ES -- DX/CL -- isee -- cboe put/call -- specialist/public short ratio -- trinq -- trin -- aaii bull ratio -- abx -- cmbx -- cdx -- vxo p&f -- SPX volatility curve -- VIX:VXO skew -- commodity screen -- cot -- conference board

Thursday, March 12, 2009


mark-to-market movement

perhaps progressing from stalemate, rolfe winkler thinks the fix is in.

The Republican Study Committee, a group of conservative GOP lawmakers, believe that instead of pumping billions to bail out banks, lawmakers could save the economy by simply eliminating controversial mark-to-market accounting rules, which require daily revaluing of assets.

... The first step is a hearing Thursday, hosted by House Securities Subcommittee Chairman Paul Kanjorski, D-Penn. Kanjorski argues that the standards have proven “problematic” for banks’ illiquid assets. Officials from the Securities and Exchange Commission, Office of the Comptroller of the Currency and Financial Accounting Standards Board are scheduled to testify. Former FASB chairman William Isaac, a key early opponent of mark-to-market, will testify.

Republican and Democratic House leadership is on board. So’s the Fed Chairman. Everyone knows which way the wind is blowing: in whatever direction is going to protect the banks and their creditors. I understand this has short term benefits for the economy. If banks don’t fail, depositors don’t lose money and the bailout will be less expensive. For a time anyway.

i began to think when isaac started showing up in the journal, on bloomberg and other financial- and mass-market media venues that some groundwork was being laid.

i myself have a migrating and soft opinion on changing the accounting. foremost is the issue of whether it will really help -- even before the issue that the market may well be correct in its evaluation of the future cash flows these securities will generate, the shift from mark-to-market to some form of cost-basis accounting would normally require banks to set aside reserves for loan losses against these securities as they now do for the vast majority of their assets which are not marked daily. would that further damage the banks? one has to wonder when jamie dimon claims to favor mark-to-market. in any eventual liquidation, they would certainly be even more insolvent. i suppose it amounts to lowering the minimum capital rules for the banks involved.

the financial times further notes that, to return to the point, the market may be marking asset-backed securities generously. citing bloomberg's david reilly:

… Of the $8.46 trillion in assets held by the 12 largest banks in the KBW Bank Index, only 29 percent is marked to market prices, according to my analysis of company data. General Electric Co., meanwhile, said last week that just 2 percent of assets were marked to market at its General Electric Capital Corp. subsidiary, which is similar in size to the sixth-biggest U.S. bank.

What are all those other assets that aren’t marked to market prices? Mostly loans — to homeowners, businesses and consumers.

Loans are held at their original cost, minus a reserve that banks create for potential future losses. Their value doesn’t fall in lockstep with drops in market prices.

Yet these loans still produce losses, thanks to the housing meltdown and recession. In fact, bank losses on unmarked loans are typically bigger than mark-to-market losses on securities like bonds backed by mortgages. …

anyway -- for the sake of argument, let's imagine it can be done and that recharacterizing derivative securities held on bank balance sheets requires minimal capital reserving and improves the capital accounting of the banks. in the short run, the need of debt-to-equity swaps -- fears of which are rippling through credit markets now -- to recapitalize banks without government capital injections would be minimized. fears might be allayed, and banks perhaps even find themselves able to raise capital.

let's further assume for argument that at least some of this upward revision is justified by the net present value of future cash flows which over time come into the banks from the underlying mortgages. these will surely be impaired to some degree, but (contra reilly's implication) let's assume not to the extent markets now price.

even on these charitable assumptions, there will still be a problem shortly down the line -- loan demand.

the presumption underlying the revision of the rules is the same as had underlain virtually every government effort to date to resolve the crisis -- that credit markets simply need a kickstart to overcome fears and return to operating more or less as they did in recent years.

i would posit that this is not going to happen. asset prices are not distorted now so much as they were distorted by the massive credit mania that peaked in 2005 and 2006. prices of contingent assets like houses are, with that boom having gone bust, now normalizing and returning to longstanding relationships to incomes -- they can not return to anything like mania levels without the return of mania financing, including sophomoric underwriting standards, wild-eyed securitization and the return of the entire shadow banking system, the massive current account deficits of the heyday of vendor finance. this catagorically will not happen, and so asset prices will fall at least to sustainable levels substantiated by income and free cash flow.

the fall in asset prices has, in combination with outsized debts accumulated in the boom, put borrowers -- importantly household, but also in many cases financial and corporate -- in a dangerously overleveraged position as balance sheet equity has collapsed. this is a powerful impulse to repair damaged balance sheets by eliminating debt, be it through default, reduction through asset sales or paying out of income. as debt is repaid throughout the system, credit supply and the money multiplier are contracting, much to the consternation and confusion of ben bernanke and the federal reserve bank's every monetary prescription. this is slowing economic activity, reducing cash flows. this is a further impediment to debt reduction, pushing more debt reduction through the alternative channels of default and applied asset sales.

the great fear at this point is that asset sales engage in a debt-deflation cycle of the kind outlined by irving fisher -- which effectively inverts the effectiveness of asset sales in repairing systemic balance sheets by driving down asset prices through illiquidity so deeply that asset writeoffs outpace cash raised and debt paid down.

this is the sort of thing that is hoped to be avoided by changing the solvency rules for the banks. and perhaps it will help.

but the eventuality will be that banks, on receiving whatever cash flows they will from their loans and securities, will be faced with trying to lend that money back out. these securities are not 30-year bonds -- most substantially retire in a few years' time, so this will be a problem almost immediately. beyond the slice of society that just won't borrow for anything and never did, there is simply little to no chance of sufficient demand for new loans from high-quality borrowers; even lower-quality borrowers will be focused on defaulting.

richard koo is not alone in saying so, but i'll call it his insight onto our conundrum -- the banks must instead lend to a spendthrift government to maintain demand while the private sector deleverages. this at least would keep money in circulation and prevent the debilitating spiral of contracting monetary aggregates, providing a low-or-no-growth economic environment on the back of government leveraging.

because this will contract the fat spreads rightly highlighted by john hempton and others, as the differential from low cost of funds to minimal yields on government bonds will be much lower than that to corporate or consumer loans -- and because losses on existing assets will not stop as the consumer deleverages -- repeated capital injections into the banks are likely to be needed, along with incredible forbearance on the part of regulators and counterparties (who would likely need to be motivated by explicit government backstops).

should these things be done, and provided that leveraging the government does not provoke a dollar crisis, a japanesque resolution to the crisis involving several years of balance sheet repair is possible.

but therein are the remaining dark questions. koo notes that the need of government fiscal deficits should match the increased domestic savings placed into the banking system as it acts to break the paradox of thrift -- this is also his grounds for not fearing interest rate or currency problems. but we have seen the IMF conclude that even a remarkable boost in the domestic savings rate to 8% of GDP will fund about $830bn of government borrowing over the next two years. current projections of government deficits range around $4tn for that period. what of that massive gap? some of it will be filled by the current account deficit, but this looks to fall as global trade slows. what of the large remainder?

i again worry that it is likely to be either monetized by the fed or vomited out of the capital markets. with the end of heavyweight vendor finance, uncle sam may not be able to run such large deficits as they became accustomed to in recent years without real domestic consequences.

UPDATE: moreover it should be said that not everyone thinks it is a good idea for the united states to attempt to fill the entire slowdown in demand. michael pettis:

The whole debate over trade is going to be framed within US and European discussions about fiscal stimuli since it is not at all clear that Chinese policymakers are contributing much more than some fairly smug, and perhaps hypocritical, statements about how everyone must embrace free trade. But the US and European discussions don’t seem particularly positive right now. According to today’s Financial Times:

Disagreements between the European Union and the US over how to combat the global recession widened on Tuesday as EU governments made clear they had little appetite for piling up more debt to fight the collapse in output and jobs. Finance ministers from the 27-nation bloc insisted in Brussels that it was doing enough to support world demand and did not need at present to adopt another fiscal stimulus plan, as Washington is urging.

I hesitate to enter these very deep waters, but I think the Europeans, at least as described in this article, might be right. There is a real need for an adjustment in consumption in the US, and I don’t think it makes sense for the US to attempt to replace excess household consumption with excess government consumption. One way or the other the US, along with China and most other countries that have contributed to one side or the other of the global imbalances, is going to have to accept a demand contraction.

Labels: ,

This page is powered by Blogger. Isn't yours?