The Obama administration and the US Congress are laying the foundations for high inflation when the economy eventually recovers from the recession.

US equity investors should be ready for the effect that a rapidly devaluating currency may have on earnings-per-shares and price-earnings ratios.

How inflation increases corporate taxes

Companies with fixed assets are usually allowed to deduct the depreciation of these assets based on historical cost.

For example, if a company buys a machine for $10 million with an expected life of 10 years and no residual value, it may be able to deduct $1 million a year from income, thereby effectively reducing its tax burden.

When inflation is three percent a year, the tax benefit from depreciation will be reduced by about 15% over a ten year period, compared to the real value of the deduction that would have accrued in a non-inflationary environment.

However, if inflation were to run 25% over a ten year period — as has occurred in developing economies that can’t get government spending under control, the tax benefit from depreciation will be reduced by 76%.

For companies with substantial fixed assets and the need to replace depreciating equipment, high inflation, combined with declining deductions for deprecation, in real terms, will effectively increase their corporate tax burden, reducing cash reserves, and threatening continued operations.

Since, under inflation, government spending is out of control, the authorities are not amenable to lowering taxes, forcing corporations to increase prices faster than current inflation to stay in business.

This leads to even higher inflation.

Distortion of asset values

Some balance sheet assets, such as land, are not subject to depreciation.

If a company spends $10 million dollars to buy a piece of land on which to build a factory, that land will still be on the books for $10 million ten years later.

With inflation of 25% a year, all things being equal, the land might actually be worth $40 million at current prices at the end of the decade. As time goes on, the balance sheet will increasingly be distorted by inflation.

After a long period of high inflation, the same accountants who are now ardently defending “mark-to-market” rules as being in the investors’ interests, will be defending the age-old practice of keeping non-depreciable assets on the books at historic costs, although these numbers are now entirely meaningless.

Distortion of earnings

The corollary of increased taxes due to the effect of inflation on depreciation reserves is the reduction in the real value of reported earnings, due to understated depreciation.

Inflation also creates other problems for the interpretation of earnings, such as the effect on the cost of goods sold and inventory valuation.

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The first thing I learned as a bank trainee, many years ago, was that all banks are insolvent — it is the nature of banking.

The banking business consists of borrowing money you have to repay today to lend to someone else who will pay you back tomorrow. If your creditors demand their money today, you won’t be able to pay — because you’re a bank and banks are insolvent.

Lessons of the New Deal

Throughout the 19th century and up until 1933, hundreds of banks regularly failed every six years or so, whenever there was an economic recession. During the New Deal, the Federal Deposit Insurance Company was set up to ensure depositors’ money, thereby effectively making banks “solvent” by government intervention.

In 1933, demand deposits were the major source of bank funding. With a government guarantee on deposits, bank runs became rare. The Glass-Steagall Act kept banks away from the dangers of investment banking. Strict margin requirements on securities loans dramatically reduced risks on what were the “toxic assets” of those days.

In 1950, checking deposits made up 70% of US bank liabilities, while small time and savings deposits made up most of the rest. In other words, the government guaranteed virtually all bank liabilities. US commercial banks were safe.

Just as important, banks were engaged in very few different kinds of operations; they were much, much easier to manage and understand than today.

But times change.

Not your grandfather’s bank

By Q4 2007, private checking deposits were less than 5% of total liabilities of US commercial banks. Interbank liabilities with respect to federal funds and repurchase agreements were 164% of US private checking deposits. Glass-Steagall had been repealed. Banks were engaging in blatant speculation in exotic securities on their securities trading desks. The effective safety measures that protected institutions that were — by definition — fundamentally insolvent, had been allowed to wither and become irrelevant.

Furthermore, and most importantly, most US bank liabilities today are no longer guaranteed by the US government. The safe banks of the 1950s are no more.

Although bankers are well aware of the “dirty little secret” of their insolvency, they still oppose “government intervention” and “over-regulation”. Bankers know that they rely on government to stay in business, but like to pretend that they should be allowed to operate as free-spirited entrepreneurs in the “private sector”.

The Crisis of 2008 was simply a modern reenactment of the bank runs of the 19th and early 20th century. Different liabilities, different times. Except that banking is now exponentially more complicated and has become virtually impossible to understand.

How to read a bank balance sheet

The second thing I learned as a bank trainee, back in the good old days, was that it is impossible to learn much of anything useful about a bank by reading its balance sheet. Whether a bank is strong or not, depends upon the quality of its assets — information that is woefully absent from financial statements.

Once we understand that banks are insolvent and require government guarantees to continue in business, the question becomes what percentage of liabilities have government guarantees and which assets are good, or whether the government will eventually have to step in, liquidating the bank and paying off depositors, leaving zilch for shareholders.

Accounting rules can’t make water run uphill

Now accounting rules don’t require banks to list their loans on their financial statements, nor to indicate terms and covenants of each financial asset. You’re not told the credit rating of borrowers, or even the weighted average of credit ratings (even if you put faith in credit ratings). Information in such detail is not even feasible.

Nor do accounting rules require that auditors actually evaluate the likelihood that a bank will get its money back on a particular loan, or any group of loans. Bank auditors don’t visit bank borrowers one by one and look them in the eye to see if they seem credit worthy, or whether they are drunken bums that have just blown the bank’s money at the racetrack.

Moreover, large international banks are extremely complicated, composed of thousands of subsidiaries, affiliates, side ventures, and special deals, and subject to the risk that some obscure trader in one of hundreds of countries where they do business may be hatching a scheme that will bring the bank to its knees tomorrow morning — operations of these banks are so complex that it is impossible to contrive a document that could possibly “protect investors” by supplying all relevant and material information.

Now, auditors don’t like to admit that bank balance sheets are bullsh*t, and that that the millions spent on auditing — for the benefit of “investors” — might just as well have been donated to charity. So they try to find some way to get someone else to give an opinion on how much bank assets might be worth — at least some part of the assets.

This is where the “mark-to-market” rules come in — based on belief in the Efficient Market Hypothesis. This theory suggests that market price reflects intrinsic value.

Mark-to-market nonsense

Historically, banks haven’t been in the business of selling their loans to others. Instead they hold loans until they come due and then credit the proceeds to cash, interest earned, or loan losses. Accountants were not able to impose mark-to-market rules on ordinary loans for the simple reason that there was no market to serve as a benchmark.

But with modern, complicated banking, some assets actually do have markets that might be used as a measure of value. Surely, some assert, it would be in “investors’ interests” to adjust the value of bank assets to changes in market price. So accountants came up with a “mark-to-market” rule that says that, unless a bank intends to hold an asset until maturity, it must indicate the value of the asset in terms of market value.

Why mark-to-market accounting is misleading

Mark-to-market accounting is misleading for many reasons, but perhaps the most important is that market prices are not the value at which all assets of a certain type could be liquidated tomorrow, but merely the price at which a very small number of securities in circulation happen to have been sold yesterday.

Furthermore, unless a bank is obligated to sell asset by a certain time in the immediate future, but instead has the option to hold assets to maturity or until market prices get better, the current value of assets may be irrelevant both to bank investors and creditors.

If a bank holds $50 million in bonds that had $5,000 traded at 100 yesterday, it doesn’t follow that the bank will be able to sell all its bonds tomorrow at this price. All securities markets — even the deepest and most liquid — only trade a small portion of securities outstanding on any one day. No security market on earth is able to liquidate all holdings of securities outstanding today, at yesterday’s price. If all securities are liquidated at the same time, and there are no buyers, the market value is zero!

Now, in some cases, mark-to-market accounting is useful, although still misleading. For example, mutual funds that promise to redeem shares on any day based on the market value of the portfolio as of the close of business, obviously must use mark-to-market accounting because they have a legal obligation to redeem shares at that price.

However, banks are not required to pay creditors based on the market value of bank assets, nor do bank shareholders have any claim on the bank based on the current market value of bank assets.

Furthermore, evaluating some bank assets on the basis of mark-to-market, and others on the basis of historical costs, means that total value of bank assets (apples plus oranges) is a gobbledygook number that defies comprehension.

If we start by admitting that all banks are, by their nature, insolvent, the key question we should be asking is “How much of bank liabilities are guaranteed by the government?”

In the 1950s, the answer was, “Almost all”.

Today, the answer is “Very little”.

Mr. Gaithner’s Stress Tests

Timothy Gaithner, the US Secretary of the Treasury and point man of the Obama administration’s efforts of resolving the economic crisis, has announced that he is getting ready to analyze the finances of US banks by subject them to some kind of “stress test”.

There is less said about these stress tests recently; perhaps Secretary Gaithner has given up on the idea.

Now, I can save the American taxpayers a lot of money by pre-releasing the results of this test at no cost:

1. All banks are insolvent, although some have assets of lower quality than others.
2. All banks fail the “stress test” unless the government guarantees liabilities.
3. Banks that have the largest portion of liabilities (i.e., deposits) guaranteed by the government are the strongest. (Mainly, small community banks.)
4. Banks that have the simplest, smallest “product line” are the least likely to fail. (Mainly, small community banks)
5. Most major international banks are not “too big to fail” — they are “too big to manage”.

Learning from the past

In other words, the way to save the banking system and reduce “systemic risk” is to require the big banks to split up and drastically simplify their operations, with the government providing guarantees for virtually all liabilities.

Liabilities which can’t be guaranteed by the government should be eliminated.

Too strong, you say?

Well it worked in 1933 and the fundamentals of bank safety haven’t really changed that much. What is different is that the government has allowed too much of the bank balance sheet to avoid regulation.

Of course, if the government guarantees virtually all bank liabilities, as in the distant (but safer) past, there will be pressure on banks to eliminate the absurd salaries and bonuses paid to bank executives.

Impossible, you say? Can’t get experienced bankers without paying a fortune?

Well consider this: In May 1970, Walter Wriston became chairman of Citicorp — arguably the world’s premier banker.

His compensation was just $257,820 a year, just $585 more than he had earned as president and CEO (Wriston: Walter Wriston, Citibank, and the Rise and Fall of American Financial Supremacy. page 307.).

Recently, watching a Congressional hearing to determine the fate of the mark-to-market rule, I was reminded of what John Maynard Keynes had said:

Madmen in authority, who hear voices in the air, are distilling their frenzy from some academic scribbler of a few years back.

Over the last six month, trillions of dollars of the life savings of hundreds of millions of people across the globe have been devoured by plunging security prices.

People want to know why. Who is to blame? Is it Barney Frank? Chris Dodd? George Bush? Greedy Wall Street Executives? Franklin Raines? There are many candidates. The mob is running amuck. There is talk of strangling the children of AIG executives with piano wire. The tumbrils are rolling through the streets. There is madness in the air.

Words matter, especially economists’ words

Keynes was right. The instigator of today’s economic mess was none of the above. The culprit, the one really responsible, seems to have been a college student, jotting nonsense in a doctoral thesis forty years ago. This nonsense was published in 1965 in the Financial Analysts Journal. Here is the deadly screed that has led to all this damage:

An efficient market is defined as a market where there are large numbers of rational, profit-maximizers actively competing, with each trying to predict future market values of individual securities, and where important current information is almost freely available to all participants. In an efficient market, competition among the many intelligent participants leads to a situation where, at any point in time, actual prices of individual securities already reflect the effects of information based both on events that have already occurred and on events which, as of now, the market expects to take place in the future. In other words, in an efficient market at any point in time the actual price of a security will be a good estimate of its intrinsic value.

These words became known as the “Efficient Market Hypothesis” and, over the years, became the justification for index funds, mark-to-market accounting rules, Morningstar’s rating system of mutual funds, executive compensation based on stock prices, total return reporting rules of the Securities and Exchange Commission, and much, much more.

These words put the smug, self-assured smile on the face of the FASB board member testifying before Congress, defending the mark-to-market rule.

Everyone is to blame

Of course, Eugene Fama, the college student in question, should not be blamed for a youthful indiscretion. After all, he was only a student and his teachers were there to set him right, but didn’t. We should shift our attention to the professors, who praised his work, and to the editors of Financial Analysts Journal who published this dangerous notion to the world.

But is it fair to blame them? After all, they were only academics, imaging what the real world was like from their ivory towers. If they were wrong, shouldn’t market participants have set them straight? How about real world security analysts, the experts at Standard & Poor’s, the bankers and the fund managers … didn’t they know better?

A convenient lie

The truth is that the Efficient Market Hypothesis has saved Wall Street billions of dollars in research costs over the years. If market prices reflect intrinsic value, why waste money doing research?

Securities analysis is hard work. It is much easier and cheaper just to look up the stock price on Yahoo. Let’s just sell unmanaged index funds. Let someone else do the research.

The “Efficient Market Hypothesis” provides cover for fiduciaries who increase their take home pay by avoiding the high cost of research.

Way, way back to basics

By 2008, the world finally came to understand that, in truth, nobody knows how much most securities are really worth.

The market has become too complicated, the products too confusing, and essential research and analysis has become too costly and has been farmed out to someone else, who has done the same.

The government of the United States, with trillions of dollars in resources, is simply unable to figure out how to value securities. Without the “Efficient Market Hypothesis” and without market prices, the United States Treasury Department has become lost in confusions and quandaries.

We must reject needless complexity and enshrine commonsense.

That’s easier said than done.

The pain of withdrawal

Unfortunately, the “Efficient Market Hypothesis” is a silent killer that lurks in thousands of financial products, laws, rules, regulations, tax provisions, and marketing schemes.

Hundreds of thousands of market participants, company executives, and securities floggers would have their lives turned upside down if the world were suddenly to back off from this deadly notion.

The arguments about mark-to-market rules and fair market accounting are all based on the assumption that markets, even markets dominated by panic and fear, are the best measure of intrinsic value and that forcing banks, pension plans, and investors to sell securities and raise new capital as prices plunge is the best medicine.

The Financial Accounting Standards Board is lost for lack of an alternative hypothesis. Accountants must put a number on assets or “investors won’t be protected”. Years ago, before the FASB existed, investors judged securities on the basis of commonsense.

• How big a dividend does the company pay?
• How fast is this dividend growing?
• Are dividend yields on risk common stock higher than bond yields of the same company?
• Isn’t a dividend today better than hoping to sell a stock to someone else at a higher price thirty years from now?

But commonsense has fled securities markets. It will be a long time before it will come back. Too many people are still enthralled by the “Efficiient Market Hypothesis”. The withdrawal pains will be severe.

There is a solution, of course: investors and financial institutions must get back to doing their own research, like Warren Buffet and Bernard Baruch in the old days. Financial products must be simplified.

Dividends must replace “total return” as the prime investment goal.

Company executives must give up stock options and buybacks and concentrate on paying higher dividends.

Regulators must rely less on accounting standards and economic theory, and more on commonsense.

Will this happen? I don’t know, but I hope so and the sooner the better.