September 29, 2008

Another "I Was Wrong" Post

From, um, "Inspector Asshole." Anyone who's been reading these threads knows he's lived up to his name, at least as regards being a real burr in my sock.

It is -- to be unavoidably insulting -- my opinion that the more one actually knows about this crisis, the more one accepts it is, in fact, a crisis. (And quite likely a fixable one.) In this case, Inspector Asshole read something about the mark-to-market rules and it changed his mind.

What are those rules? Basically that whenever someone conducts an arms-length (legit) transaction in an asset, anyone holding similar securities must mark down the value of their securities to reflect the new market price. And thereby reduce the level of assets they show on their books. And since valuable properties (not as valuable as they once were sold for, God knows, but still valuable) are being deleveraged down to near zero value (sometimes by intentional manipulation -- some want these companies to go bankrupt in order to buy them out during bankruptcy proceedings), this not only reduces a company's paper assets, but it invokes rules about how much cash a bank or lending company must keep on hand in relation to its assets and obligations. As many of a bank's assets (these artificially diminished toxic assets) are now pretty close to zero, a bank can wind up bankrupt on paper when, in reality, it actually has a fairly decent balance sheet.

Some propose temporarily suspending these mark-to-market rules... perhaps let them value these assets on paper according to their best price in a two-month window after the housing bubble broke. That would, hopefully, reflect a diminished but still somewhat realistic value, far less than the prices they once sold for, nicely corrected by the bubble burst, but nowhere near the close-to-zero value these assets supposedly have now.

Before you take this to be a panacea-- the only thing we need to do --bear in mind Newt Gingrich was proposing this (among other measures) two weeks ago but has now decided that some sort of rescue is now required, and that simply reforming the mark-to-market rules is not, at this point, going to stabilize the markets and get credit flowing again.

Helpful, probably. But not helpful enough. Because the reality is that these assets can't be sold at the moment, so even if they're marked up on paper to something resembling a realistic value, banks and institutions holding them are still currently sitting on billions in unsalable, illiquid assets.

More on Mark-to-Market: From November 7, 2007. Predictable.

If you think banks are writing off large amounts of assets now, wait until new accounting rules take effect this month.

The Royal Bank of Scotland Group estimates that U.S. banks and brokers, already under massive losses caused by the collapse in the subprime credit market, potentially face hundreds of billions of dollars in write-offs because of what are called Level 3 accounting rules, according to Bloomberg.
Related Articles

* The SECís New Take on Loan Commitments

The U.S. Financial Accounting Standards Board Rule 157, which is effective for fiscal years that begin after November 15, 2007, will make it harder for companies to avoid putting market prices on securities considered hardest to value, known as Level 3 assets, the wire service reported.

''The heat is on and it is inevitable that more players will have to revalue at least a decent portion'' of assets they currently value using ''mark-to-make believe,'' Bob Janjuah, Royal Bank's chief credit strategist, reportedly wrote in a note published Wednesday.

Janjuah noted that, for example, Morgan Stanley has the equivalent of 251 percent of its equity in Level 3 assets, Goldman Sachs has 185 percent, Lehman Brothers has 159 percent and Citigroup has 105 percent, according to Bloomberg.

On the other hand, Merrill Lynch has Level 3 assets equal to 38 percent of its equity. As a result, Janjuah believes Merrill ''may well come out of all of this in the best health.''

In the fair value hierarchy, Level 1 is simple mark-to-market, whereby an assetís value is based on an actual price. Level 2, known as mark-to-model and used when there aren't any quoted prices available, is an estimate based on observable inputs, Bloomberg explains.

Level 3 consists of unobservable inputs, such as those that reflect the reporting entityís own assumptions about what market participants would use to price the asset or liability (including risk), developed using the best information available without undue cost and effort, according to FASB. There is no verification requirement if the assumptions are in line with those of market participants.

Mike Pence is still claiming that repealing or modifying mark-to-market would substantially fix the problem. Well, for one thing, that allows companies to hold on to these for longer and perhaps avoid bankruptcy, but it doesn't actually fix the problem of these assets having a current value of zero.

Further, the Pence plan also involves loans and insuring the value of mortgages -- which seems to me to be an even bigger intervention in the market, and potentially putting the US on the hook for even more obligations it couldn't possibly cover if they all went tits up.

Allowing holders of these securities to suddenly mark up their values does little at all to restore market confidence or get the markets in these assets functioning again.

I just think the more loans you give these guys, the more you're increasing the odds they won't actually pay them back. Balance sheets don't look much better with huge loans on them.

Anyway, Inspector Asshole (ahem) weighs in below:

Ok, so I've read some and I see that the reasons include something I do understand - accounting rules for 'distressed' assets. I'm an accountant. A manly accountant, not a nerdish- okay, so I'm a nerd too. Anyways...

They (these distressed assets) have to be shown on the balance sheet and marked down to marked down to market value. This means that suddenly, normally healthy companies have assets that actually have value, but have been artificially and temporarily valued at fucking zero goddamned dollars even if they bought them for several million. Even, and I want the market-valuation absolutists to read this very carefully - even when those assets are ownership of actual real property that have intrinsic worth. Due to this rule, the credit markets are being affected in a way that is not tied directly to the fact that loans were made to itinerant phrenologists and spastic mimes. Those were the root cause. The problem with valuation of these loan packages including defaulted mortgages is a fucking multiplier.

Let's put it this way - think of the "credit drain" and bad things as a military force. The CRA loans to carnies and strippers with Tourette's Syndrome is like a company of infantry - pretty impressive. The problem with marking down to market prices is like giving each sonofabich a Davey Crockett nuclear howitzer.

This means that through temporary and artificial means, a company that would say own 30,000 houses/shitty mortgages, all with $3K worth of salvagable copper in them that could be torn out and sold- that they bought for $3 million - suddenly don't have jack shit on their books. All of it is valued at zero because no one will buy it. That isn't a rumor - that is actually happening. Marking down to zero isn't done on a goddamned whim. It is documented. People/entities with these assets that have intrinsic value cannot label them on their balance sheets as what they paid for them - they must write that they are worthless.

This makes huge companies suddenly in dire straits. They may not be able to make payroll NEXT WEEK. A number of companies, who might be loaded with these, will fail.

This is because they suddenly have to book a loss - huge paper losses - that have no real relation to the situation over just the next three months.

Let me repeat - healthy companies will be unable to prove they own enough assets to float a loan. Past liabilities will be dishonored. This will spread within 21 to 30 days up and down the food chain. Each 2 weeks will result in larger and larger cycles of shrinkage of asset valuation, sudden outlays for demand notes, inability to meet payroll, layoffs, and cancellations (with penalties) of contracts.

Distribution networks would be among the first hit. I haven't gone further than that in my research. But right there, we're looking at some severe dislocation. Severe as in diabetics having to stock up on insulin.

This does have the possibility of being retardedly bad - think what would happen if 1/3rd of the train and truck traffic ceased. Stopped without notice.

The problem is systemic - not just to the credit market - it is systemic to how we do business between states. It is systemic as in "No Produce Scheduled Until Next Week" type signs in your Safeway.

If it doesn't get fixed in 2 weeks, by January some communities will be isolated due to no diesel for the road crews. In New York.

I was wrong.

Posted by: Inspector Asshole at September

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posted by Ace at 08:55 PM

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