A Guide to Hiding Toxic Assets

Tomorrow marks an important economic decision regarding FAS 157 and mark-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 mark-to-market accounting has affected the banks, and what the real intentions behind banning FAS 157 really are.

As it 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, then 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.

Mark-to-market Margin Call

As with the futures trader, the banks are dealing with massive margin calls. Gold, like a CDS, is mark-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 mark-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 mark-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 sheer quantity in loans required to support the massive derivative 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 on. 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. Mark-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 mark-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

Mark-to-market accounting allows us some transparency. Removing FAS 157 is absurd and criminal. The whole argument behind removing mark-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 mark-to-market accounting. By removing mark-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 mark-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.

Comments

[Hari Swamin...:]

OK, the point is accepted. But why would this create an opportunity for profit ? What would make this shoe drop again unless M-to-M is brought back ? And why would they be brought back especially if "they" know this will create havoc in the market ?

My question is - is there another way by which these assets will be exposed thereby creating the shorting opportunity ?
Hari

Apr 02 05:52 AM

[henarl:]

Your points are well taken altho in your example 100 x 900 = 90,000 - not 900,000.

Apr 02 11:18 AM

[kdo:]

Hate to point out to you that every bank is in essence net long CDS.

Apr 02 01:16 PM

[User 382982:]

In reference to Hari's question - I think that what the author is arguing is that eventually, the underlying cash flows of these "toxic" assets will fall to the levels at which they are currently marked to today. Said otherwise, if you "mark to model" today at 60 cents on the dollar, what you are stating is that the expected cash flow backing your asset has fallen so that the present value of your asset is down 40%. If the market is valuing this asset at 20 cents today, that means the market is pricing in cash flows that equate to an 80% in NPV loss.

My issue with the author's argument is that marking to model does not mean banks are just delaying the "inevitable," and that these assets will eventually be worth what they are marked to today. Marks may very well be pricing too much economic distress, and If banks mark to model correctly (i.e. they are realistic about expected cash flows and loss reserves), assets should reflect the what kind of economic state we're in (a severe Recession but not a Depression).

Apr 02 01:57 PM

[notsosmart:]

why is only made-off in jail? its all ponzi & many should be jailed.he is a piker compared to the wall st bankers.new motto on our monopoly money"too big to fail,too many to jail".make sure to learn your kids chinese.

Apr 02 04:07 PM

[AndrewBaker:]

Great article. Take the leveraged long side now, as everyone is doing, and closely watch the upside, taking profit whenever it loses momentum. At the same time, be prepared to go leveraged short when the big drop comes, which will happen when the wool over a lot of people's eyes falls away.

A week or so back, a bear comment got rave reviews. Now it gets slated. Sheep and bulls at this time have a lot in common.

Apr 02 04:22 PM

[ThaddeusN:]

Ignoring the current situation for a moment, I believe that mark-to-market accounting creates more problems than it solves for the banks. It creates pro-cyclical balance-sheets and degrades the value of prices in signaling the true value of assets. I would recommend the paper by Plantin, Sapra, and Shin the J. of Accounting Research.

Apr 02 04:46 PM