Lesson 19: Anatomy of a Recession Part 3: Orchestrated Chaos Section B: Rule 157
After Paulson and the Democrats took power, 3 things happened that added volatility to the market, made a lot of investment bankers rich, and paved the way for the 2008 elections: 2. The second significant event of 2007 (see Lesson 17) was Rule 157. Passed by the Federal Accouting Standards Board, Rule 157 became effective on November 15, 2007. To understand its significance, you must first understand mark-to-market accounting (MTMA). It is a method of accounting that prices an asset based on its market value, instead of its purchase price or its income potential. It can be abused: Enron used MTMA and inflated market prices to overstate the book value of holdings that were actually losing money. MTMA can also hurt a company, especially in the middle of panic and market manipulation. Rule 157 classified assets based on their appraisal difficulty, level 3 being the most difficult. Level 3 securities include mortgage-backed securities (MBS), especially ones containing sub-prime mortgages (see Lesson 17). Rule 157 required that level 3 securities be valued and revalued every quarter, using MTMA. MTMA was not practical for appraising MBS, which were essentially worthless in the market, but were making real money nonetheless. Afer all, most homeowners, even sub- prime ones, are still paying their mortgages. Before rule 157, banks used more complex methods, such as Discount Flow Analysis, to appraise such securities. But Rule 157 had teeth, known as Sarbanes-Oxley.* 5 years before, Congress passed the Sarbanes-Oxley law in response to the Enron, Tyco and WorldCom scandals. It imposed stiff civil and criminal penalties for accounting irregularities, and made senior corporate executives personally responsible for their companies' financial reports.
Investment banks already could not raise money from investors in the market. With their MTMA-suppressed financial reports, they were not able to borrow money either. Next Lesson: Orchestrated Chaos Part C: Sports-Betting and Game-Rigging * The Sarbanes-Oxley law, has been blamed in other ways for contributing to our recession. It created an extensive auditing bureaucracy whose requirements are extremely time-consuming and expensive for any small, publicly traded company. Any company that wants to go public must spend millions of dollars just to comply. According to the National Venture Capital Association, the number of venture-backed technology IPOs declined from 245 in 1999 to 29 in 2003. References: Suspend Mark-To-Market Now! by Newt Gingrich The Chilling Effect of SARBANES-OXLEY by Lynn Stephens and Robert G. Schwartz www.soxfirst.com