Passing Lane – May 2011

By wmadministrator

Hernando de Soto
Hernando de Soto, a renowned Peruvian economist, won the CATO Institute’s Milton Friedman Prize for advancing liberty in 2004. In 1980, de Soto founded the Institute for Liberty and Democracy, where he and his colleagues developed and promoted a simple idea with radical implications: poverty in Peru and other poor countries is largely caused by the lack of formal property rights and the lack of the rule of law. He published two groundbreaking books making this argument, and he has advised leaders of poor countries around the world on the steps needed to lift the poor out of poverty.

Bloomberg Businessweek published an article by de Soto in its May 2 issue. Here are excerpts. (The full article is available at businessweek.com.)
During the second half of the 19th century, the world’s biggest economies endured a series of brutal recessions. At the time, most forms of reliable economic knowledge were organized within feudal, patrimonial and tribal relationships. If you wanted to know who owned land or owed a debt, it was a fact recorded locally – and most likely shielded from outsiders. At the same time, the world was expanding. Travel between cities and countries became more common and global trade increased. The result was a huge rift between the old, fragmented social order and the needs of a rising, globalizing market economy.

To prevent the breakdown of industrial and commercial progress, hundreds of creative reformers concluded that the world needed a shared set of facts. Knowledge had to be gathered, organized, standardized, recorded, continually updated and easily accessible.

The result was the invention of the first massive “public memory systems” to record and classify – in rule-bound, certified, and public registries, titles, balance sheets and statements of account – all the relevant knowledge available, whether intangible (stocks, commercial paper, deeds, contracts, patents, companies and promissory notes) or tangible (land, buildings, boats, machines, etc.). Knowing who owned and owed, and fixing that information in public records, made it possible for investors to infer value, take risks and track results. The final product was a revolutionary form of knowledge: “economic facts.”

Over the past 20 years, Americans and Europeans have quietly gone about destroying these facts. The very systems that could have provided markets and governments with the means to understand the global financial crisis – and to prevent another one – are being eroded. Governments have allowed shadow markets to develop and reach a size beyond comprehension. Mortgages have been granted and recorded with such inattention homeowners and banks often don’t know and can’t prove who owns homes. In a few short decades, the West undercut 150 years of legal reforms that made the global economy possible.

The importance of economic facts may not be obvious to Americans. Without standardization, the values of assets and relationships are so variable that they can’t be used to guarantee credit, to generate mortgages and bundle them into securities, to represent them in shares to raise capital.

When then-Treasury Secretary Henry Paulson initiated his Troubled Asset Relief Program (TARP) in September 2008, I assumed the objective was to restore trust in the market by identifying and weeding out the “troubled assets” held by the world’s financial institutions. Three weeks later, when I asked American friends why Paulson had switched strategies and was injecting hundreds of billions of dollars into struggling financial institutions, I was told that there were so many idiosyncratic types of paper scattered around the world that no one had any clear idea of how many there were, where they were, how to value them or who was holding the risk. These securities had slipped outside the recorded memory systems and were no longer easy to connect to the assets from which they had originally been derived. Oh, and their notional value was somewhere between $600 trillion and $700 trillion dollars, 10 times the annual production of the entire world.

Three years later there’s still plenty to be concerned about. Governments have worked to enact major financial and regulatory reforms, such as the Wall Street Reform and Consumer Protection Act ushered through Congress in 2010 by former Sen. Chris Dodd, D-Conn., and Rep. Barney Frank, D-Mass.
Dodd-Frank has sought to move derivatives into clearinghouses where more data about them can be collected. It’s a step in the right direction. But if you believe in the value of public memory and economic facts, the reforms leave a number of problems outstanding.

1) 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. The intent was to streamline what many real estate experts recognize are outdated, disaggregated and cumbersome processes. The result, however, is that today, says professor Christopher L. Peterson of the University of Utah, “about 60 percent of the U.S.’s residential mortgages are now recorded in the name of MERS rather than the bank, trust or company that actually has a meaningful economic interest in the repayment of the debt. For the first time in the nation’s history, there is no longer an authoritative public record of who owns land in each county.”

2) Default Swaps:
 The leverage that created so many bad mortgages and the derivatives to help finance them would not have been possible without “credit default swaps” (CDSs) – ingenious derivative instruments that allowed lenders to insure their risks against defaults and pass them on to others. In principle, widening the market should be a good thing. But these risks have slipped outside the public memory systems, making it very difficult to know who ultimately bears the risk and where it is.

3) Exemptions: When the recession sent the prices of financial holdings spiraling downward, some banks and financiers were exempted from the U.S.’s long-established “mark-to-market” accounting standards, which forces firms to report the value of their assets at current market prices. It’s reasonable to establish value other than through market prices, according to proponents, if the market is unusually depressed. But such a privilege creates the ability to destroy facts by hiding losses, increasing the price of assets to levels at which no one will buy.

4) Off-Balance-Sheet Accounting: The modern balance sheet can be traced to Luca Pacioli, the 15th century mathematician and father of accounting. In the 1990s, governments began destroying Pacioli’s legacy by allowing companies in financial difficulty to pass facts concerning debts from their public balance sheet to a less visible memory system called a special purpose entity (SPE) (or to sweep debt information into the balance sheet’s footnotes in words so obtuse that the statements cease being factual). Such “off-balance-sheet accounting” makes companies appear more profitable, despite their debts. By the time Enron closed its doors in 2002, it had created some 3,500 SPEs.

5) Government Use of Swaps and Repo Markets: Greece is the most
notorious example of a country using derivative-based currency swaps to swell the value of government assets by pushing national debts into the future.
Gustavo Piga, a professor of economics at the University of Rome Tor Vergata, revealed this fact-destroying practice: A country issues a debt in one currency – dollars, let’s say – at fictional exchange rates that it swaps for a euro debt for
a certain period of time. Thus it gets an inflow of money that makes the ledger look positive because the actual debt appears as a swap that has
produced income.

6) Rating Agencies:
 Originally created to get and communicate the facts regarding the trustworthiness of businesses through a ratings scale, ratings agencies were an innovative way to get an abbreviated picture about a given business. But their reputation suffered when highly rated companies barely survived the outbreak of the recession or had to be rescued.

If we can agree that the recession wasn’t about bubbles but about the organization of knowledge, we can move on to restoring the systems that allowed the global economy to expand more in the last 60 years than in the previous 2,000.

We are now staring at a legal and political challenge. A legal challenge because American and European governments allowed economic activity to cross the line from the rule-bound system of property rights, where facts can be established, into an anarchic legal space, where arbitrary interests can trump facts and paper swirls out of control.

Markets were never intended to be anarchic: It has always been government’s role to police standards, weights and measures, and records, and not condone legalized sleight of hand in the shadows of the informal economy. To understand and repair one of mankind’s greatest achievements – the creation of economic facts through public memory – is the stuff of nation-builders.
Big Ass Fans President Is ‘Economy Hero’
Inc. magazine named Carey Smith, president/CEO of Lexington-based Big Ass Fans, its national Economy Hero, selecting him over 249 other applicants. Inc. and partner SAP created the competitive award to highlight companies and their CEOs that are helping the country get out of the recession by providing jobs, innovative work and new business models.

Smith was selected for the top honor and given a prize package worth $250,000 for a continuous commitment to creating jobs and ground-breaking work. The economy has affected Big Ass Fans like most companies in the country, but it did not implement layoffs or cancel existing benefit programs. Instead, the company looked for new markets and customers and developed new products for its long-term business success.

“I am honored to be named this year’s Economy Hero,” Smith said. “Our company has continued to grow in spite of the recession due to our constant investment in engineering to develop new and innovative products that provide energy-efficient air movement solutions for a wide range of applications.”
Big Ass Fans (bigassfans.com) is the leading manufacturer of fans for large industrial, agricultural, commercial and residential settings. Its units range from 6 feet to 24 feet in diameter and use low horsepower motors to generate energy-efficient air movement.
Gift Funds WKU?Alumni Center Library
Bob and Martha Jean Owsley of Cecilia, Ky., are supporting the Augenstein Alumni Center at Western Kentucky University through a gift of $100,000 to fund the Bob and Martha Jean Owsley Library in the new center.

Donald Smith, executive director of the WKU Alumni Association, said he is grateful for the support of the Owsleys and the other nearly 200 donors who have contributed almost $3.4 million so far to the $5 million Augenstein Alumni Center project. Groundbreaking is scheduled for July 15.

Bob Owsley is president of First Cecilian Bancorp Inc., and chairman of the board of the Cecilian Bank. He attended Bowling Green Business University – predecessor of WKU’s Gordon Ford College of Business – for three semesters before he was drafted into the U.S. Army. He returned to school in 1956 and completed his education. Owsley has been with the bank since Sept. 2, 1958, just days after he graduated from BU.

Martha Owsley completed the BU’s secretarial program in 1951. She and Bob Owsley married on June 13, 1954, while she was working as a secretary at Fort Knox Headquarters.

Bob Owsley calls his student experience a “wonderful thing,” as he knew all his fellow BUers, from his fellow students right up to J. Murray Hill, then-president of BU, who was from Owsley’s hometown of Rineyville, Ky.

“The school was small enough to get our arms around everyone,” he said. “Our instructors were all part-time business people from downtown Bowling Green. When they said something, I knew they had experienced it.”
Keeneland:?Not?Getting Older, Getting Better
Congratulations to Keeneland on a strong 75th anniversary spring racing meet that posted some of its best attendance and handle numbers ever despite a record 13 inches of rain.

“If it were possible to chart adverse weather with all the race meet statistics, this would be one of the top Keeneland meets ever,” said Keeneland President and CEO Nick Nicholson. “I want to commend all involved, including our entire team, the horsemen and even both tracks themselves.”
Give some credit to a decision five years ago to install a synthetic all-weather racing surface that owners and trainers found hospitable and to engaging fans with new social media outreach that helped boost attendance past last year when the weather was gorgeous.

Total meet attendance was 241,684 – the third-highest spring meet ever – compared to 238,282 last spring. The on-track handle was up 3 percent to $18.5 million, with the all-sources handle up 9 percent to $117.2 million.

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