noted for accounting acumen. I usually agree with Mr. Norris, but have quibbles with today’s column, excerpts of which follow (emphases added):

banks and legislators are pushing for a change in accounting rules to end mark-to-market accounting for financial assets. They are sure that market values are too low, so why not just assume they are really higher? That illogic has caught on [as (1) both of this week’s intervention bills encourage the SEC to consider suspending those rules, in a] push for bad accounting [and (2) the SEC this week issued a statement giving issuers considerable flexibility in measuring fair value amid distressed market conditions].

The American Bankers Association concluded that [the SEC] had slapped down auditors who were forcing banks to unreasonably reduce the value of assets no one was buying. . . . Auditors cringed, awaiting appeals of clients to let them value assets as they please. [Still, the SEC statement] could persuade Congress not to make things worse, and not really give the banks new permission to fudge their books.

It is possible, perhaps probable, that many mortgage securities are undervalued now, amid [prevailing] uncertainty and fear . . . [Pending legislation] calls for the government to buy securities from banks for more than current market value but less than the government hopes they will be worth someday. Whether it will succeed depends in part on whether banks conclude that other banks are solvent after the money arrives and the dodgy securities depart. . . .

Quibbles:

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Personal Investing Now

Buffett 2 ed cover for Co Op Blog.jpgPeople are wondering about personal finance. Many ask me: is now a good time to apply time-tested principles of value investing, buying stocks at low prices compared to long-term value? Maybe, but one must be cautious as a practical matter; curious persons may also be interested in a bit of value investing history.

The most famous value investor, Warren Buffett, wrote to his fellow Berkshire Hathaway shareholders in 1986:

“Occasional outbreaks of those two super-contagious diseases, fear and greed, will forever occur in the investment community. The timing of these epidemics will be unpredictable. And the market aberrations produced by them will be equally unpredictable, both as to duration and degree. Therefore, we never try to anticipate the arrival or departure of either disease. Our goal is more modest: we simply attempt to be fearful when others are greedy and to be greedy only when others are fearful.”

[The quote appears on p. 157 of my collection of Buffett’s letters, The Essays of Warren Buffett: Lessons for Corporate America (2nd ed. 2008).]

Recent Buffett investments may suggest he is attempting to be greedy now amid prevalent fear, with recent large capital allocations to Goldman Sachs ($5 billion) and Constellation Energy ($5 billion) and a smaller one in BYD, the Chinese battery maker ($230 million). But he said that the prudence of his Goldman investment depends on Congress passing legislation authorizing government intervention in the crisis. Congress failed to do so yesterday but promises another try.

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Accounting’s Role as Cause and Cure of Crisis

Green Eyeshade.jpgCongress is signaling belief that accounting standards are a cause and may be a vital component of the cure for the current credit crisis. Slipped into Congress’s bailout bill is a short but potentially pivotal authorization to the Securities and Exchange Commission to suspend accounting standards applicable to many of the troubled assets at the heart of the credit crunch.

Those assets are reported at current market prices, which have declined precipitously and resulted in freezing credit markets. The bill envisions the SEC allowing these troubled assets to be reported at values higher than current market price, such as their value if held to maturity and collected in accordance with contractual terms. If the assets can be reported at higher values, banks face less pressure maintaining capital required by counterparties or regulations. But if reported at lower values, current pressures may continue or worsen.

Government transactions in these assets will be a basis for determining market value and thus how they are reported under fair value accounting standards. Government will wish to reflect lower prices in the name of protecting taxpayers; but higher valuations, by increasing apparent capital strength of enterprises continuing to hold related assets, may promote chances that the program succeeds in stabilizing credit markets. If fair accounting standards are suspended, it won’t matter what prices government support reveals. The upshot is that accounting standards may play a pivotal role in this policy discussion. Should they?

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Agreement on Principles

US treasury_department_4.jpgFollowing is the full text of an Agreement on Principles circulated today at 2:24 pm EST by Senate Banking Committee:

1. Taxpayer Protection

a. Requires Treasury Secretary to set standards to prevent excessive or inappropriate executive compensation for participating corporations

b. To minimize risk to the American taxpayer, requires that any transaction include equity sharing

c. Requires most profits to be used to reduce the national debt

2. Oversight and Transparency

a. Treasury Secretary is prohibited from acting in an arbitrary or capricious manner or in any way that is inconsistent with existing law

b. Establishes strong oversight board with cease and desist authority

c. Requires program transparency and public accountability through regular, detailed reports to Congress disclosing exercise of the Treasury Secretary’s authority

d. Establishes an independent Inspector General to monitor the use of the Treasury Secretary’s authority

e. Requires GAO audits to ensure proper use of funds, appropriate internal controls, and to prevent waste, fraud, and abuse

3. Homeownership Protection

a. Maximize and coordinate efforts to modify mortgages for homeowners at risk of foreclosure

b. Requires loan modifications for mortgages owned or controlled by the Federal Government

c. Direct a percentage of future profits to the Affordable Housing Fund and the Capital Magnet Fund to meet America’s housing needs

4. Funding Authority

a. Treasury Secretary’s request for $700 billion is authorized, with $250 billion available immediately and an additional $100 billion released upon his or her certification that funds are needed

b. The final $350 billion is subject to a Congressional joint resolution disapproval

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Where’s the SEC?

SEC Seal.gifCredit market dramas have put the Securities and Exchange Commission in the background, where Chairman Chris Cox is being stung by rebuke for his neglect of investor interests and capital market safety, while fiddling away with luxury items few care about like high-tech financial reporting called XBRL. Now stalled yet again, despite earlier exuberance, is the SEC’s proposal to switch the US from its own accounting standards (GAAP) to new international financial reporting standards (IFRS).

Mr. Cox formally began to back this initiative aggressively early last year. He staked much of his legacy on it. Auditors and managers favor it and benefit from it. Investors and auditing standard setters express serious reservations about the plan, which many say has been rushed. Even the SEC seemed to accept this criticism, most recently saying it would propose a longer timetable for the shift than Mr. Cox and the SEC initially imagined.

Still, the SEC promised a month ago, on August 27, that a Release outlining milestones on this road would be forthcoming shortly. As of today, the SEC has issued no such Release, despite the SEC Chief Accountant, Conrad Hewitt, and Corporate Finance Chief, John White, describing its contents and assuring the public one would be forthcoming “this summer.”

Why not?

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Congress Should Ask Treasury: Can the US Self-Regulate?

365px-International_Monetary_Fund_logo_svg.pngAs Congress debates bills to let government buy $700 billion of distressed mortgage assets, it may want to ask if the US can still self-regulate or needs advice from outside experts. With little fanfare or media coverage, the Treasury Department recently signaled willingness to invite representatives of the International Monetary Fund to conduct an examination of the US economy, financial infrastructure, regulatory apparatus and other systemic elements.

This IMF examination, commonly performed for emerging economies, could identify causes of the current crisis and offer reforms less subject to domestic political pressures. It may be premature for the current bill to address causes or prescribe cures with specificity. But Members and Senators could ask both Treasury and the IMF about whether anything should be in the asset purchase legislation to enable or require Treasury to undertake such an examination.

The IMF is imperfect, of course, having occasionally failed to forestall looming financial crises or offered policies that worsened a brewing crisis. But it has plenty of experience with these problems. An example, with parallels to the current crisis, and indeed a contributing cause of it, is 1997’s Asian financial crisis.

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A Lehman Restitution Fund

Imagine how employees and shareholders of Lehman Brothers feel heading home this weekend. Their firm filed for bankruptcy on Monday, costing them jobs and sacrificing their net worth. This weekend, Congress will write legislation authorizing government to buy hundreds of billions of dollars of troubled assets from many other firms that will thus escape that fate. If this result seems unfair, arbitrary or induced by representations made to Lehman by the Fed and Treasury, should Congress make provision to balance out this result by creating some form of restitution?

Last weekend, the Federal Reserve and the US Treasury reportedly stated or signaled to Lehman’s leadership that no federal assistance would be forthcoming for it or other firms bearing the burden of troubled assets clogging the credit markets. Lehman filed for bankruptcy at least in part on the strength of those communications. Similar signals or statements partially explain Merrill Lynch’s decision to agree to a takeover by Bank of America.

Those authorities reversed course the next day when selectively extending financial support to American Insurance Group. Today, those authorities, now finally coordinating with Congress, indicate a planned wholesale intervention to remove essentially all such troubled assets from essentially all firms. If that decision were taken last week instead of this week, or if Lehman and Merrill had chosen to sit tight this week, the government repurchase would have included troubled assets held by those firms as they existed. Employees and shareholders of those firms would be in a much better position today, one functionally equivalent to peers at other firms facing substantially similar problems.

A consensus appears that the case-by-case nature of the Fed and Treasury approach this week, and earlier, was arbitrary. To the extent that the Fed or Treasury made statements to Lehman, or Merrill, on which the latter relied to their detriment, a reasonable case arises that some form of restitution may be warranted.

True, Congress cannot correct all mistakes that the Fed and Treasury made or address every inequity that their potentially unprincipled decision-making process created. And certainly factors other than Fed or Treasury statements or signals likely influenced Lehman’s, and Merrill’s, decisions. Perhaps the fate of those firms and their employees and shareholders should simply be chalked up to the workings of capitalism and attendant labor and equity markets.

But if the Fed and Treasury, unelected and only remotely accountable officials, are culpable in any way, Congress, elected and accountable representatives, may wish at least to consider whether some form of restitution may be justified. Given the huge size of the troubled asset purchases that Congress is poised to authorize, a restitution fund to compensate Lehman (and Merrill) employees and shareholders would be a relatively small proportion of the total.

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List of Differences Between US GAAP and IFRS

Is anyone aware of the existence of a simple list of differences between the requirements of traditional US accounting (GAAP) and international financial reporting standards (IFRS)? A simple listing of the top 25 or so differences between these two systems could be a handy tool for many purposes, including for reference, research, and instruction. But I and colleagues interested in finding such a list have not been able to locate one.

This is somewhat surprising to us. After all, pending debate over moving the US from GAAP to IFRS involves a fundamental question: how convergent or divergent are the two systems? There is no question that the two differ on numerous topics in important ways. Examples include inventory, research & development costs, and leases. Extensive research explores the effects of such differences on resulting reports of net income and shareholders’ equity. But there does not appear to be a simple list of the major differences by topic.

If anyone is aware of one, I’d be grateful to know about it. Alternatively, I may create one and share it on the SSRN as a “working paper.” I would invite others to comment on it to improve its accuracy and also update it as the two sets of standards continue to change.