End the war on reality

-- James Saft is a Reuters columnist. The opinions expressed are his own --

By James Saft

LONDON (Reuters) - Having conclusively lost, it is about time that officials on both sides of the Atlantic propose a truce in their long running war on financial reality.

The plans to inject government capital directly into ailing banks, to guarantee further bank deposits and to stand behind interbank lending are excellent first steps. They implicitly recognize the seriousness of the situation and, by putting governments' deep pockets directly behind proposals, they win confidence by concrete action rather than obfuscation or misdirection.

But continued assaults on mark-to-market accounting standards and short sellers show that many in positions of authority still apparently think that suspension of disbelief is the key to fighting the crisis.

The approach now is a heck of a lot better than it has been recently.

Britain stands out for aggressively recapitalizing its banks in a 37 billion pound ($64 billion) program and for starting a bank borrowing backstop plan likely to set the pattern for Germany and France. This isn't sufficient in itself, but it cuts to the heart of the problem: bank solvency and liquidity. It also provides a measure of protection to the comparatively innocent (taxpayers) and a measure of punishment to the comparatively guilty (shareholders and bank employees).

Euro zone countries too took positive steps: guaranteeing new bank debt issuance temporarily and committing to recapitalize "systemically" important banks if needed.

Even the United States is on board and will use some of its $700 billion bailout package to inject capital into banks, money that will be far better spent than if it had been used to buy up lousy debt at farcical "hold-to-maturity" prices. (Yes, I realize they were going to use a sophisticated auction process to ensure that fair prices were paid for debt. No, I don't think that was going to work any better than the sophisticated processes that came before.)

These positive steps are probably not sufficient to end the crisis. While there is good reason for banks to be more willing to lend to one another today than last Friday, more banks will undoubtedly fail and lending premiums will probably ebb rather than melt.

There are also a host of negative unintended consequences. State aid is usually addictive, and I wouldn't like to predict how or when the banking system goes cold turkey. Politically directed lending is also a risk, as is the possibility that well intentioned real estate lending to help out homeowners stops the market from finding a real clearing price to set the stage for a genuine recovery.

But the great virtue of the capital injections is that they tacitly admit that this is a failure of an entire system and not just a market failure or the fault of a few bad apples which needs to be "contained."

KILL YOUR SACRED COWS

Approaches to accounting and market practices such as short selling, however, still lack realism.

Mark-to-market accounting, under which banks are forced to use market prices to value securities they hold, has been attacked by bank and politicians who say it unfairly makes financials use panic market prices rather than the true value of the income and capital repayment that a loan or securitization might generate over its life.

Euro zone countries agreed to ensure "sufficient flexibility" in how accounting rules are implemented while the U.S. accounting board has moved to allow "significant judgment" in determining fair value in dislocated markets.

Unless the governments of the world want to provide all of the capital in the banking system this is the wrong thing to do.

"The most important thing is to restore transparency in the market," said Lena Komileva , head of G7 market economics at Tullett Prebon in London. "Changing mark-to-market would have a cosmetic effect but would do little to restore confidence."

Banks are not lending to one another and investors are not committing new capital because they already don't believe their accounting.

By the same token, banning short selling sends a dangerous and counterproductive message and very likely made things worse.

The problem wasn't shorts, who in aggregate discipline the market and are a welcome solvent in a system biased toward nest-feathering optimistic assumptions.

The problem was longs, specifically leveraged longs like hedge funds which were forced to sell last week when faced with margin calls and redemptions.

Since the beginning of what we once quaintly called the subprime crisis officialdom, especially in the United States, has underestimated and downplayed the problems.

Hank Paulson and Ben Bernanke said subprime was "contained," which as it hasn't spread to Mars is still true, while Gordon Brown's line that this is a problem that "started in America" ignores the folly and greed of borrowers and lenders in Britain.

Earlier versions of the U.S. bailout plan were focused on producing spurious valuations for bad debt that might give investors confidence.

Confidence is probably too much to ask. I'll settle for reality.

-- At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund --

(Editing by Ruth Pitchford)