Wednesday, April 8, 2009

Mark to Magic Model Fantasy Market

The Sovereign Society Offshore A-Letter
Tuesday, April 7, 2009 - Vol. 11, No. 87

The Magic Behind “Mark-to-Market”
And Why the FASB has Changed Nothing

Dear A-Letter Reader,

This from the New York Post;

“One Wall Street trader told The Post that what’s been most puzzling about the purchases is how aggressive both banks have been in their buying, sometimes paying higher prices than competing bidders are willing to pay.

Recently, securities rated AAA have changed hands for roughly 30 cents on the dollar, and most of the buyers have been hedge funds acting opportunistically on a bet that prices will rise over time. However, sources said Citi and BofA have trumped those bids.”

Doesn’t make any sense at all…does it? Why would the same banks that’ve needed hundreds of billions in federal bailout money – primarily because their balance sheets are overloaded with questionable assets – be out there trumping bids for the same toxic assets?

It simply doesn’t add up.

Unless – that is – you understand the magic of Mark-to -Market accounting…and what was really going on here…

Enron and the Magic of Mark-to-Market Accounting

Whenever a story starts with Enron…well, you can generally guess where it’s headed from there.

Jeff Skilling, former CEO of Enron, demanded that the firm be allowed to use Mark-to-Market accounting rules as a precondition for coming on board. Enron’s accounting firm approved, and they got to work with it straight away.

Mark-to-Market is a pretty simple concept to grasp. It’s the practice of marking all assets of a similar class to whatever price similar assets are fetching in the market today. So, for example, let’s say that cows have been trading for about US$10 each in today’s market. I have five cows on my farm…therefore the “mark-to-market” value of my cow portfolio is US$50…or my total number of cows multiplied by the market price.

Like others, this method is often prone to fraud. After all, anyone with access to the marketplace has the ability to manipulate market price – by deliberately overpaying or underpaying – giving them the ability to manipulate their own portfolio values. Let me explain…

The market price for cows is still US$10, so at the moment my “marked-to-market” cow portfolio is still worth fifty bucks. Let’s say that I sell a cow for that market value – US$10. Then, I dig down into my pocket for seven dollars. I take the combined US$17 to market and buy a cow. Sure, they might think I’m a lunatic for vastly overpaying, but let’s look at what just happened to my marked-to-market cow portfolio…

I’ve still got five cows in total. But, since I paid US$17 for that last cow, the mark-to-market value of each cow is now US$17. My marked-to-market cow portfolio is now worth US$85…that’s US$35 more than before, and it only cost me US$7. Who’s the lunatic now?

Enron used a network of shell companies and duty-built legal structures to make this happen. They might sell a handful of Nigerian barges to one of their legal structures, only to buy them back a month or two later. This helped Enron set a higher market price and manipulate their books. When you look at it like that…fraud is actually quite easy.

So…You’re Saying that Enron and U.S. Banks Used the Same
Kind of Accounting Rules?

That’s exactly what I’m saying.

Granted, Enron was a little more blatant and a little easier to catch, but it’s the same principle. As you can see in the quote above from the Post, both Citi and BofA traders are dumbfounded by some of the bids they’re being ordered to enter at these auctions.

And today – in the example of U.S. banks – it’s just as easy to understand. Let’s say I own Citigroup. For the sake of simplicity, let’s say I’ve got twenty units of housing securities marked at ten billion dollars apiece. No one wants to buy them – since they’re obviously garbage – so the market’s thin and I know that I’ll be facing a major writedownwrite-down if I just stand idly by. Let’s say I’m sure that I’ll have to write each unit down by at least a billion dollars – to nine billion a piece.

So instead of being honest and taking one on the chin, I send my traders out into the market. I order them to bid the price up to ten billion a piece, when I know that the securities are only worth nine billion. So I’m throwing away a billion dollars. But with the magic of mark-to-market, I’m throwing away a billion dollars so that I can save twenty billion (by not having to mark down my remaining housing securities), which is a no-brainer.

The Truth Behind Wall Street’s Cry for Help:

Meanwhile, banks are actually insistent on suspending mark-to-market accounting rules.

Why would they give up on such a great racket?

Because – as their story goes – they believe that the market value of their debt securities doesn’t reflect their true value. The super banks believe that the market’s too pessimistic…after all, these securities are cash-flowing now (meaning that they’re paying according to plan without an abnormal rate of default) so there’s a good chance they’re worth far more than what the market says, right?

Now it all comes together – the banks’ story continues – the marketplace is so pessimistic…and so many of our assets are marked-to-market…that we’re actually perfectly healthy! It’s just these troublesome write-downs due to the accounting rules that are killing us…or so they say.

You want the truth? Can you handle the truth? Here goes;

As the article from the Post indicates, the banks have no scruples about manipulating mark-to-market. Perhaps they’re upset about how much it’s costing them at this point – to keep the prices inflated at unrealistic levels – but that cost would be the only downside for them here.

After all, of America’s twelve largest banks, less than a third of their assets are marked- to- market. And the rest of their loans – called “unmarked” – are held near their original cost. These unmarked loans are contributing the lion’s share of the losses at this point.

What’s more, according to Chris Mayo’s recent report, the assets in question have only so far been marked down to approximately 98 cents on the dollar. A 2% haircut…barely a trim. If America’s banks are shaking in their boots over a 2% discount, then I can’t help being pessimistic about their prospects for survival in the coming years.

In reality, the shift away from mark-to-market accounting changed nothing. It’s not a miracle cure that’s going to free the “victimized” banks from vicious write-downs. It will only help them obscure the truth for a few more moments as they’re eventually forced to claw for more bailout money and fight back the cry for nationalization.

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