Let’s Play Pretend!

When elementary school kids want to escape the confines of their circumstances they pretend to be pirates, princesses, and Jedi knights. Now, with the relaxation of “mark to market” valuation rules announced yesterday by the accounting trade’s self-regulatory body, our bankrupt financial institutions can escape their own reality by pretending to be solvent. The unraveling of our fairytale economy over the last few months has not yet convinced us that the time has come to put away childish things. The applause that greeted the news yesterday on Wall Street is a clear sign that we still have some growing up to do.

The imaginative conceit that lies behind the accounting change is that the toxic assets polluting bank balance sheets are not really toxic at all. They are in fact highly valuable assets that for some irrational reason no one wants to buy.

Using the “mark to market” accounting method, mortgage-backed securities were valued relative to the latest prices fetched by the sale of similar assets on the open market. Currently, those bonds are being sold at deep discounts to their original value. By “marking” their unsold bonds down to those prices, the insolvency of our financial institutions had been laid bare. The new accounting changes will allow the nervous owners to assign more “appropriate” (i.e. higher) values. Problem solved.

It is important to note that the Financial Accounting Standards Board made their rule modifications only after intense pressure had been applied by Washington and Wall Street. In their heart of hearts, I can’t imagine that there are too many bean counters happy with the outcome.

The banks and the government have argued that the assets should be valued based solely on current cash flow. Most mortgages, after all, are not delinquent. Therefore, a few bad apples should not spoil the whole cart, and those that are not yet delinquent should be valued at par. This method assumes we have no ability to look into the future and make assumptions about what is likely to happen, which is presumably what the market is already doing by valuing the assets lower than the banks wish.

All kinds of bonds (corporate, government and municipal, etc.) that are not in default frequently trade at discounts. In fact, the reason that agencies such as Moody’s and Standard and Poor’s rate bonds is to assess the probability of default. The higher that probability, the lower the value placed on the bonds, regardless of their current cash flow.

For example, GM bonds that mature 10 years from now currently trade for only 8 to 10 cents on the dollar, despite the fact that GM is current on all interest payments. The 90% discount reflects investor awareness that GM will likely default long before the bonds mature. By the new logic, financial institutions with GM bonds on their balance sheets should be able to ignore the market and value these bonds at par.

Some argue that the comparison is invalid because GM’s bonds are liquid while mortgage-backed securities are not. However, if sellers of GM bonds were holding out for 70 or 80 cents on the dollar, those bonds would be illiquid too. The reason GM bonds are trading is that sellers are realistic.

The same should apply to bonds backed by mortgages. To assume that a 30-year, $500,000 mortgage on a house that has declined in value to $300,000 has a high probability of remaining current to maturity is ridiculous. The borrower could lose his job, his ARM might reset higher, or he may simply tire of paying an expensive mortgage for a house that is unlikely to be sold at a profit. Any bond investor with half a brain will factor in these probabilities and look for deep discounts. The only way to accurately assess a real present value is to let the market discover the price.

Despite the pleas from bankers and politicians, mortgages are not plagued by a lack of liquidity but a lack of value. If sellers would be more negotiable, there would be plenty of liquidity. Who knows, at the right price I might even buy a few. The problem is that putting a market price on these assets would render most financial institutions insolvent, which is precisely why they do not want to let that happen.

Simply pretending that all these mortgages will be repaid does not solve the underlying problems. It may keep some banks alive longer, but when they ultimately do fail, the losses will be that much greater. In the meantime, solvent institutions are deprived of capital as more funds are funneled into insolvent “too big to fail” institutions – hiding their toxic assets behind rosy assumptions and phony marks.

Going from the sublime to the completely ridiculous, in a speech at the just-concluded G20 summit in London, President Obama urged Americans not to let their fears crimp their spending. It would be unwise, he argued, for Americans to let the fear of job loss, lack of savings, unpaid bills, credit card debt or student loans deter them from making major purchases. According to the president, “we must spend now as an investment for the future.” So in this land of imagination (where subprime mortgages are valued at par), instead of saving for the future, we must spend for the future.

I guess Ben Franklin had it wrong too – apparently a penny spent is a penny earned.

For a more in depth analysis of our financial problems and the inherent dangers they pose for the U.S. economy and U.S. dollar, read my newest book “The Little Book of Bull Moves in Bear Markets.” Click here to order your copy now.

For a look back at how I predicted our current problems read my 2007 bestseller “Crash Proof: How to Profit from the Coming Economic Collapse.” Click here to order a copy today.

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3 Responses to "Let’s Play Pretend!"

  1. ex oz lender   April 3, 2009 at 6:09 pm

    Good article.When I play one on one sport with my 8 yo son, he inevitably changes the rules whilst the game is in progress to his advantage, not mine. When I first read in August 2008 that someone proposed changes to mark to market rules, I couldn’t help think of that analagy.But I still don’t get this (quite large) stock rally. Were stocks that cheap /under fair value ?

  2. George Harter   April 4, 2009 at 12:31 am

    For ex oz lender, no they weren’t of course. This dead cat is being moved by people in desperation. A year ago, the financial press was bathed in stories such as “BUY NOW! We are already moving up from the bottom!!!!! REAL ESTATE-OVERSOLD! BUY NOW! DON’T MISS OUT CHOICE PROPERTIES ARE MOVING FAST!!That was in Q2/Q3 2008. These people can not digest all the rough news. A line I am stealing, “They are the type of people who were rearranging the deck furniture while the Titanic sank!”George HarterBaghdadontheHudson, USA

  3. Wilson Siu   April 4, 2009 at 5:11 am

    Dear Peter,I follow your comments weekly and sometimes daily. I was reading an analysis by Mark Thoma in regards of deflation.In his paper, it has pointed out and explained clearly that deflation is a likely scenario;however, he did not include variables such as the level of US$ versus gold.If the US is an island economy where it has thr manufacturing base to produce all its own good, then whatever the level of gold is, in a typical recession/depression, price level will go down due to higher unemployment rate leading to lower wages, thus lower cost of production.However, as you have pointed out in numerous occasion, the US does not have the manufacturing base it once had, and have been exporting inflation to the world for the past 20 years. Thus when the trend reverses, it will be importing back inflation due to the US$ declining of value relative to gold.Which force do you think is greater? The domestic deflationary forces such as the unemployment rate leading to lower wages or the inflation that is shall inport due to US$ declining relative to gold. Well of course the argument must be based on a certain price level of gold. But for argument’s sake, lets say if gold price is US$1500.However, this leads to another problem. Gold went up from US$200 in 2002 to US$900 in 2009, yet during the period the US did not have inflationary pressure due to the dollar losing value relative to gold. That is because Asian exporters, regardless of the gold price, sold goods to the US receiving the US$ that they see and still(for the time being) see as US$ being as good as “gold”. Thus did not increase their export price at all despite the US$ has lost 75% value during the time period 2002-2009.So the ultimate question is, it requires people’s perspective of the US$ to be not as good as gold, until exporters will add a price premium to the products that they sell to the US. So what needs to happen for that to happen.How do you expect it to play out? Thanks!