WALL STREET'S DOING IT AGAIN (PART II): Our Daisy Chain of Debt

Last week I wrote in a post that Wall Street was "doing it again." Specifically, in the post I discussed how broker-dealers in the 1960s had "borrowed" assets from client accounts and used them as collateral to secure loans from banks (i.e. repo borrowing). They then used the money to make investments elsewhere, which they (or the firm) pocketed when the gambles paid off. Problems developed, however, because numerous broker-dealer deals failed, which led to over $100 million in losses for their clients.

As you can imagine, investors were furious. Congress acted and we ended up with new regulations through Rule 15c 3-3. To be sure, broker-dealers in the United States still retained the authority to borrow against client accounts. But they would not be able to operate as loosely as they did in the late 1960s (securities accounts were segregated, new net capital rules were implemented, reserve requirements were imposed, etc.). This is precisely why this article by Money Morning's Keith Fitz-Gerald is an eye opener.

In "How Banks Are Using Your Money to Create the Next Crash" Fitz-Gerald makes it clear that market players are not only using client accounts to borrow money and make trades elsewhere, but they're now borrowing and gambling at record levels.

How is this happening, you ask? Check it out.

Let's say you have a portfolio valued at $5,000. Most of what you have is invested in stocks, securities and other market instruments. Suddenly, you find yourself in need of cash (for whatever reason) and dip into your investment fund. You borrow $2,000 against your $5,000 portfolio. Legally you have to pay the $2,000 back or suffer serious early withdrawal tax penalties. But you're fine with this because you're actually paying yourself back.

Good so far? Great. This is where it starts to get good.

According to SEC Rule 15c3-3, the broker-dealers who run your portfolio can take what you owe to yourself - in this case $2,000 - and use that amount as a source of credit for their own use. Loosely speaking, your broker-dealer can use your promise to repay yourself as if it were a promise to pay the firm. The idea is that since you're going to return the $2,000 to your fund, you're actually paying your broker-dealer because they're the ones who manage the account.

It makes perfect sense, doesn't it? I mean, since you owe your account money, it's actually a credit for the broker-dealers who manage your funds, right?

But wait. It gets better ... for the broker-dealers that is.

According to the rules broker-dealers can add 40% of what you owe to "their" credit accounts. So, for example, if you borrow $2,000 from your account your $2,000 debt magically turns into a $2,800 credit (or borrowing limit) for the broker-dealers. Once your broker-dealer borrows $2,800 and then deposits it in a bank the $2,800 (less reserve requirements) can then be invested or lent out elsewhere. This money can then be deposited, and then used again (again, less reserve requirements), then deposited and lent again, then ... well, you get the point.

This daisy chain of debt is one of the primary reasons that the size and volume traded in our financial markets has exploded (computers, deregulation, etc. have also contributed to its growth).

In effect, your debt contract enables broker-dealers to borrow and gamble in other areas that they might never had done, were it not for your account. And while it's been going on since the 1960s, it really exploded with computers, deregulation, and the creation of new security products (repo borrowing surged past $1 trillion before the 2008 market collapse).

The explosion in financial trading has been phenomenal. Consider the following.

While our national economy produced approximately $14 trillion in goods and services in 2011, the total value (i.e. "notional value") that our financial market players have gambled on various market instruments, or now claim some kind of control over, has grown to well over $300 trillion (commercial banks contribute about $120 trillion to this amount).

To put this in perspective, this is akin to your debt-laden neighbor making $60,000 a year and your bank allowing him borrow $1.2 million to invest gamble as they want.Try asking your bank if they'll let you borrow 20 times the value of your assets & income.

But wait. It gets even better. On a global level, if we throw in what market players in the G-10 nations are doing, the total value (i.e. notional value) that our market players now control or claim some kind of authority over now hovers around $600 trillion, or 40 times what America produces in a year. Nice.

At the end of the day, this financial daisy chain is built on your hard work. It derives it's entire value from your financial accounts (and your debt). But here's the kicker. Whatever paper trail of wealth that's created won't be shared with you (have you ever seen a note in your monthly portfolio statement that reads "Here's an extra $20,000, which represents a small part that I earned from using your account to make bets elsewhere"? Neither have I).

According to Larry Fitz-Gerald, not only is this wealth extracting daisy chain legal, but "it's common practice specified in the fine print of most brokerage agreements." And it's called rehypothecation.

I think I'll leave it that for now.

- Mark

ADDENDUM: All of this is only the beginning. The legal use of your account (i.e. rehypothecation) has created a murky world where activities derived from your account (i.e. pledged collateral rights tied to rehypothecated instruments) can be used by several entities at once (p. 9). This is one of the reasons that the size of our shadow banking system (which is largely unregulated) now reaches into the multiples of trillions (p. 9), while the size of our real economy pales in comparison to our symbolic economy by a ratio of at least 20: 1. 

THIS SHOULDN'T BE A SURPRISE TO ANYONE (but I'm sure it is)

Bank of America is being accused of cooking the books to hide potential losses of at least $10 billion. Yawn ...

If you've followed this blog, and read about Bank of America's faux paybacks ... or the wonderful world of book cooking Structured Investment Vehicles here and here ... or corporate America's evolving legal blame game ... Bank of America hiding $10 billion in losses shouldn't be a surprise to anyone. But I'm sure it is.

The only question now is how they explain and then bury the problem with some more creative book keeping.

And you wonder why market-to-market is so important for the banks ...

- Mark  

WE'RE SCREWED, II ... THE HOUSING MARKET VERSION

Remember this graph from Chicago mortgage broker Michael David White?

It shows us (red line) that housing values have fallen. But what's also true is that the amount of debt (blue line) tied to those homes have not collapsed, even with write-offs and renegotiations. There are a number of reasons for this. Among those include not enough homeowners qualifying for renegotiations and the fact that the biggest banks haven't had to mark down failing mortgage loans. This means our nation's financial institutions are carrying bad loans but they haven't been forced to mark them down to their actual market value.

And why should they?

When the market meltdown started in 2008 President Bush and Congress gave Wall Street and the banking industry a magnificent "deregulation" gift when they said financial institutions wouldn't have to mark down their toxic financial assets (and the instruments that they spawned). In essence they regulated market prices out of the market (by suspending mark-to-market accounting methods) and said to the banks, "You can attach any value you want to your toxic assets ... but don't worry, consumers and homeowners still have to abide by their contracts. If they don't, go ahead and attach fees and/or foreclose. Be happy."

Then we have President Obama's gift to Wall Street. His $75 billion Home Affordable Modification Program (HAMP) has turned into a significant market subsidy for the banks and Wall Street. This Huffington Post piece by Shahien Nasirpipour and Arthur Delaney helps explain why.

Here a few key points about HAMP:

* REJECTIONS DOMINATE: Of the 1.2 million distressed homeowners who entered HAMP (through June) more than 529,000 have been kicked out (though 389,000 have benefitted from permanent modifications).

* FINANCIAL INSTITUTIONS FIRST: Banks are using a "Net Present Value" test. This allows financial institutions to determine whether a loan modification will make "investors"  more money than a foreclosure. Put another way, even after dumping trillions of taxpayer funded bailout dollars on to Wall Stree, the needs of banks and investors dominate a $75 billion program that was designed for homeowners.

* UNICORN MATH: Extending a loan modification process to distressed homeowners has only served to allow banks to carry bad loans on their books at full value, delaying loss recognition.

* HOMEOWNER FORECLOSURES, BUT NO PENALTIES FOR BANK NON-COMPLIANCE: Companies like Countrywide - the beneficiary of billions in taxpayer funded loans and guarantees - have told applicants that they aren't participating in HAMP. Foreclosures continue. Yet, the Treasury Department has yet to fine a single servicer for noncompliance with HAMP.

* BLOATED FINANCES: Delays have allowed banks to tack on tens of thousands of dollars in additional interest and other fees, which they use to inflate the value of the mortgage contracts they hold.

There's more, but you get the point.

While many market analysts will tell you that HAMP has helped achieve stability for the housing market, it has done little to nothing for the majority of distressed homeowners who've applied to the program. Worse, it shows that in spite of creating trillion dollar loans, transfers, and other guarantees for Wall Street - in the process, creating the biggest bailout in human history - individual homeowners were never supposed to be the primary beneficiaries. The biggest financial institutions on Wall Street were the targeted group.

But wait. It gets better (or is that worse?). Mortgage broker Michael David White explains why our housing problems pale in comparison to what's going on around the world. As bloated as our housing bubble economy got, it's not as bad as other parts of the western world ...

In a few words, many of the key western countries (except Germany and Japan) are looking down the barrel of gun when it comes to housing. Greece may have been the first salvo in a much wider market mess facing Europe, and the world.

Stay tuned. Things will be getting worse.

- Mark

OUR EVOLVING THIRD DEPRESSION

Economist and NY Times' op-ed writer Paul Krugman sees the beginning of "the Third Depression" in America and around the world. Pointing to the Long Depression of the 19th century (beginning in 1873) and the Great Depression of the 20th century (1929), Krugman argues that what we saw both times was "an era of nonstop decline." This is what we face today.

Arguing that the Third Depression is really just getting under way, Krugman writes that "this third depression will be primarily a failure of policy" and points to "last weekend’s deeply discouraging G-20 meeting" where governments obsessed about inflation "when the real threat is deflation." For Krugman "preaching the need for belt-tightening when the real problem is inadequate spending" is a policy prescription destined for disaster because of the millions who remain unemployed.

The primary culprit here is "the victory of an orthodoxy that has little to do with rational analysis," with policymakers slavishly adhering to the idea that we need to assuage markets by holding back on spending. The outcome is a stunningly shallow belief globally "that imposing suffering on other people is how you show leadership in tough times."

When we throw in the fact that Republicans derailed legislation last week that would have extended unemployment benefits and sent billions to states in an effort to avoid layoffs it's easy to understand Krugman's pessimism. Over 1 million people will be affect by this decision. To be sure, apart from being unhinged ideologues who say one thing and do another, the Republican party's real goal is to keep the market collapse going so they can pin it on President Obama in November (so much for "America First"). Still, in the final analysis what we have is a leadership - both national and global - who cling to the tenets of a dying ideology like the monarchs of Europe clinged a decadent and dying feudal system.

Apart from the fact that Krugman has gotten so many things right over the years, I'm inclinded to agree with Krugman's assessment because of the evolving characteristics of our economic situation. The biggest issue for me is how we continue to believe that if we appease the same corrupt market gods who got us into this mess that they'll act good and respond with appropriate investment strategies, just like the textbook says it should happen. This expectation is simply naive.

From the tricks behind high frequency trading, to the astronomical bets made in derivative markets few understand, to the lack of transparency surrounding toxic assets, to the use of unicorn math (mark-to-market accounting) and a genuine depence on government favors (both bailouts and legislation), we are witnessing the wholesale destruction of market capitalism around the world. The focus is no longer on wealth creation, but wealth extraction. Adam Smith is turning in his grave.

That policymakers believe fiscal authority, without serious real financial reform, will save the day in this environment says much about our failure to learn the lessons of history. A third depression, indeed.

- Mark

WHAT DO YOU KNOW ... YOU CAN TURN A PINTO INTO A MUSTANG

Some of you might recall that back in October of 2009 I wrote "You Can't Turn a Pinto Into a Mustang." At the time I was using Ford cars to explain how - in the real world - you can't take a piece of crap car (Pinto) and suddenly revalue it and get classic car (Mustang) prices. That is, of course, unless you're one of the financial institutions that can take advantage of a Jan. 1, 2009 government ruling which says "Go ahead, revalue the toxic crap you own ... we don't mind."

In my October post I explained (by using Ford cars as a metaphor) how the Financial Accounting Standards Board's (FASB) 2009 ruling effectively allows America's financial institutions to ...

Level I: Price their financial instruments according to everyday market prices, known as the "mark-to-market" method.

Level II: Price their financial instruments according to what similar assets might sell for if more of them were around and/or sold. On this, think assessed value on hard to value antiques or one of a kind goods.

Level III: Ignore Level I and Level II pricing methods and simply make shit up ... known in the accounting world as the "mark-to-make-believe" method. 

All too often, it appears that America's financial institutions are using Level III mark-to-make-believe methods to make up their prices. What I didn't explain at the time are the details behind the game. Here's how it's happening ...

It turns out that when FASB implemented "Statement 157" on January 1, 2009 - in addition to directing financial firms on how to assess "fair value" for their goods (Levels I, II, or III) - it also left a loophole wide enough for William "The Refrigerator" Perry to walk through.

More specifically, FASB rules allow America's financial institutions to ask for a pricing waiver on financial instruments if they don't like the numbers from Level I or Level II methods. This is akin to a homeowner who hopes to secure a loan on their house being able to say, "I don't like the value my house was assessed from the Level I or Level II methods. I want a waiver so I can apply mark-to-make-believe (Level III) methods ... yeah, I want to let Peter Rabbit assess the value of my house."

Put another way, you get another shot at reassessing the value of your house at a price that has nothing to do with what it's really worth. Making matters worse, other financial institutions, the American taxpayer Federal government, and other unsuspecting market players have to play along with the charade and accept the price too.

To be sure, the financial firms have to fill out some extra paper work to gain access to the mark-to-make-believe (Level III) pricing method. The FASB does have it's standards (wink, wink). But what's a few more fairy tales penned in an economy that already has an Alice in Wonderland character to it? Once you're down the rabbit hole does it really matter if you burrow deeper?

Gaining access to mark-to-make-believe (Level III) method is the result of a loophole that says if your financial asset is exposed to "forced liquidation or distress sale" conditions you can apply for a waiver. As you might guess, given the market conditions of the past year, virtually any toxic financial instrument created on Wall Street could qualify for a Level III categorization, as long as the financial firm is willing to do the paper work.

And just like that, a toxic CDO or an SIV (which are akin to financial toilets), can be revalued to some made up number that makes Wall Street's financial mandarins feel better about themselves. More importantly, because of Tim Geithner's hare-brained scheme - which allows financial firms to use their toxic crap as collateral for new money - financial firms can dump their repriced assets on the American taxpayer Federal Reserve for new loans, credit, and profits.

To be sure, the market value of the product may still be in the toilet. But who cares? As long as the book value of the instrument hasn't collapsed we can all make believe that our banks are doing just fine. Thank you FASB.

In the end, it's because of FASB (which is under the SEC) that Wall Street's biggest players (1) have been able to maintain the illusion that their assets and their financial institutions are worth more than they really are, and (2) can go to Uncle Sam for more loans and credit guarantees, using collateral that's toxic and/or has tanked in value.

So, yes, if you work in Wall Street's Alice in Wonderland world, it appears you can turn a Pinto into a Mustang.

-  Mark

HOW WE'RE GETTING RIPPED OFF

OK, I've been writing for some time now about some of the smoke & mirror games that allows Wall Street's biggest financial players to "privatize the profits and socialize the losses." To do this, they've been dumping their toxic - or close to toxic - assets on the American taxpayer, and securing good money for their efforts. Two of ways that Wall Street has been doing this include:

1. Using shaky contracts as collateral for government-backed loans.

2. Revaluing shaky contracts above market price to make these loans bigger than they should be.

If you want to know the technical terms and details behind these deals go to this post from Yves Smith at nakedcapitalism.com. All of the stuff she posts is a treasure trove of insight and information. This post, however, is dedicated to simplifying (oversimplifying?) the details.

Let's say you acquire a car. You expect to make lots of money racing it. You also expect to sell it later as a classic. The car makes you look edgy. You have lots of friends. All is good.

But then things go bad. You wreck the car in a multi-car crash. Your car is still drivable, but you're not going to win any races any time soon. You now have no friends.

Even if you fix the car, problems will arise because of questions about the frame, replacement parts, etc. But things become even worse because people know that you wrecked your car in a demolition derby, where everyone else was trying to win races, just like you.

No one wants the cars that were in the derby. So sad.

The market for cars in general isn't good. But the market for wrecked cars in the derby you raced in - no matter how nice they were to begin with - is even worse.

Now imagine going to a bank and saying, "Give me a full value loan on my fine auto ... it will be worth much more once I fix it." In the real world, this is the response you should expect to get ...

But in our "privatize the profits, socialize the losses" world the Federal Reserve has figured out a way to help you (i.e. Wall Street) out. The Federal Reserve created a Primary Dealer Credit Facility (PDCF) where owners of wrecked vehicles can use their cars as collateral to get a loan. And, just like that, based on the original promise of the car (and your promise to fix it), your racing investment is now worth something.

But no one is quite sure how much a car from the demolition derby - even the ones that escaped major damage - might be worth. Still, you're confident, because The House (the Federal Reserve) is letting you sit at the tables, with their money. They're going to be helpful. Your derby friends return.

Suddenly, things get even better. Since the car is drivable, and you promised to fix it, the Federal Reserve's PDCF window allows you to value the car according to what you think it's worth - or what you think it should be worth - once the market for your wrecked vehicle improves (this is the concept behind "mark-to-market"). Cha-ching ...

You leave the car with the Fed as collateral, and walk out with some real money.

Do you return for the car, and pay back the money? Wouldn't it be so much easier to leave it with the Federeal Reserve? You've got the money, right? Instead, because there are no penalties for being reckless, you go out and buy another car, and do it all over again. The Federal Reserve American taxpayer has to eat the losses on the collateral you left.

In many instances, this is what we're going to end up with on many of the collateral contracts the Federal Reserve the American taxpayer is absorbing through the Fed.

While all of this may be an oversimplified version of what's going on, it makes the point. We're taking on toxic instruments, and exchanging it for good money. But most Americans don't have a clue about any of this because of the complexity behind Iron Maidens, market-to-market accounting, CDOs, etc.

This is why greater transparency about the what the Federal Reserve is doing is necessary. They're not giving up enough information now, which makes the details even more fuzzy. Worse, because there were never any penalties for reckless behavior in the first place (the behavior was rewarded), we may be setting ourselves up for another financial demolition derby.

Stay tuned.

- Mark

MARKET DELUSIONS RUN DEEP, II

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.

MARK-TO-MARKET’S A RED HERRING
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.

DUMPING THEIR STUPIDITY ON THE AMERICAN TAXPAYER
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 WE SUSPENDED MARK-TO-MARKET
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.

CONCLUDING COMMENTS ON MARK-TO-MARKET
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

MARKET DELUSIONS RUNNING DEEP ... AGAIN

I was directed to this by a friend. Read the link before you go any further. To be sure, I'll synposize the piece as I move along below, but read the piece first. It will help you understand the commentary.

………………

Let me preface what I present below, and in the next few posts, by saying this: The argument by Brian Westbury and Robert Stein looks good. It especially looks good if you want to believe that greed and market stupidity didn't cause the market collapse.

Look, Westbury and Stein (W&S) are cherry picking and distorting issues to explain why we shouldn’t use market prices to price million dollar assets. Their doing it for the benefit of their industry, and to satisfy personal interests. Here’s the irony of their “let’s-not-use-market-prices-to-gauge-the-value-of-assets” mentality. In the run up to the market meltdown market players consistently told us that the prices we were seeing were correct. Prices are indicators of “what the market will bear” we were told.

We didn’t need to worry about how prices got so high because, according to market players like W&S, prices contain all the information we need. Part of the reason why they want us to believe this is because, as long as prices were going up, it allowed them and everyone else in their financial market chain to pay themselves big fees and even bigger bonuses. Markets, after all, are rational.

Then the market collapsed. Oops.

WHY THEY WANT TO SUSPEND MARKET PRICES
After the market collapsed in 2008, and blew all their “markets are rational” nonsense out of the water, market players like W&S wanted special pricing considerations. Specifically, they wanted to re-price the value of security assets that no longer fetched what it used to before the market collapse.

This is important to understand because collapsing prices would have forced many market players to put up collateral, or sell what they had to generate cash. This would have further depressed security market prices. Like nice homes in a crumbling neighborhood, even the good securities would be affected by collapsing prices.

Market players stood to lose millions. Worse, the industry more than likely would have suffered through a series of lawsuits, as investors started asking “What happened to my money?” The legal lessons of Orange County in 1994 still linger.

But W&S don’t want middle class America to focus on their industry losing millions and facing lawsuits. If we did, we would start asking “Why the hell did you lend and borrow so much to gamble on such toxic crap?” Instead, industry analysts concocted Chicken Little-like “the sky is falling” arguments designed to shift attention away from the degree of stupidity inherent in the market at the time. Then they write pieces like this to try and convince you and me that their industry is not to blame for anything. They’re saints.

Put more simply, market players wanted to be able to re-price assets to save their skin. The fact that re-pricing assets would also put money in their pockets, by keeping “assets under management” relatively stable, was just icing on their financial cake.

GETTING THEIR WISH
According to W&S the market for asset-back securities dried and crashed only after November 2007, when the financial industry was forced to use “market” prices, instead of computer models and cash flows, to value their financial instruments. Like the chronic drunk who gets a DUI and then blames it on being pulled over for a broken tail light, W&S are deliberately confusing cause and effect.

According to W&S having to re-price assets - and not shady lending practices, and even shadier models - is what caused the market to collapse. In an attempt to appeal to our inner FDR, W&S even made a point of noting that FDR was able to stabilize markets only because he suspended market prices in 1938.

Ergo, according to industry experts like W&S we needed to suspend using market prices - or what the industry mind-numbingly refers to as “mark-to-market” (MTM) - to value multi-million dollar security assets. And market players got their wish. Last April (2009) market players effectively regulated market prices right out of the market when the Financial Accounting Standards Board (FASB) suspended the MTM price method.

CONCLUDING COMMENTS (for now)
Let’s recap.

1. Market prices are good as long as prices go up, and fees and bonuses are paid on these prices.

2. Market prices are bad when market greed and stupidity is exposed, and market players stand to lose millions and get sued.

3. Regulating market prices out of the market is good because FDR did it, and it saves the financial industry from doing some soul searching.

In a few words, suspending MTM is necessary for the financial industry because it allows them to suspend reality. It’s one of the reasons accountants refer to the practice as “mark-to-make-believe”.

But financial market players want the suspension of market prices to come with no responsibilities, and all the benefits of government guarantees. What a bunch of pricks. I’ll explain why over the next few days …

- Mark

SEN. DODD BLOWS KISSES TO WALL STREET, HOLLYWOOD STANDS UP FOR MIDDLE CLASS

With taxpayer funded Wall Street still playing games with regulations and accounting standards, like mark-to-market, Congress needs to act by creating a strong, independent Consumer Financial Protection Agency. Otherwise we're heading for another economic meltdown. But Congress is dragging it's feet. Out-going Senator Christopher Dodd (D-CT) is even throwing kisses at the banking industry, no doubt to secure a lucrative lobbying job after he leaves office.

Dodd's signed on to a toothless bill that would create a consumer proetction agency ... that would be housed in the Federal Reserve! You know these people. They're the same group of guys who think it's their responsibility to keep failed banks propped up in perpetuity, and who don't know how hundreds of billions of taxpayer funded bailout dollars have been spent by our failed banks. As I noted in my previous post, the Federal Reserve has only one job. To protect the integrity of the currency. That's it. If they can't do even that (and they aren't) what makes Dodd and his colleagues think the Fed's going to put any effort into protecting the American consumer?

With Congress doing the wrong thing it's nice to know that one group of well-connected and wealthy people are willing to focus on what needs to be done: Hollywood.

If you haven't seen it yet, Will Ferrell, Fred Armisen, Chevy Chase, Dan Aykroyd, Dana Carvey and Darrell Hammond, the Saturday Night Live actors teamed up on a web video designed to convince Congress to do the right thing on financial regulatory reform. So they wouldn't miss the '80s, Jim Carrey was called in to play Reagan in the "Funny Or Die" video.

Funny or Die's Presidential Reunion from Will Ferrell

My next post will deal with the mark-to-market nonsense noted above. It's something bankers won't want to miss.

- Mark

LEGACY ASSETS & TALF

OK, let's assume that you're upside down on your house. You owe more than your house is worth. Still, you walk into a bank and are able to get a government-guaranteed loan based on the promise that the house eventually will create enough wealth (equity) so that you can pay off the loan. Imagine, getting a $250,000 loan (it's market value today) on a house when you owe $350,000.

You can use the money for many things, until the market recovers. Better yet, since there's a government guarantee, you could even walk away and leave the bank with your house if the market doesn't recover. Heads I win, tails you lose.

Many of you who owe more than your house is worth are probably thinking, Wouldn't that be nice? Well, this is exactly what Wall Street's financial titans have access to with the Federal Reserve's $2.45 trillion legacy asset program (one of many such programs).

So, what's a legacy asset? In a few words, legacy assets are the fine sounding name that the financial sector and the Federal Reserve gave to debt investments that were not paying off after last year's market panic. In your world a legacy asset would be a house that is upside down. On Wall Street legacy assets are debt contracts (home loan mortgages, credit cards, or other debts) that were sold to market players as money making instruments, but are no longer being paid. They are bad debts.

In the real world, non-performing debts would be written off, and the lender (or the industry) would learn a very hard lesson about reckless lending. Not so in our Alice in Wonderland Economy.

Here's how we got to this point.

ROOTS OF "LEGACIES" ... ASSET BACKED SECURITIES
Starting about 25-30 years ago once-promising debt contracts were bundled up and sold to market players. Over time we would call these bundled up debt contracts "asset backed securities" (ABS). Market players purchased these ABS products because America's middle-class could always be counted on to make regular payments over the life of the loans they took out. Your credit card payment or your home mortgage payment are the real assets here.

Because of vigorous lobbying by the financial sector, bankruptcy and foreclosure laws were tightened up to help make sure this would happen (see especially the Bankruptcy Act of 2005). Over time market players got giddy and even started making big (and incredibly stupid) bets on these debt products paying off. These were trillion dollar bets that dwarfed the size of our national economy, and threatened our economic viability.

As we now know, things didn't work out too well. Credit and loans between financial institutions dried up. The market collapsed. People lost their jobs. Market players who made big stupid bets (called credit default swaps) didn't have the money to pay their bets. 

Market players and financial institutions who thought America's middle-class would make their (ABS) investments pay off went nuts. They even blamed consumers for not paying their bills, even when they couldn't pay the stupid bets they had made.

No matter how you looked at it, the ABS markets were in trouble.

FROM ABSs TO "LEGACY ASSETS"
This explains, in part, why the Bush and Obama administrations swung into action. With the help of the financial sector and the Federal Reserve they created a nifty sounding name to deal with collapsed ABS markets. They called them "legacy assets." They were still worth crap, but at least "legacy assets" sounded better than "liability" or what they were, dying assets.

Legacy assets ... it's a nice name for a dying instrument. Kind of like euthanasia. Except instead of killing someone painlessly - especially someone suffering from an incurable illness - we put our tumor riddled and dying financial assets on life support. Here's how.

To put America's legacy assets on life-support we created something called Term Asset-Backed Securities Loan Facility (TALF). In real simple terms TALFs are government-backed loans. They can be accessed by those who hold financial crap, or non-performing ABSs. To better understand the concept let's use our home example from above.

If TALFs were available to America's home owners they should be able to use their homes to get a loan from the bank, even if they're upside down on the loan. Unfortunately, TALF loans are only made available to America's largest and most powerful financial players by the Federal Reserve of New York (and, no, President Obama's Making Home Affordable Program doesn't even come close to TALF; it's a joke).

Here's the real good part.

The big financial players don't need to put up any good collateral for the loans they get. They can use their poorly performing ABSs as collateral. If the collateral doesn't pay off then you and I are stuck with the bill (see "What happens if a borrower does not repay its loan?"). How much will this add up to? We don't know just yet. But we do know that the Federal Reserve has made at least $1 trillion available for these TALF (ABS) products, and another $1.45 trillion for non-performing assets in the housing market.

This is well above the $1.5 trillion that Presidents Bush and Obama made available via the Congress-approved bailouts.

WHAT WE'RE LOOKING AT ...
So, how well are things going? No one is quite sure, especially since there's no telling how bad markets really are because of our bailout-driven, re-inflated economy (not to mention the impact of mark-to-market garbage inflation). But we do know that the TALF terms are quite good for Wall Street, especially given the terms that the credit card and mortgage companies give middle-class America. Consider the following:

1. No Pre-Payment penalties (unlike many home loan contracts).
2. Principal rather than interest paid first.
2. TALF loans can continue if underlying product is paid off (TALF's % rate terms make this attractive).

Over 2009 we know that at least $50 billion has been lent out for "legacy assets" (via TALF) either in the form of mortgage backed loans or other debt-driven instruments (credit card debt, student loan debt, car loans, etc.). The Federal Reserve has already lent money for products that may not be worth the amount of the loan. Either way, market players have been able to generate cash for necessities - like their bonuses - and can walk away from the loan if the underlying product doesn't pay off.

Again, heads they win, tails we lose.

But the U.S. taxpayer is told not to worry about being taken for a ride. Somehow, rigged "stress" tests in a bailed out industry are supposed to give us confidence that "markets" will work and the Fed will get our money back. And besides, the only way these the product can fail - according to the NY Fed - is if "extremely unlikely economic circumstances" appear (you know, like in 2008).

With record bonuses continuing to occur, in a bailed out and undisciplined market, somehow this doesn't inspire confidence.

- Mark

UPDATE: For an overview of what productive, non-financial, legacy assets are supposed to look like click here.

HEY, WHERE'S OUR FINANCIAL TOILET?

Imagine you have a family member who has a gambling problem. But they don't call it a gambling problem. Instead they talk about "a system" that they have. It's guaranteed to break Las Vegas. In their minds they are not gambling. In their mind they are "investing" time and money (in their minds, they're not sociopaths either. But that's another story).

Their investments gambles, as we all know, require money. But the family doesn't have any money to spare. So the investor gambler has to find cash. If this is done legally they will go to a bank. Or they will draw money from a retirement account, or some similar pot of cash. Eventually their debt loads become unbearable and financial institutions either stop lending or require more collateral. Pretty simple, right?

Now imagine if your gambling family member is able to convince banks to lend money, no questions asked. A permanent line of credit. They can go to Las Vegas and stay until their bets pay off. Sweet.

So, which route would you follow if you were our gambling family member? (A) Put up more collateral, and go to Las Vegas, (B) Secure a permanent line of credit (no questions asked), and go to Las Vegas, or (C) Stop borrowing and actually work for your money?

I know. Tough call.

Our bailed out financial institutions chose Option "B." This is how they did it.

To gamble with a continuous stream of other people's money - with virtually no questions asked - our nation's financial institutions created a nice accounting gimick called Structured Investment Vehicles (SIVs). These SIVs were, in essence, legal shelters where financial institutions could dump all the toxic investments bets they made with borrowed money. In a few words, SIVs are no better than legal financial toilets.

These financial toilets were made possible because our nation's financial institutions convinced the experts at the Financial Accounting Standards Board (which the Securities and Exchange Commission oversees) that moving financial crap off of their books was a good thing.

Over time the financial sector was even able to convince naive market players and gullible media sycophants to refer to their debt-laden SIVs as "capital arbitrage." Creating and moving so much bad debt and toxic crap never sounded so sexy (though, it still looks like - fair warning, don't click if you're stomach's not up to it - this).

I bring all of this up because alot of the crap our nation's financial institutions created in their financial toilets (SIVs) is still not worth much. Much of it, if you will, still stinks. Think about it this way. If you bought a house for $300,000 in 2007 it might only be worth $150,000 today. You and I have to eat this kind of financial loss. The banks don't want to eat what they have in their SIV toilets. Part of the reason for this is that it amounts to hundreds of billions of dollars in losses, which means their balance sheets won't look as good as they're telling the world.

This is where it gets really fun.

Banks now want regulators to allow them to revalue the bad bets they made - which they shoved into their SIV industry toilets (or "trust preferred securities") - at the price they originally paid. This way, the fees and bonuses that are tied to these bets get paid off at full value. Banks win big (again). Incredibly enough, the regulators are actually considering the proposal.

Hey, I have an idea. Since the regulators are caving in on things like this, let's do the following.

I say let the banks revalue their SIV financial crap. But on one condition. You and I get to revalue our homes at the market value we saw between 2004 and 2007. And just like the financial clowns who are getting bonuses and fees from revaluing the toxic crap they created, you and I get to sell our homes back to the banks at 2004-07 prices.

What's good for the goose is good for the gander, right?

I know, I know. It will never happen. I just wanted to share with you how our market system has very little to do with accountability and competition, and more to do with favorable legislation, manipulated regulations, and bailed out financial toilets.

- Mark

P.S. As a point of reference, the revaluation of depressed assets that I've described above is referred to as "mark-to-market" accounting. Responsible industry insiders refer to the method as "market-to-make-believe." I discuss market-to-market in previous posts, and in my book. Click on the labels and themes below for more information.

MARKET CHEERLEADERS LIVING IN FAIRYTOPIA

Back in March I got into a rather interesting e-mail discussion with one of the economists at Merrill Lynch (in New York). It came after I read one of their monthly newsletters, where the authors presented the world with what they thought was sound market analysis. It was garbage, and I let them know.

Well, hang on to your hats. We're now getting more and more of the same garbage, as you can see in this "It's Not the Government's Recovery" piece by Brian S. Westbury and Robert Stein. The authors do their level best to show the world that people in the bailed out financial sector (like them) know what they're doing when, in fact, they don't get it. In my view, they have no idea about cause and effect relationships when it comes to our current market environment.

Check this out.

The authors first claim that accounting gimmicks like "mark-to-market" - which allows the financial sector to reprice garbage - have made things better. And it did ... for market players on Wall Street.

What the authors don't mention is that the freedom to reprice their garbage came in the bailout language signed by President Bush after Newt Gingrich and the financial industry lobbied Congress extensively (here's what I think about mark-to-market), while others worked on FASB rules. This means that the federal government altered the rules for the industry to help revitalize collapsed market prices. There were no invisible hands here as the authors suggest.

Then the authors argue that "easy money and the the normal tendency for free markets to heal from panic" created the conditions for recovery. This is truly pathetic.

Look, I voted for President Obama and genuinely want him to succeed. But the recovery isn't real (no matter what Larry Summers says). Those of you who read this blog regularly know why. To the extent that things may have stabilized, the "easy money" policies (via low interest rates) that made this possible were mandated/facilitated by the Federal Reserve. This occurred with the cooperation of the White House and the Treasury Secretary. This is government policy.

Finally, the authors also hide behind industry junk terminology ("V-Shaped recovery", "monetary velocity," etc.) that, I'm sure, impresses gullible family members and drunk neighbors. But it does little more than camouflage reality. It completely misses the multi-trillion dollar guarantees that the Federal Reserve, the FDIC, and the Treasury Department created for Wall Street's market garbage. This along with mark-to-make believe are what is creating the illusion that things are picking up on Wall Street (by facilitating counterparty payoffs). 

At the end of the day, what Westbury and Stein present is stunningly superficial and myopic. It really belongs in the Irving Fisher School of Permanent Plateaus. More to the point, to suggest that markets are "healing" because of some kind of Magical Market Pixie Dust is simply delusional.

There's more from the authors (including the incredibly ignorant suggestion that the "economy would be doing even better ... if government had stayed out of the way") but it's clear that Westbury and Stein really have no clue what's happening in the economy. These guys are living in a free market fairytopia.

That they're writing this stuff, and people take them seriously, should be a Red Flag. They're cheeleaders, not analysts.

- Mark

YOU CAN'T TURN A PINTO INTO A MUSTANG

In our wonderful world of finance market players have been able to create and bet on garbage. Then they have been able to get the U.S. taxpayer to pay for their stupidity and greed in the form of bailouts and market guarantees. We're looking at more than $20 trillion so far. This is what makes the following so intriguing.

It turns out that because of the different types of financial instruments market players created, that the U.S. Financial Accounting Standards Board (FASB) decided to create three separate levels of accounting to separate and grade the good financial instruments from financial crap that was produced over the past 10 years.

Level I is for basic financial instruments that you can buy and sell. Everyone agrees who owns it, and agree on what it’s worth. It’s like your car. You own it. Everyone has an idea of what it’s worth because it's pretty much a standard automobile. And if you want a second opinion, you can go to Kelly’s Blue Book.


Level II is for financial products whose value are less known because they’re not traded as often. But the products are part of real markets that are known and (mostly) respected by financial players. It’s like the car collector who has a rare car whose value is indeterminable, but everyone knows they’re worth something. If you want a second opinion, you go to an expert.


Finally, Level III is for financial products that are not worth what market players paid. They're toxic and worth crap in the market. Everyone knows it, but the owners are hoping that it will be worth something one day. It’s like owning a Pinto. You may have purchased it for a good chunk of change but, ultimately, it’s worth crap - and everyone knows it. Still, there’s hope that in the future (like in the next Ice Age) it might be worth something (as a form of shelter).


But, today, it’s worth crap. Especially since you know that it could blow up in your face at any time.


Pretty simple, huh? OK, on to the next point.

Apparently, the number of financial - and very toxic - crap at Level III accounts for about 15% of all the financial instruments out there (up from 9% last year). That's alot of Pintos. But it's still only 15%, so what’s the problem, right? This is the wrong question.

We should be asking How much is this 15% is worth?

It turns out that while all of these financial instruments (in Level III) have a combined book value of about $610 billion their real market value has plummeted. No one knows how low the value of these instruments are because no one wants to purchase them (especially since home prices and foreclosures are moving in opposite directions). It’s like you bought a “classic” Pinto for $10,000 only to find on delivery that “classic” meant you purchased a used beat up Pinto that’s really worth $250.00 (even with the aerodynamic luggage rack).


Why is this important? Because, according to one account, $610 billion in Level III crap is “many times bigger than the market cap of the banks.” Put another way, all the crap that’s on the books at Level III has the potential to bust these banks in the future because their value is more than the banks are worth.

This explains why market players want to change the accounting rules. They want to revalue the toxic financial instruments according to non-market prices. In Finance Speak they want to abolish "mark-to-market" accounting methods. In our car market, one could say they want '65 Mustang value, for their piece of crap Pinto.


The accountants who follow and understand this stuff have another take on this. They say what the financial sector is really asking for is that “mark-to-make-believe” accounting standards be applied to their industry.

Whatever they call it, Wall Street's financiers want to be reimbursed by the federal government full book value for the toxic financial instruments that they've created. They want another subsidy. Mark-to-Make-Believe will help them do this.

As Yogi Bera would say, "It’s déjà vu all over again."

- Mark

P.S.: For a somewhat humorous take on the financial sector's blood-sucking ways, check this out.

AND YOU THOUGHT PUBLIC WELFARE WAS EXPENSIVE BEFORE ...

I know this post is a bit long. But not understanding these issues is exactly why we get screwed out of our hard earned dollars. Conservatives like to complain about giving their money to the poor when it's stuff like this that drains our tax coffers, and has the potential for collapsing our system.

Below is an e-mail that was sent to me from one of our local politicos. It was sent to him from a local conservative politician, who I have had several ("collegial") conversations over other issues in the past.

In a few words what's posted below is an argument designed to get congress, and the American public, to legislate market prices out of the market. The writer is arguing that we need to suspend Mark-to-Market, which is little more than a scam to inflate portfolios and bonuses in the financial sector.

Because of bailout guarantees taken on by the Federal Reserve you and I will eventually pay for inflated portfolios and bonuses (in the form of higher taxes or inflation). Simply put, professional market players are banking on our congressional representatives, and the American public, being too stupid to figure this stuff out. My response to this argument follows. If you can't follow the logic of the argument (you're not alone) just jump to my response, which explains what these people are really trying to do.

Here's the argument as it was sent to me ...

Apparently, public policy hath no fury like a CPA scorned.

In late 2007, the Financial Accounting Standards Board (FASB) imposed mark-to-market accounting on the US financial industry. This required financial firms to value securities at market prices, and then account for any gain or loss as a change in regulatory capital. Within a year, the US was in the middle of the worst pure financial panic in a hundred years. Coincidence? We think not.

On its surface, market-to-market or "fair value" accounting makes some superficial sense. Markets usually provide transparent and verifiable prices, so companies can't just contrive numbers to make their earnings look good.

The problem with mark-to-market (MTM) is that it makes no accommodation for the fact that market prices for securities often deviate - sometimes substantially, but always ultimately temporarily - from the underlying fundamental value of the assets. Since markets are forward looking, MTM forces financial firms to take hits to capital over something that "might" happen in the future, but has not happened yet. It's like forcing homeowners to come up with more capital when a hurricane approaches because their house might be destroyed.

This, in turn, creates a vicious downward cycle as capital constraints hurt banks, undermine the economy and drive prices lower, and then destroy more capital. In 2008, when markets for mortgage-backed securities became extremely illiquid, the financial crisis intensified. This drove away private capital and enticed government to flood the system with liquidity. This government activity helped cause panic and a recession. But all of these government programs were just a way to work around the accounting rules.

As former FDIC chairman William Isaac has repeatedly said, if mark-to-market rules had been in place in the early 1980s, the Latin America debt crisis would have destroyed every money center bank in the US. Thank goodness that did not happen. Instead, the system was given time to heal. That's what should have happened in 2008. Instead, FASB stubbornly stuck to its guns over MTM accounting.

Finally, in mid-March 2009, with stocks at new lows, Congress started to twist arms on the issue. FASB was forced to loosen up its rules and allow cash flow to be used when markets were illiquid. Just this small change did the trick. Banks were finally able to raise new capital, $100 billion or so, and the stock market surged. In fact, things have improved so much that the Federal Reserve and Treasury are finding less and less interest in the programs they designed to "save" the financial system.

But now, like a horror flick monster that just won't stay dead, FASB's accountants are proposing to expand the application of mark-to-market accounting rules across the board, to include all financial assets, including regular loans. The outcome of this debate is extremely important.

MTM accounting, because it ties the balance sheet of an institution to its income statement, and then its capital accounts, creates unnecessary volatility. There is no real market for bank loans and the value of any loan is always in the eye of the beholder. As a result, "who" is doing the beholding determines the viability of an institution and maybe even the health of the economy.

If that power is given to accountants, who have no actual responsibility for running financial institutions, but can be tarred with some of the liability (think Arthur Andersen), the result will be a more tentative banking system that takes less risk. That may sound good these days, but imagine watching a football game played by accountants who stop running because they might get a broken leg when tackled. Fair value accounting needs to be fully suspended - now.

The following is my response to this nonsense. And, yes, it really is nonsense.

... Thanks for sending me this. Let me start with this: Suspending MTM does little more than legislate the market price out of the market. It's a bad idea ...

What I see in the piece you sent me ... is terribly slanted and bereft of any real understanding of how markets are supposed to work. Mark-to-market (MTM) is what helped blow the lid off of the incredibly stupid things that some of the financial institutions were doing. Suspending MTM until "market" prices recover in a heavily bailed out and subsidized economy is a bad idea. That's like asking a bookie to suspend the debts owed until the bettor can find enough money from his rich uncle to cover his old bets, so he can start anew.

Look, good market players know how to (or should know how to) account for "temporary" deviations in prices. The reason the U.S. financial system collapsed was not because MTM exposed temporary deviations. The financial system collapsed because derivative, CDO, and CDS markets had grown so large that they dwarfed the entire value of the stock and housing market. The nonsense had to stop some time. The CDS and CDO market were badly inflated, poorly capitalized (as to their ability to pay out), and dependent on bad debts in the housing markets. These contracts - good and bad - were then bundled together and sold as a "new" investment instrument. We knew this wasn't good stuff 10 years ago (see the intro of chp. 12 in my book) and eventually became exposed because of MTM, which is a good thing.

The piece also makes reference to how the market for mortgage backed securities (MBS) became "illiquid". Look, the MBS market became "illiquid" because the market was inflated and based on faulty-bad assumptions from the beginning (artificially low interest rates, No Doc loans, NINJA loans, poorly vetted CDO-CDS market instruments, etc.). Once market players saw the lid blown off they became spooked. Lending stopped because banks and other investors didn't trust one another, or what they had on the books (which they now want to reinflate). This was compounded by the fact that many of those who were putting money into the market were "bad" debtors that Hyman Minsky would have categorized as Ponzi-scheme investors. As we saw during the market collapse, these CDO-CDS-MBS market players were not hedged, or even good speculators (see p. 207-208 in my book).

Also, I find it interesting that the author would reference former FDIC chairman William Isaac and the Latin American debt crisis (which came to light in 1982). Several U.S. banks had lent Latin America (but in this case especially Mexico) so much money that it exceeded total bank assets. How smart was that? This was not a Latin American debt crisis. It was a Western lending debacle (we could get into the flow of Petrodollars, and corruption levels, but I'll leave that for another day). The system was given "time to heal" during the debt-loan crisis because people needed time to digest the incredible stupidity of lending so much money to corrupt regimes because of false assumptions. Keep in mind that his government-escorted bailout occurred under Ronald Reagan.

The result? "Too big to fail" entered our political and financial language permanently. We saw banks "recover" under a U.S.-escorted recovery program that led to an explosion in the secondary market (for debt securities) that, in many respects, helped create the conditions for the CDO-CDS market we have today.

Finally, I'm not sure what to do with this comment: "... in mid-March 2009, with stocks at new lows, Congress started to twist arms on the issue. FASB was forced to loosen up its rules and allow cash flow to be used when markets were illiquid. Just this small change did the trick. Banks were finally able to raise new capital, $100 billion or so, and the stock market surged." Cause and effect is assumed and, more to the point, aren't substantiated here. Look, more money became available because of political pressure and because the Federal Reserve created so many programs, and encumbered so many financial obligations, that the U.S. taxpayer is now on the hook for anywhere between $7-9 trillion dollars (more if you look at other areas). Freeing up $100 billion is a drop in the bucket when you've got access to trillions that's backed by Fed guarantees.

At the end of the day, suspending MTM is a bailout gimick designed to perpetuate "too big to fail" long into the future. It's a market subsidy that Lenin would have embraced when he introduced NEP. In this case, the American taxpayer ("the peasants") retain commercial autonomy while the "commanding heights" of the economy (war, banking, etc) remain dependent on the state for favorable legislation and "centralized allocations" of resources when necessary (again, see what the Fed has encumbered). And, was the case under Lenin's NEP, while financial institutions are instructed (allowed) to operate commercially, they are not expected to deliver output according to state mandated quotas.

There's more, but the piece you sent me is really little more than a Wall Street apologists attempt to perpetuate what got us into this mess. The increasing use of the state for favorable legislation and to achieve market goals says much about the chasm that exists between the theory and reality of today's free market proponents. These guys are on no firmer intellectual ground than Lenin or Stalin.

There's more to the argument which I didn't address, but I'm sure this is enough for now. My sense is that congress will cave and give the financial institutions what they want. I hope not. Because of the collapsed CDO-CDS markets the costs could potentially reach into the trillions.

And you thought public welfare was expensive before the meltdown.

- Mark