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Hernando de Soto on the Lack of Knowledge in Finance

Hernando de Soto argues that in the past, things were much simpler. If you owned property, the information regarding your property was safeguarded locally and it was clear who the owner was and who made the loan  (if the property was fiananced).  Today, things are much more complicated. It is harder to track who owns what. Those who bought paper assets cannot figure out who the actual owner is. Shadow inventory consists of a total asset value of $600 to $700 trillion dollars which is 10 times the size of the world economy!

De Soto believes that the problems with today’s financial industry and banking have not been solved. He outlined the following sectors as trouble areas:

Mortgage Bundling

“Banks that have tried to foreclose on nonperforming mortgages have discovered that in many cases they can’t collect the debts. Why? Because some companies that pooled, packaged, and converted those mortgages into liquid securities had dispensed with the usual procedures to record mortgage owners and passed the property to a shell company called MERS, which pretended to own the mortgages.”

According to Christopher L. Peterson, professor of the University of Utah, “For the first time in the nation’s history, there is no longer an authoritative, public record of who owns land in each county.” Various courts have deemed foreclosures as being improper. Another problem that persists is with areas in which home prices are still declining.  This will increase the already massive pipline of foreclosures.

Default Swaps

Credit default swaps still exist and pose a threat to the financial system. They have been a key part in making securitization possible. Getting rid of these would have reduced leverage in the fiancial system and getting rid of these should have been a no-brainer.

Exemptions

Mark-to-market accounting has been suspended which banks can now overvalue the net worth of their assets. This, however, is a bit of a double edged sword. Mr. Market has often valued assets at prices that were far above or below fair value. This policy added too much volatility to banks’ financial statements and was a poor idea to implement in the first place. When assets prices are rising, the banks are happy because they can report results that are in their favor. The same is true on the downside in which if the market results in a panic sell-off (whether it is truly justified or not), the banks would be forced into taking writedowns.

The other method, which consists of the value being based on a model, also has its problems. When market conditions change, banks can hide the symptoms by not having to take the writedowns until much later or if the borrower defaults. This results in a lack of transparency for investors.

Off-Balance Sheet Accounting

This method “makes companies appear more profitable, despite their debts. By the time Enron closed its doors in 2002, it had created some 3,500 SPEs (special purpose entities).” Another accounting trick being used is to place information in footnotes that are carefully worded.

Rating Agencies

Do we need to explain here? Rating agencies are simply fire alarms that go off after the house burns down.

In the end, record keeping had been an advanced part of Western capitalism. The financial innovations over the last 20 years has put this system in jeopardy.

Source: http://www.businessweek.com/print/magazine/content/11_19/b4227060634112.htm

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