Mark To Market Scam: A Guide To Hiding Toxic Assets

Tomorrow marks an important economic decision regarding FAS 157 and marked to market accounting.  This is going to be another reason to, at the very least, question government intentions.  The following is a complete look into how marked to market accounting has affected the banks, and what the real intentions behind banning FAS 157 really are.

As it’s well documents, credit default swaps are derivative products.  That’s just a fancy way of saying that CDS are purchased with leverage.  In other words, you can sell $100,000 of default insurance while holding $2,500 of capital.  Being that these products are currently (not for long) marked to market, the value of the derivatives are derived from the price they can receive by selling them on the open market.  This is where all of the problems regarding bank earnings and problematic debt to capital ratios come from.  Let’s think about it in a different way.

Think of an investment bank or bond insurer as a futures trader.  As with CDS; commodity, equity, and currency futures are also derivatives traded on leverage.  That means I can lose more on a futures trade than my initial capital investment.  For example, the non-member outright speculative margin for a gold futures contract is $5,399.  That’s what I need in my account to buy a gold futures contract.  Now, the underlying value of that contract is equal to 100 troy ounces, or approximately $900,000.  Each $1.00 move in the price of gold means a $100 move in my account balance.  If the price moved against me by more than $54.00, than I would lose more than the required margin.  The thing is that my brokerage house, and every other brokerage house, wouldn’t let that happen.  They would stick me with a margin call in which I would be forced to either add money to my account or liquidate my position, possibly with negative equity.  Now just apply those same ideas to an investment bank’s balance sheet.

Marked to Market Margin Call

As with the futures trader, the banks are dealing with massive margin calls.  Gold, like a CDS, is marked to market.  The value is defined by what I can sell my long back or buy my short back at.  Where they differ is liquidity.  The bid ask in the gold futures market is very tight because there are thousands of willing buyers and sellers constantly trading and contributing to price discovery.  The bid ask for the CDS market on the other hand may be 20 cents on the dollar by 80 cents on the dollar.  That means long side holders of CDS have to mark their assets at 20 cents on the dollar.  The problem is that this wreaks havoc on capital to debt ratios.  Think about what would happen to the futures trader if you were short and the bid dropped to 20 cents on the dollar in the gold market.  The marked to market value right now would be $180,000.  Your unrealized loss would be $714,600 and you can believe your brokerage house would seize your account and you’d probably never be allowed to trade again.  Well that’s exactly what marked to market is doing with balance sheets of the investment banks, and they have billions of dollar worth of these CDS that are getting marked down.

The brokerage house is my lender and is liable for my losses.  That is the case for the lenders to the investment banks as well, which happens to be the other investment banks.  You see, there aren’t any lenders other than institutional lenders who can provide the shear quantity in loans required to support the massive derivatives positions held by these banks.  It’s like one of those human circles made by everyone laying on everyone else’s knees.  Bank A lent to Bank B and then A would then just buy a CDS on the money they lent out to B.  Then B lends to C and B buys a CDS.  That is what the one prized “supermarket model” was based off of.  That is how we got “too big to fail,” but I’m getting side tracked.

What I’m trying to say is that this is why the banks are in such terrible shape.  Marked to market means the banks need more capital on hand.  As we’ve seen, if the banks don’t keep the proper capital to debt ratios they get downgraded by the credit agencies. Then financing becomes more expensive as short term non-investment grade corporate debt markets have been some of the worst hit.  Unfortunately, bank earnings have gone down the toilet as well, and for the same reasons.  They report in their earnings the unrealized losses of the marked to market CDS that are bid at 20 cents on the dollar (just an example figure).  The lower earnings have decreased stock prices to the point where raising liquidity would require massive share offerings (bond offerings are obviously difficult, if not impossible in this climate).  So what you have is a situation where marking to market of CDS derivatives has collapsed capital to debt ratios forcing the banks to raise capital and at the same time, is limiting their ability to raise the necessary capital.  Given all of that, the skeletons still have to come out of the closet.  Postponing the inevitable will not only make the situation worse, but it will also only increase the distrust Americans have towards their government.

The Final Truths, Motives, and Profit Opportunities

Marked to market accounting allows us some transparency.  Removing FAS 157 is absurd and criminal.  The whole argument behind removing marked to market is that these assets are perceived to be worth more down the road than their current value.  This is simply not the case.  These ideas are based on the same ridiculous scenarios that Obama based the budget deficit on (tax revenues in an economy that will decline by 1.2% in 2009 and grow by 3.6% in 2010…funny).  The “theoretical” asset values are established on a completely unrealistic economic outlook; I mean it’s not even close.  When it’s all said and done, the banks will be lucky to get 5-10 cents on the dollar.  They will probably be better off finding willing buyers now than they will in 18 months.

So here’s the real reason why the government will ban marked to market accounting.  By removing marked to market, the banks will no longer have to claim the associated unrealized losses on the derivatives; and marking them to magic (mark to model) will reduce the losses from writing the derivatives down.  It’s just another way to hide the assets from the balance sheet.  Another aspect of marking the CDS to magic is that the Fed will be able to grow its balance sheet (already surpassed $2 trillion) faster and more efficiently.  I fully expect the Feds to grow their balance sheet by 4 or 5 multiples from current levels.

The President, Congress, Fed, and Treasury sure talk about bringing transparency, but actions speak louder than words.  They have their twisted reasons.  Like everything else the government mettles in, the imbalances they create are really opportunities to make money.  For the above mentioned reasons, by banning marked to market you can fully expect the banks to start churning out a couple of profitable quarters.  The pundits will proclaim the recovery is on, which is really the ultimate goal of the government.  Markets will rally and Obama will say I told you so.  Then there’s people like you and me who recognize it for what it is and take this opportunity to profit.  This false rally will be a great time to get short the financials.  It’s a second chance for everyone who missed the massive downside move the first time.

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Comment by David

2009-04-02 14:28:05

I find your mark-to-market comments problematic - primarily because you do not differentiate the affected securities. A significant part of the m-t-m problem exists because the pricing model(s) for debt securities relies on current trading activity, which recently has ranged from slim to non-existent. The reason; former market participants are NOT participating - and the bids are WAY UNDER the norm. The result in far too many cases is that paying debt securities are grossly undervalued. And those asset valuations, as you rightly stated, have produced a host of interconnected problems.

As I see it, the m-t-m mandate was significantly misapplied - and, thanks to highly questionable government decisions, America’s bill will be far greater than it ever needed to be.

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Comment by Cindy Peret

2009-04-02 21:14:51

Well, I believe David has no complaint when market was still bull last years. Pls remember the connection between liquidity and risk appetite. I believe the new mtm regime will create a much larger damage to the system - moral hazard.

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