Everybody is happy, things are looking up …

Reading today’s news, one would think that we have just made major progress in reversing the downward spiral of the United States economy.

According to Reuters …

“Wall Street rallies on economy, bank rule”

“Stocks rallied for a third day on Thursday as more data pointed to a stabilizing economy and changes to a bank-accounting rule were seen as shoring up the volatile financial sector in the short term.”

“Another lift to sentiment came as leaders of the G20 announced an additional trillion dollars to support the International Monetary Fund and boost flagging trade.”

Other than a group of self-indulgent and self-serving politicians collectively agreeing to share $1 TRILLION dollars of their taxpayer’s money with the rest of the world, what really happened?

Did housing prices stabilize? NOPE!

Did the trend of massive job loss reverse? NOPE!

Did outsourced manufacturing return to the United States? NOPE!

Was there a new invention that would increase industrial revenues and production? NOPE!

Did we decide to implement the nuclear generation of energy and start on the road to energy independence? NOPE!

So why is Wall Street rejoicing?

Long story made short: the government threatened the accounting industry, through the Financial Accounting Standards Board (FASB), and forced them to modify an existing accounting rule known as FAS 157 or more colloquially “mark-to-market.” Essentially modifying an onerous  rule that was forcing  financial institutions to value all of its assets at their present day value.

Flawed from the beginning …

The fundamental flaw of “mark-to-market” is that it forces financial institutions to price long-term assets, like derivatives which have little or no value when they are issued and steadily grow in worth as they march through time to their maturity date, as short-term investments. While the rule apparently makes sense when dealing with short-term securities and commodities, it makes little sense for long-term investments like 30-year mortgages and derivatives.

There are historical precedents proving that this type of thinking is wrong and extremely detrimental to financial systems. In fact, noted Nobel Prize-winning economist Milton Friedman observed that the “mark to market” rules were one of many proximate causes of the great depression and associated them with the failure of numerous banks. FDR repealed the rule in 1938.

Unfortunately, the rule was re-imposed as a standard in 2007. And, guess what, banks collectively lost billions of dollars of value.

But that does not mitigate the existing problems …

Our existing financial problems are based on: 

one, derivatives and other securities whose intrinsic value depends on the value of the underlying collateral and the ability to pursue legal remedies should the collateral be foreclosed; 

two, leverage whereby one uses borrowed money to purchase derivatives using those derivatives as collateral and repeating the process for each additional purchase until you have an inverted pyramid of debt resting on a narrow point -- with one slight push and the pyamid topples;

three, thinking you can purchase some form of insurance (credit default swaps) from another entity to compensate for any abnormal risk in the base collateral;

four, governmental interference by complacent and corrupt politicians who provided customized legislation for their special interests in exchange for campaign dollars and votes – and an Administration whose regulatory agencies shirked their sworn enforcement duties; and

five, a Federal Reserve which tinkered with interest rates to solve a problem for the benefit of the financial community rather than the citizens of the United States.

Reality bites …

Imagine pooling one thousand mortgages and selling the rights to the cash flow, as homeowners make monthly payments, to the holder of the piece of paper that indicated your ownership of your portion of the pooled assets.

Now divide the mortgages into three groups: risky, not-so-risky and rock-solid. Rip the piece of paper into three parts and sell them to three different investors for different prices based on the level of the risk. It’s ok to tell the investors that the not-so-risky investment is really rock-solid because you purchased an insurance policy from another company and a ratings agency, that you paid for their opinion, agreed with you that, yes, these not-so-risky mortgages were rock-solid mortgages.

Now, being a Wall Street Wizard who wants to further protect against the risk of regional defaults, let’s purchase pieces of paper from lots of mortgage pools and then pool these into a super-pool – with the intention of selling off these newly-created securities as investments.

Consider for a moment, a financial institution who invests 1 million dollars of their core capital in these securities and borrows another 4 million dollars based on the strength of their balance sheet. They buy 5 million dollars worth of these new securities as collateral and then use these securities to purchase 25 million dollars worth of additional securities. AH,  the benefits of leverage.

Unfortunately, some of these institutions purchasing this leveraged paper were insurance companies, mutual funds, retirement funds, union pension funds who all wanted to "amp up" their yields. (And make large performance bonuses.) And the ONLY reason they were legally allowed to buy these toxic products was because the ratings agencies assured them that they were rated triple-A, investment grade securities.

As long as the real estate market is rising and people are able to tap into cheap money to re-finance their loans, everything is rosy, mortgages are being paid, financial institutions are making money. Everybody is happy – but the Wall Street Wizards are ecstatic:  they are making humongous bonuses on buying and selling these securities – regardless of whether or not they are actually worth a plug nickel.

Whoops – here comes a market downturn. Something not even seen on the horizon.

The riskiest mortgages and some of the not-so-risky mortgages start to default because they cannot be re-financed due to a lower property appraisal value. As the number of foreclosed properties in a neighborhood multiply, property values plummet. Still, it’s not so bad until … someone yells FIRE! Panic sets in, further accelerating the slide of property values and the crumbling of derivatives. People are losing their jobs, causing even more defaults. People who couldn't afford a car were allowed to purchase a $300,000 home based on relaxed lending standards -- even being allowed, in some instances, to count welfare assistance as income.

The fallout:  with derivative prices cratering, participants in security pools demand to cash out their investment and simply do not purchase more securities. Since these pools rely on short-term funds to purchase long-term investments, pool operators are forced to sell some of their investments to pay for client redemptions.

The mortgage originator who originated the loan is asked by their warehouse lender to re-purchase loans which have slipped into default because of “early payment default” where the homeowner has paid little or nothing on their mortgage or has fraudulently misrepresented their ability to purchase a home. The originator suddenly sees a demand for millions of dollars and chooses to go bankrupt. And the virus is passed to the warehouse lender who is pressed by their money source – and chooses to go bankrupt. The pool operator who can’t find anyone willing to purchase his paper, crashes the pool and chooses bankruptcy. The leveraged banker who purchased 35 or more times the value of their entire financial institution in securities is technically insolvent, holding securities worth whatever the market is willing to pay for them as distressed goods) and still owning money to those from whom they borrowed.

Recognizing the market is going to hell in a handbasket, to use a colorful phrase, everybody calls upon their insurance companies to cover their loses. Whoops – this wasn’t really insurance; like the kind regulated by the state insurance commission who mandates actuarially-determined loss reserves. This was companies betting the farm that the day of reckoning would never come and they would continue to book fat fees as profits forever.

Even those who tried to foreclose on the collateral found that, much to their surprise, the courts would not accept them as the owners of the property. Why, because all of the mortgages were run through a shredder and the individual strips were sold to investors worldwide. No one apparently could reverse the process and paste the strips together, so as to actually convince a court to foreclose on the property.

Enter mark-to-market: with no buyers and no way to value their derivative securities, the financial institutions are forced to book  ginormous losses that will put them out of business if Uncle Sam doesn’t step in to help.

The credit markets are frozen. Nobody will lend a dime in consumer or commercial loans – or to another bank, because nobody knows what each financial institution is really worth.

First, the Federal Reserve loans the banks billions of dollars using whatever dodgy paper the bank can provide as collateral. (It has to be or have been rated AAA – investment grade by the ratings agencies). And second, Uncle Sam steps in to loan the insurance company(s) billions of dollars to insure that the financial institutions which are in extremis don’t crash and burn.

Surprise – The Federal Reserve Bank’s money did little or nothing to stimulate lending. The money sat in the Fed’s computer as a bank credit. If borrowed money was used for anything, it was used either to purchase other financial institutions (sometimes at the behest of the government) or shore up their own balance sheets. The government’s purchase of toxic securities did little or nothing to help.

Plan “B”

Other than the fact that the Administration is capitalizing on the financial crisis to further their own ideological and social engineering agendas, what the hell can be done except continue to pump more money into the system. Which will not do diddly-squat to improve consumer/taxpayer confidence, raise prices and provide for an explosion of inflation down the line.

So how can we return value to the underlying collateral. Short answer: No f***ing way! So we turn to PFM: Pure F***ing Magic.

1.   We tell the accountants to re-write the mark-to-market rules and let the financial institutions re-value all of their assets.

2.  We let "them" decide what things are really worth -- even though the market may be illiquid, similar securities have sold for fire-sale prices, in many cases they cannot perfect their legal claim to the underlying collateral. And the housing market has not stabilized.

Now, the federal regulators can send in the auditors and be assured that the financial institution is not in dire need of an emergency bailout and takeover.

Did we solve the problem of stabilizing the housing market so that there is real value under those various sliced and diced derivatives? NOPE!

Did we solve the problem of curbing employment so people can continue to pay for their homes – as well as for living expenses? NOPE!

Did we solve the legal quandary of who actually owns a property when the mortgage is sliced and diced? NOPE!

Did we manage to figure out how many trillions of dollars in bogus mortgages there are and which insurance policies (loosely speaking) should be honored? NOPE!

Did we pump sunshine up enough asses to restore some investor confidence and alleviate the anger that is being directed towards complacent and corrupt politicians and financial company executives? NOPE!

Is there an answer?

Yes, but it is not a pretty one.

(1)   We need a regime change. We need to replace all of the sitting politicians that are up for election in 2010 with fiscal conservatives who will repeal the profligate spending of the legislature, repeal most of the existing finance laws and replace it with an anti-fraud framework.

(2)   We need to examine each and every mortgage and each and every so-called insurance contract. Those insurance contracts covering side-bets by people who did not own the security being insured, would be nullified. Those who committed mortgage fraud will be forced to move and the property re-priced for the current market.

(3)   The overleveraged financial institutions will be forced to book their real losses and if they go out of business, so be it.

(4)   Those who received compensation and bonuses based upon toxic products will have those funds sequestered and repatriated to an investment pool on a case-by-case basis or face criminal prosecution in a court of law.

(5)   The Federal Reserve will be nationalized and become part of the Department of Treasury. No more outsourcing the management of the country’s money to bankers who act, first, in their own self-interest.

(6)   Using the Lincoln model, the United States will slowly replace the fractional banking system with a increasing full-equity banking system using non-interest bearing “greenbacks” which would enjoy the same “full faith and credit of the United States” guarantee that Federal Reserve Notes enjoy today.

(7)   The taxpayer would take a one-time hit at the end of the banking conversion program. This is necessary to close out our books.

(8)   Without inordinate interest payments, the national debt would be paid off and deficits eliminated. Balanced budgets, with prudent reserves, would be established.

(9)   But most of all, lawyers would not be allowed to run our government; creating unintelligible gibberish for their personal gain.

(10)  Dishonest politicians would be held to account.

Americans have always improvised, adapted and overcame adversity. There is no earthly reason why we cannot turn around this situation which was primarily created by complacent, corrupt politicians and a Federal Reserve system which was created specifically to eliminate depressions, bank failures and financial calamity.

And while there are numerous other prescriptive remedies, there is but one single problem facing the us: where are we going to find a leader who understands what is going on and can capture the public’s attention to fix our sinking ship of state?

-- steve

Yes, I recognize that there is some simplification in the default process described, but to go further would require a book. If anyone has some better ideas, let me know. I lost a significant part of my retirement fund too! 

Added at 7:50 a.m. 4/3/09:   Proof that I must be on the right track. Here are the words of a politician praising the process. And such a politician he is ... he helped to detrack any regulatory reform at the giants Fannie Mae and Freddie Mac which posed a significant risk to our national economy. He is at the forefront of almost all bad or egregious financial legislation. Ladies and Gentlemen, I give you the words of Barney Frank ...

Frank Statement on FASB Ruling on Mark-to-Market Accounting

Washington, DC – House Financial Services Committee Chairman Barney Frank (D-MA) today issued the following statement on the Financial Accounting Standards Board’s ruling on mark-to-market accounting:

 “I applaud the very important actions taken by FASB today, which has made significant progress toward addressing inaccurate asset valuations in the markets. The FASB believes the rule can be applied more fairly and take into account the currently dysfunctional state of some markets.  The integrity of the standard-setting process is preserved, while avoiding the pro-cyclical effects of improper valuation practices.”

Apparently Frank acknowledges that the asset valuations of the financial institutions were inaccurate and now this adjustment will make their previous POOMA (Pulled out of my ass) guestimates more accurate. Orwell couldn't have said it better: black is white and this measure avoids the pro-cyclical effects of improper valuation practices. Bullshit: it is exactly the pro-cyclical effects that they want to encourage to make the financial institutions appear sounder than they really are -- to encourage investor confidence and investment and to reduce the amount of dwindling TARP funds that are needed for the rescue.

-- steve

Reference Links:

Wall Street rallies on economy, bank rule | Reuters

Barney Frank Statement on "Mark to Market" | House Commitee on Financial Services