Post No. 49: Finally, Someone Explains Something That We Can Understand

I was fortunate enough to receive a decent education at some decent educational institutions. I also took corporate, business, accounting, banking, finance, and various other management courses.

However, I must be honest. I do not understand even a quarter of what occurred over the past 20 – 30 years to lead to our current financial situation.

Although I am sure that most of us can point to some emotional, conceptual issues, be it outsourcing, illegal immigration, two foreign wars, decreased industrial output, and greed, I just really feel like I am in the minority in terms of understanding investment banks, hedge funds, selling short, bundling, derivatives, and such.

Just last week, I contacted two of my graduate school buddies, one with a specialty in banking, and the other in corporate securities, and I told them that I hoped that they were in the Senate Banking Committee sessions to keep them honest.

One of them, “The Bear” (no relation to the term to describe financial markets), forwarded the following article to us by John P. Hussman, Ph.D. of Hussman Funds, entitled You Can’t Rescue the Financial System If You Can’t Read a Balance Sheet, which was posted by Dr. Hussman earlier today. It provides food for thought.

September 29, 2008

You Can't Rescue the Financial System If You Can't Read a Balance Sheet
John P. Hussman, Ph.D.
All rights reserved and actively enforced.

This is a bad idea.

However the final legislation is written, the Troubled Assets Relief Program (TARP) being rushed through Congress will evidently be built around its single worst provision, which is that the Treasury will have authority to purchase distressed mortgage securities from U.S. financials.
As I noted last week in An Open Letter To Congress Regarding the Current Financial Crisis, the sequence of bankruptcies that we've observed among U.S. financials has been almost exactly in order of their gross leverage (the ratio of total assets to shareholder equity). The reason for that is:
1) as the assets of a financial company lose value, the losses reduce the asset side of the balance sheet, but also reduce shareholder equity on the liability side;

2) as the cushion of shareholder equity becomes thinner, customers begin to make withdrawals;

3) in order to satisfy customer withdrawals, the financial company is forced to liquidate assets at distressed prices, prompting a further reduction in shareholder equity;

4) go back to 1) and continue the vicious cycle until shareholder equity goes negative and the company becomes insolvent.

Let's return to the basic balance sheet of a typical financial company before the writedowns:
To read the remainder, click on: http://www.hussmanfunds.com/wmc/wmc080929.htm.