Monday, March 8, 2010


A couple of days ago a friend sent me this market analysis, written by two economists, who explain why Wall Street wanted to suspend market prices on certain products. This practice, which suspends the "market-to-market" (MTM) accounting method, essentially allows market players to reprice an asset that they hold if it's generating income, even if the underlying asset is under water (akin to a homeowner making payments on a house that is not worth what they owe on it).

The logic behind suspending market prices is to help keep those who "own" the product from having to provide more cash or collateral to backstop the asset. The idea is to prevent fire sales on Wall Street. All things being equal, this is a good idea.

But all things aren't equal.

I wrote about this on Friday, and made it clear that the suspension of MTM effectively allows the financial sector to suspend reality. Among the many concerns I have is that suspending MTM is being done for the wrong reasons, with virtually no strings attached, and with plenty of government guarantees. It virtually invites another market collapse.

As Bloomberg’s David Reilly points out, MTM is little more than a diversion employed by America's biggest financial institutions “to dodge two big issues -- their reckless use of borrowed money to boost returns and their inability to make sound loans and investments.” According to Reilly, of the $8.46 trillion in assets held by the 12 biggest banks before the meltdown, only 29% of it was something that could be marked to market. In some cases it wasn't even that at that level. General Electric Capital - which is similar in size to the sixth-biggest U.S. bank - said that just 2 percent of it's assets could be marked to market.

What’s really dragging down the banks? According to Reilly, its loans made to consumers, businesses, and other institutions. Because loans for cars, credit cards, and other activities are held at their original cost, when they fail to pay out they act as a drag on the banks. When this happens they need to come up with more collateral, or loan loss reserves. The banks didn't have the money. This is what banks were up against.

Put another way, MTM is a red herring that diverted attention form the bad loans banks made.

Real investors know this. They’re worried about the loan portfolios and the bad investments of the biggest banks. Simply put, they didn’t trust what the biggest banks were doing, and where they were lending their money. As Reilly points out,

… the Big Four have a higher percentage of tough-to-value assets due to their investment- banking activities. In many cases, losses that stemmed from those holdings reflect banks’ decision to enter risky transactions or markets. In that case, mark-to-market simply recognizes the reality of those missteps.

The biggest banks were being dragged down by their short-sighted lending decisions and their own stupidity. Mark-to-Market helped expose this.

Apart from transparency, and exposing the short-sighted decisions of America's financial institutions, why should we continue to use market prices to gauge what a product is worth? Because suspending MTM effectively allows financial institutions to reprice toxic securities. This, in turn, allows them to tell their creditors, their customers, and the government “Look at how much our securities are worth now … we don’t need more collateral or loan reserves … And besides, based on our magically repriced asset, if we want we can get a government guarantee or a government backed loan (through Federal Reserve and Treasury Department sponsored programs).”

I won’t go into the details how this happens (take a look at TALF and Maiden Lane programs to get an idea). Still, it's says much that Bank of America is shoving more and more of it’s “nonconcurrent” (and probably most toxic) loans on to the backs of the American taxpayer.

Consider the following. Last year, only 2.7% of BofA’s failing loans were backstopped by the American taxpayer (student loan guarantees, etc). Today over 20.5% of BofA’s $61 billion bad loans are now the responsibility of the American taxpayer. Take a look at the numbers.

I can't tell (yet), but it seems to me that BofA is doing this because they’re now able to tell the government, “These loans aren’t really bad because the underlying asset is still worth $100 million. See, we just repriced the asset.”

Yeah, and watch me pull a rabbit out my hat … nothing up my sleeve. 

At the end of the day, MTM is not the real problem. The problem is how much banks borrowed against assets whose prices have collapsed. I'm not sure, but it seems to me that suspending MTM was just another way for America's biggest financial institutions to reprice assets so they could dump them on the government through taxpayer funded guarantees.

OK, so the Financial Services Accounting Board (FASB) suspended MTM last April (2009). This could be a good thing. Franklin D. Roosevelt did it, so it can't be all that bad, right?

What we've forgotten is that FDR backed away from MTM because he had other programs and regulations in place (or being put in place) to help insure that suspending MTM wouldn't get out of hand ... or lead to excessive borrowing, inflated books, or wild speculation in other areas. What this tells me is that if we're going to take market prices out of the market, as FDR did, we should also reinstate the 1933 Glass-Steagall Act, which kept commercial banks, investment banks, and insurance companies away from each other's business.

While we're at it we should also repeal the Federal Reserve's 3-2 decision in 1987 that allowed commercial banks back into the securities' market in a big way. We should also put some teeth into the Securities and Exchange Commission, pare back FDIC guarantees, limit brokered deposits, do something about credit default swaps, repeal FANNIE MAE's privatization, and put some teeth into limiting GSEs. And, for good measure, we should have brought back HOLC (instead of President Obama's disasterous, and bank-driven Making Home Affordable Program) and bolstered the hand of labor.

The point is, FDR suspended MTM only because there was a regulatory framework in place to help insure the stupidity we saw in the run up to meltdown in 1929 (and 2008) did not occur.

At the end of the day, the market analysis from the two economists got it wrong. Bringing MTM back in 2007 didn’t cause the market to collapse. It simply exposed the market stupidity that was going on after we deregulated the markets.

Look, I have no problem with suspending MTM, like FDR did. But if we're going to suspend MTM, and channel the legacy of FDR in the process, we should also bring back FDR-like programs which worked to insure that bubbles and other market stupidity didn't get out of hand in the post-war era.

We want to keep in mind that one of the reasons that market players were able to create such fabulous "wealth" over the past 20 years was because no one really knew how much some of the instruments they created were worth. But their computer models did. This helps explain why so much toxic, over-leveraged, debt was created. Market players were living in a market world governed by computer models rather than the logic of the market. MTM helped expose this fairytopia.

Simply suspending MTM, without calling for the regulatory infrastructures (especially related to over leveraging) that helped make our economy such a success in the post-war era, is like throwing a group of kids into a candy store and saying "Do what you want, but don't eat too much". Without rules, things will get out of hand.

What many ignore in all of this is that if our financial institutions hadn't borrowed and lent so much against shady assets - or if they had kept enough capital reserves - they wouldn't be worried about MTM valuations. Hyman Minsky has much to say about this (I'll leave Minsky alone for now; you can read about Minsky in my book, or in the labels below). But in a deregulated environment, where the biggest market players are borrowing and/or betting on assets of dubious value, well ...

Banks and other financial institutions have been making stupid decisions for years. The series of bailouts and subsidies for industry is long and sobering (for my money, much of it starts with the bank bailouts in 1982, and the S&L debacle). What happened in 2008 should have been a wake up call for the industry.

If market players don’t like what they saw once MTM exposed what was happening after 2007 they should act like real market players. They shouldn’t be getting so deep into products that create such a big mess for them, and the American taxpayer. That’s the way real market players deal with uncertainty.

Pretty simple if you ask me.

- Mark

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