* Thanks to Bob the Nailer for this heads up and scary trip down one of history's insane moments.
Posted on 04/03/2009 7:51:01 PM PDT by sickoflibs
When elementary school kids want to escape the confines of their circumstances they pretend to be pirates, princesses, and Jedi knights. Now, with the relaxation of "mark to market" valuation rules announced yesterday by the accounting trade's self-regulatory body, our bankrupt financial institutions can escape their own reality by pretending to be solvent. The unraveling of our fairytale economy over the last few months has not yet convinced us that the time has come to put away childish things. The applause that greeted the news yesterday on Wall Street is a clear sign that we still have some growing up to do.
The imaginative conceit that lies behind the accounting change is that the toxic assets polluting bank balance sheets are not really toxic at all. They are in fact highly valuable assets that for some irrational reason no one wants to buy.
Using the "mark to market" accounting method, mortgage-backed securities were valued relative to the latest prices fetched by the sale of similar assets on the open market. Currently, those bonds are being sold at deep discounts to their original value. By "marking" their unsold bonds down to those prices, the insolvency of our financial institutions had been laid bare. The new accounting changes will allow the nervous owners to assign more "appropriate" (i.e. higher) values. Problem solved.
It is important to note that the Financial Accounting Standards Board made their rule modifications only after intense pressure had been applied by Washington and Wall Street. In their heart of hearts, I can't imagine that there are too many bean counters happy with the outcome.
The banks and the government have argued that the assets should be valued based solely on current cash flow. Most mortgages, after all, are not delinquent. Therefore, a few bad apples should not spoil the whole cart, and those that are not yet delinquent should be valued at par. This method assumes we have no ability to look into the future and make assumptions about what is likely to happen, which is presumably what the market is already doing by valuing the assets lower than the banks wish.
All kinds of bonds (corporate, government and municipal, etc.) that are not in default frequently trade at discounts. In fact, the reason that agencies such as Moody's and Standard and Poor's rate bonds is to assess the probability of default. The higher that probability, the lower the value placed on the bonds, regardless of their current cash flow.
For example, GM bonds that mature 10 years from now currently trade for only 8 to 10 cents on the dollar, despite the fact that GM is current on all interest payments. The 90% discount reflects investor awareness that GM will likely default long before the bonds mature. By the new logic, financial institutions with GM bonds on their balance sheets should be able to ignore the market and value these bonds at par.
Some argue that the comparison is invalid because GM's bonds are liquid while mortgage-backed securities are not. However, if sellers of GM bonds were holding out for 70 or 80 cents on the dollar, those bonds would be illiquid too. The reason GM bonds are trading is that sellers are realistic.
The same should apply to bonds backed by mortgages. To assume that a 30-year, $500,000 mortgage on a house that has declined in value to $300,000 has a high probability of remaining current to maturity is ridiculous. The borrower could lose his job, his ARM might reset higher, or he may simply tire of paying an expensive mortgage for a house that is unlikely to be sold at a profit. Any bond investor with half a brain will factor in these probabilities and look for deep discounts. The only way to accurately assess a real present value is to let the market discover the price.
Despite the pleas from bankers and politicians, mortgages are not plagued by a lack of liquidity but a lack of value. If sellers would be more negotiable, there would be plenty of liquidity. Who knows, at the right price I might even buy a few. The problem is that putting a market price on these assets would render most financial institutions insolvent, which is precisely why they do not want to let that happen.
Simply pretending that all these mortgages will be repaid does not solve the underlying problems. It may keep some banks alive longer, but when they ultimately do fail, the losses will be that much greater. In the meantime, solvent institutions are deprived of capital as more funds are funneled into insolvent "too big to fail" institutions - hiding their toxic assets behind rosy assumptions and phony marks.
Going from the sublime to the completely ridiculous, in a speech at the just-concluded G20 summit in London, President Obama urged Americans not to let their fears crimp their spending. It would be unwise, he argued, for Americans to let the fear of job loss, lack of savings, unpaid bills, credit card debt or student loans deter them from making major purchases. According to the president, "we must spend now as an investment for the future." So in this land of imagination (where subprime mortgages are valued at par), instead of saving for the future, we must spend for the future.
I guess Ben Franklin had it wrong too - apparently a penny spent is a penny earned.
If you realize both parties in Washington think our money is theirs and you trust them to do the wrong thing, this list is for you.
If you think there is a Santa Claus who is going to get elected in Washington and cut a few taxes and spend a few trillion and jump start the economy, and get our lost money back, this list is not for you.
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"To assume that a 30-year, $500,000 mortgage on a house that has declined in value to $300,000 has a high probability of remaining current to maturity is ridiculous. The borrower could lose his job, his ARM might reset higher, or he may simply tire of paying an expensive mortgage for a house that is unlikely to be sold at a profit. Any bond investor with half a brain will factor in these probabilities and look for deep discounts. The only way to accurately assess a real present value is to let the market discover the price."
"Going from the sublime to the completely ridiculous, in a speech at the just-concluded G20 summit in London, President Obama urged Americans not to let their fears crimp their spending. It would be unwise, he argued, for Americans to let the fear of job loss, lack of savings, unpaid bills, credit card debt or student loans deter them from making major purchases. According to the president, "we must spend now as an investment for the future." So in this land of imagination (where subprime mortgages are valued at par), instead of saving for the future, we must spend for the future."
So fine, why can’t market investors make up their own minds anyhow as to whether these best-case valuations or some modeled discount is the way to go? Is this data actually hidden from market investors, or is it just that nobody wants to sit down with a calculator or spreadsheet and work it out? Seems to me it shouldn’t make any difference in the Dow, unless investors felt that easing the rules gave the institutions a chance to escape a forced bankruptcy.
Ironically we got into this because interest rates were too low, we were adding too much debt, and the housing price evaluations were too LOW. Now the party that benefited from it says it was lack of regulations causing the problem and the fix is to :”lower interest rates to zero, adding on more debt, and raise evaluations way beyond what anyone would pay.” What is magic about the prices that home buyers were willing to pay in 2005?
Obama from Bush “More of the same”
To avert confusion let me say that I’m just talking about mark to market, not the rest of the cowpatty.
We got mark to market from the aftermath of Enron. With this rule, we reasoned, Enron could not have hidden the worthlessness of its deeply recursive web of essentially nothing.
And that was true.
We had no idea that a future troubled mortgage business was going to be hit by the same reckoning and keel over at a hiccup.
But in this case the data is out in the open, not in an Enron-like web. Anyone choosing whether to invest in a mortgage company can see it. If it benefits that company on Wall Street, it’s because the mortgage company is, at least, no longer forced to declare bankruptcy based on what its individual assets would sell for now at a fire sale. Investors are permitted to bet that the troubles will pass.
Obama is yet another figurehead of the abominable marriage between socialism and its liberal “one world” sponsors. They’ll spend their way to a national default, if we don’t feed them.
Wise Americans will save and will spend as little as possible, until they have done so.
If you rent out a block of 20 homes and one tenant is delinquent and another stops paying you, that is no reason to declare your entire portfolio worthless. To extend the analogy, 100 percent of your 20 renters are paying on time but another landlord in another state had 3 tenants stop paying rent. That doesn't mean your portfolio is worthless. FASB did the right thing.
People during the dot com bust went thru a similar sham. They had options granted at a higher price, the bust wiped out any possibility of making a dime on the options, but they had to caugh up their own money to pay a huge tax bill on the grant price even though they were worthless and the person could not draw a single penny from the option grant. A stupid accounting rule said that granting options was equal to profits. Not true whatsoever.
At best, accounting is a black art. Accrual accounting is guesswork and complex. Cash accounting is simple - debits on the left, credits on the right.
In the next two months retail and commercial real estate are going to completely collapse and it will make the mortgage mess look like a picnic. If you have any stocks GET OUT. Please keep your arms hands inside the car, this is a dark ride.
Not even George Orwell could have dreamed up this insanity.
"Serfs of the world, UNITE! Spend for the good of mankind!"
Mind the gap, please. The $4 trillion gap!
What about all the dollars the fed has recently created? Seems there are more dollars out there now many more times than we ever imagined. That's got some home sales looking up. And the risk of future inflation is another reason to buy a house now ,certainly if you dont have one. Seems they could inflate there way out of this, helped by fear of future inflation.
It is not a black art, and it is not so complex in principle. The problem is that suppose you purchased that apartment complex assuming 97.5% rent payments on time and that rent would increase 10% per year so that in 5 years you would have break even cash flow, ignoring maintenance costs. San Francisco and New York have been like that for a long time so this is not hypothetical. Now suppose you wake up and 3 tennants are not paying their rent, others are threatening to move unless you hold your rents to now declining market rates and you did not count on advertising costs, broker costs and legal fees to empty apartments, advertise them and get rent paying renters in them, and suppose you suddenly discover that new applicants have lousy credit histories.
Your apartment building is no longer worth the speculative factor of 2 times the discounted cash flow value of the building, which is also dropping like a rock.
Valuation of cash returning assets is not hard. In a world of ever expanding credit, we have not been doing it for 25 years. The value for a long long time has not been cash return, but rather speculative inflated return on equity which is realized by taking out cash in equity loans.
Non speculative valuation is simple. It is current discounted cash flow (including rents, less maintenance, taxes insurance AND reasonable managment labor costs) adjusted to something like long term bond rates PLUS a risk premium.
They cannot inflate their way out of a housing crunch by putting more money in the hands of the bankers. If you want to inflate the economy you do what the Russians did not to long ago. Raise the salaries of all government workers plus welfare and social security plus renegotiate contractor salaries up. The result is an instant broad based infusion of cash that is instantly spent and you get instant inflation. No government workers do not end up relatively better off because the cash infusion is so fast and broad that prices instantly adjust upwards, as do private wages.
Of course, the masters of the universe only get their money later rather than first unlke the present way of attempting inflation by handing the loot to them directly.
Everyone with a credit card take note..... I wonder if bamie would like it if everyone paid their taxes with cash adances from a credit card? You know, to spend money you don’t have towards prosperity.
uggggghghghgh thats “advances.”
RE “Everyone with a credit card take note..... I wonder if bamie would like it if everyone paid their taxes with cash adances from a credit card? You know, to spend money you don’t have towards prosperity”
LOL. great idea, credit card from bailout banks!
That was my point - cash accounting is much more simple (i.e. not so much of a black art). I assume you agree with my statement that FASB's new guidelines makes more sense then marking all MBS/CDO asset prices based on thin, situational, point-to-point market transactions that may not reflect reality outside of that particular transaction?
“What about all the dollars the fed has recently created?”
Well we will need something to burn in barrels under the overpasses to stay warm. Inflating the last bubble won’t change a thing for retail or commercial real estate. The problem there is much larger than the problem in home mortgages.
http://www.moneyandmarkets.com/alarming-news-bank-losses-spreading-32910
Interesting. This is the Schiff/Rogers argument for hyperinflation, the government will continue to create money to keep interest rates low to postpone the next collapse, as it usually does. All while the dollar collapses
* Thanks to Bob the Nailer for this heads up and scary trip down one of history's insane moments.
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