Obama and McCain Don't Understand the Financial Markets

By: Frank_Holmes

I saw both John McCain and Joe Biden on CNBC this week, and I was astounded by the shallowness of their answers on how to address the current economic crisis.

Both offered the typical Capitol Hill solution to any problem – more regulations.

Each tried to disguise his answer in fuzzy language – McCain said he didn't want “over-regulation” and Biden said he wanted “common-sense regulation”. But the bottom line is the same – neither of them has a real idea on how to deal with a financial crisis that has continued to escalate.

One of their blind spots goes right to the fundamental nature of the crisis that in the past few days has led to a fire sale of Merrill Lynch, driven Lehman Brothers into bankruptcy and has AIG teetering on the brink of collapse.

The Democratic and Republican candidates think of it as a Wall Street problem and that “ Main Street ” shouldn't be asked to “bail out” these fat-cat financiers. This is a flawed way of looking at a financial hurricane that will defy Washington's usual approach of exploiting the “haves vs. have-nots” issue. This is a killer storm that will flatten everything in its path.

A call for more regulations shows just how out of touch these guys are when it comes to the realities of capital markets.

The cure is not more regulation – in fact, the current rules are a big reason why we're in this dire situation.

Almost a year ago, an accounting rule known as FAS 157 went into effect. This rule has been called the “fair-value rule,” but it's not working that way. FAS 157 is forcing companies to write off tens of billions of dollars in debt-related investments.

That's because of FAS 157's requirement of a “mark-to-market” valuation on these investments each quarter. Mark-to-market essentially means the value of these investments if they had to be sold immediately. Current uncertainties and liquidity issues have chased away just about all of the buyers for many of these investments, so the markets are distorted. When there are no buyers, under FAS 157 the value has to marked down, sometimes to zero. This is the case even for securities that could be sold in the future at face value once they reach maturity.

Overlaying FAS 157 with the demands of Sarbanes-Oxley creates a recipe for continuous quarterly write-downs until all value is gone. New York has lost its status as the world's financial capital since Sarbanes-Oxley was enacted, and the harsh requirements of FAS 157 may accelerate that trend.

This is not a blind defense of the companies that have invested heavily in derivatives that Warren Buffett called “financial weapons of mass destruction” in 2002. In the next six years, these financial WMDs grew by 500 percent to more than $500 trillion. The sheer size of these derivatives has greatly increased the risks of catastrophe, and the danger is further elevated because of FAS 157 and Sarbanes-Oxley.

Source: U.S. Global Investors

Because global financial markets are woven in a complex web, turmoil in one sector is felt elsewhere. Some wounded financial companies are desperately selling healthy stocks to raise capital to stay afloat, and this heavy selling pressure is forcing down the price of these stocks. The same is being done by leveraged hedge funds that have been hurt by their investments in financial stocks – they need to raise money for shareholders who want out of their fund, so they are selling good stocks to get cash.

This talk of new regulation reminds me of one good rule that got away. The SEC eliminated the “uptick rule” for short-selling stocks last year, and this has facilitated a rise in illegal “naked shorting” that has hurt financial companies and impaired their ability to refinance.

The New York Times had an interesting op-ed article on this subject on Sept. 14 titled “Too Few Regulations? No, Just Ineffective Ones" by Tyler Cowen, an economics professor at George Mason University.

One of Cowen's best observations was "financial regulation has produced a lot of laws and a lot of spending but poor priorities and little success in using the most important laws to head off a disaster. The pattern is reminiscent of how legislators often seem more interested in building new highways - which are highly visible projects - than in maintaining old ones."

He also pointed out that 70,000 new pages of federal regulations in a single year is not an uncommon feat, and that the inflation-adjusted spending by the federal agencies regulating banking and finance has gone up more than 40 percent since 1990.

New rules are what Washington knows how to do best – it's how legislators measure their worth. And while there are times when new regulations make sense, this isn't one of those times.

Hearing the solutions offered by McCain and Biden today reduces my confidence that either the Democrats or the Republicans have the knowledge or the imagination to take on the biggest economic crisis in America since the 1930s.

By Frank Holmes, CEO , U.S. Global Investors

Frank Holmes is CEO and chief investment officer at U.S. Global Investors , a Texas-based investment adviser that specializes in natural resources, emerging markets and global infrastructure. The company's 13 mutual funds include the Global Resources Fund (PSPFX) , Gold and Precious Metals Fund (USERX) and Global MegaTrends Fund (MEGAX) .

More timely commentary from Frank Holmes is available in his investment blog, “Frank Talk”: www.usfunds.com/franktalk .

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