The Accounting Crisis: Mark to market and the Destruction of the U.S. Banking System

Did you ever see the Stephen King movie The Happening, where people throughout New York City are committing suicide in mass? You see people literally turning on themselves to end their own lives as a result of some strange spore released into the air by plants protecting their existence. Well, if you think about it this is analogous to the current destruction underway in the financial system of the United States. Banks literally are turning the knife on themselves by sheepish lending practice while the accounting rule of mark to market is silently spreading to induce the massive death and destruction.

Mark to market is a rule whereby publicly traded companies must "mark," or declare, the value of their assets to what it would be worth if it was to be sold at that very moment. This rule, while widely used in valuing liquid assets such as securities was applied to nonliquid assets, such as real estate, after the Enron scandal. The general hypothesis towards applying the rule to nonliquid and liquid assets alike is to prevent companies from misleading investors by valuing its held assets at higher price than their "real" value.

The problem in the banking world is that banks are regulated stringently by the Federal Government and must maintain a certain ratio of assets to loans to be considered legally solvent. The result is that when a bank must mark its assets down according to the accounting rule, it is legally required to cover that write-down by adding another asset, usually cash, or decrease the number of loans it has outstanding. Since their is no practical way to call loans, banks must raise additional cash when the marketability of their assets fall regardless of whether those assets are performing perfectly.

Approximately 2.5-6% of home mortgages are in foreclosure. A staggering number, but not insurmountable. Now add that under 50% of Americans have a mortgage on their home. What do you come up with? Yes, you're right! The banking crisis has less to do with the foreclosures and more to do with arbitrary accounting rules. As infuriating as the truth is, the mark-to market accounting rule is forcing banks to value the homes that they hold mortgages on down to the values being received in foreclosure sales representing somewhere between 1.25%-3% of total homes!  Even if one intends to pay every last payment of one's mortgage with the paycheck from one's stable Federal government job, and that mortgage payment is less than 25% of one's take home pay, the bank has to value that home as if foreclosing on it today.  

The mark to market rule literally created the same bubble it is bursting.  When the market was trending to the moon in 2002-2005, banks were allowed to mark the assets up to the market price.  This increased the assets on their balance sheets and created more room for lending, thus pushing prices higher as more credit was made available.  This sinful consequence flew in the face of sound accounting where gains on illiquid assets are not to be realized until sold.  Subsequently, as prices began to fall, banks "marked" their assets lower limiting their ability to lend, which limited credit and prices fell further.  Once prices fell further, the banks had curtail lending more and guess what?-Prices fell further.  The sad reality is that the houses being sold determining this market value were not sold by choice, but rather as a result of foreclosure and therefore no true market existed.  Further, with buyers unable to access credit because of banks having to hoard cash to make up for falling values on assets (95-97% of which were performing) fewer transactions occurred to stabilize prices.

Here is the rub, foreclosures had very little to do with the financial crisis, accounting and fear were the culprits, and I can prove it.  If Bank A foreclosed on house 1 previously valued at $250,000, Bank A would not have to mark that asset down so long as they issued a new loan to the next Buyer at $250,000.  Even if the next buyer couldn't afford the house and would subsequently go bad on the loan in one year, the asset value by rule would be $250,000.  As a result, it was lenders unwillingness to lend that literally caused their inability to lend.

Clearly I understand that the moral hazard associated with the securitization of mortgages, relaxed standards by Freddie and Fannie and outright fraud caused much of the bubble of the housing market,  but the illogical extension of marking illiquid assets to the market amplified the problem from a rising market to a bubble and then from  a declining market to a catastrophe. 

 A great example of how the market rule amplifies itself occurred when Wamu was deemed insolvent by the FDIC and Chase Financial was given Federal assistance to take over the massive mortgage lender.  In taking over Wamu, Chase marked all of the acquired mortgages down to what Chase and regulators deemed a palatable level.  Regardless of whether or not the mortgages were performing, Chase marked them down as if they were to be sold that very day according to the accounting rule.  Almost immediately following this transaction Wachovia was on the brink of insolvency as a result of how Chase had discounted the assets.  All the experts agreed that there was no market for new homes and that the most difficult issue facing Wall St. and banks was how to put a value on them.  Wachovia was profitable.  Their loans were performing. Mark to market killed Wachovia because of how Chase valued the assets of Wamu in the forced sale.

Solution:  An illiquid asset is worth whatever it is originated at and at its sale, disposition, trade or disposal a gain or loss is to be recorded.  No matter what the system for valuing assets it will never be perfect, but surely it can be without unintended exaggeration.  After all accounting is supposed to illustrate reality, not create it. 

The Float: What does it truly mean to be a service based economy

Often times folks speak about the United States being a service based economy as a matter of fact and a simple meaningless truism.  While it is a fact that the United States is currently a service based economy, it certainly shouldn't be stated as an acceptable matter of fact.  This is not something to glaze over.  It is an unacceptable reality of decades of laziness that has lead our country to essentially zero growth since the early nineties.   

That's right zero growth.  Look at the value of any meaningful item (and by meaningful I mean substantial durables or assets).  Cars, homes, land and commercial real estate has made no meaningful appreciation.  No three percent per annum, in fact, the value of these are completely flat with the exception of a mountainous spike caused by monetary policy.  Believe it or not, after all the fury, we have made no progress.  How could this be?  Shouldn't our holdings at least have kept pace with the monstrous inflation we experienced up until 2007?

The answer is yes it should have, but no it didn't.  What the media, the government and economists don't want to tell you is that the "global economy" has stagnated our country.  The promise that every generation shall be better than the last is in jeopardy because policy makers don't understand that while globalization is wonderful for corporate profits in the short run, it devastates that same economy in the near term and eventually cripples a nation.  In the short run, exporting jobs to another country causes a company's cost of labor to decrease and even after the paying of shipping costs creates a larger margin for that company.  Those profits are usually invested by the company in new product or corporate investment vehicles that generate more profit for shareholders.  Certainly a desirable result.

Sometimes, a company will even pass along a share of the savings from the labor to the consumer, although this rarely happens as prices generally never fall regardless of where a product is produced.  A funny side note is that many Americans believe corporations pass on the savings from producing items out of the United States despite CPI figures clearly stating cost savings do not result in price reductions.  That said, greater profits derived from cheap outside labor does create greater profits that lead to higher stock prices, shareholder dividends, and greater CEO compensation.  Certainly a logical result.

The problem is that the behavior is short sighted.  It is the equivalent of killing a sheep for its wool.  Over time, the benefit of the exportation of labor gets piled into very few players in the economy.  The failure of a significant portion of the population to purchase anything due to nonavailability of substantive work leads to steep and severe recessions.  To remedy the recessions the government creates lax monetary policy to subsidize the inability of its citizens to function in the market as consumers.  This creates a vast number of service sector jobs centered around finance, sales, distribution, and logistics.  

Now the big problem comes.  The money from the lax standards purchases all it can and because the population does not create, build, develop or manufacture anything there are no jobs of substance that can continue to function.  The country stops buying at the current levels and the ripple effect literally shatters the economy shattering price levels back to pre-lax monetary policy levels.  Its all float, and that's what no one understands.

If all we do is sell to each other without any substantive jobs, there is no true production in our economy.  We cannot fall back on making diapers, toothpaste, clothing or pens.  If we were building these items, then those jobs would carry the service industry jobs through downturns and lead to the general increase in standard of living of all members of the country.  As population grows, those substantive jobs would grow in numbers and they would not be lost simply because the economy slows.  These jobs might slow, but not vanish.

The float is how Americans currently make a living.  They don't even truly sell anything.  Here it is in a nutshell: Joe American grabs his catalogue of foreign manufactured widgets and agrees tp sell them to Sam American for $10 a piece.  Once the order is placed Joe puts his order in and purchases those widgets for $5 a piece.   Joe isn't selling anything, just pushing through a meaningless profit margin.  Worse yet, as more players enter Joe's business his profits erode.  Since Joe has no power to innovate he will simply have to cut back on his standard of living to continue in his business- thus reducing the standard of living of everyone else that Joe interacts with.

 

Now, Joe paid for those widgets on  a line of credit from Clueless Bank of USA.  That's the float. Joe American and Clueless Bank of USA are on the seas of uncertainty.  Contract or not, if Sam American cannot pay because of a failure in his service based business, mostly because the "Joes" of society aren't buying from Sam because they have reduced spending due to the increased competition now in the "pushing profits" business, Joe is stuck paying interest.  If he cannot pay the principal or resell the widget Joe will default on the loan.  Clueless Bank of USA takes the loss which affects its ability to lend, creating a scenario which multiplies and duplicates itself by the cessation of credit lines to people similar to Joe American.

If everyone has jobs like Joe  American the economy is literally a string of dominoes with the tipping of the first domino leading to all of them falling in line.  This situation cannot sustain itself.  Can everyone see what is missing?  The creation of a good.  That's right a substantive business that literally performs a real function.  Turning plastic into containers or textiles into clothing.  These jobs are a necessity.  Someone must build the widget and when credit is extended to a company that builds widgets, at very least that bank has the widgets, machinery, real estate and assets necessary to build those widgets as collateral.  Further, that bank has the security of knowing that widgets must be made,  and if the business it loans to fails, someone must come and take their place to satisfy the citizens need for widgets.  This places a stability under the value for the companies assets.  Moreover, the workers at the widget factory create stability in the market for consumer goods and services as they are still working due to the demand for widgets.

In the case of the servicer, he has no purpose.  Anyone can sell the widgets.  Further, there is no meaningful collateral for the widgets especially because the bank's basis of $5 per unit is not the true cost, it is the true cost plus foreigner's profit plus shipping.  The bank is buried going into the transaction.  Moreover, we have no steady worker to buffer the loss of consumption during slowdowns in the economy.

From Rome to Great Britain, no great empire has sustained itself once it has engaged in free and directionless trade with foreign countries.  While it is true that trade empowers both parties with greater production and utility than could have been achieved without trade, economists never distinguish how that benefit breaks down between the parties.  In the case of super power and non industrialized country, the benefits are skewed dramatically in favor of the non industrialized country.  In the long run, the small gains of the industrialized country are significantly smaller than the gains of simply producing the goods unilaterally.  History has taught us this lesson with every great empire losing its stature subsequent to succumbing to mercantalists tendencies to trade away its production capacity.  

Trading allows the weaker country to gain relative strength against the stronger country.  Eventually that strength grows to bargaining power which leads to greater wealth.  Wealth leads to ambitions, and in time the smaller country shall be formidable companion with its own voice and identity.  Should that identity differ from the once greater trading partner the once strong empire shall find it has created a security; as well as, financial threat to itself.  If it continues the weaker party shall gain, not only identity but the will to oppose the stronger.

Like my good friend always said when we played bones, "Not all money is good money."  

What is wrong with our economy?

As the 2009 year begins, this site shall provide timely guidance on how to make the economy of the United States viable and eventually vibrant in the long run. Today it is important for a short discussion on the proper diagnosis of what is wrong with our economy so that the proper cure can be developed.

The problem is very simply, deflation. While this word conjures terrible imagery and tends to carry a bundle of consequences that create fear and panic, one should not fear this diagnosis as it is accurate and can be remedied. Law makers, analysts and business leaders will never admit when an economy encounters deflation because it signals the complete failure of a market or economy. Deflation renders the actual market incapable of righting itself through mechanisms such as supply and demand, and necessitates intervention, whether by government, nature or large private players to reset the devastation.

For those not familiar with deflation I shall provide an example. This morning on the AOL homepage an article was titled "Don't buy a Camera Yet." The article went on to state that consumers should put off purchasing cameras, televisions, computers and other large electronic items as prices are sure to fall further. This behavior, while prudent perhaps, is deflationary as it incites hoarding by the population. It sends the message to hold your money as it shall be able to buy you more goods for the same amount later. Once the citizens decide that the "holding cost" of money is less than the fall in the costs of goods and services the death spiral begins. People stop spending and prices go lower. The problem is simply that as the price falls, people still don't buy so the price falls further.

This translates into an economic level where price falls and quantity falls as well. There is no supply and demand correction because price and quantity are no longer inversely related. In other words, price falls and the market does not react. Once the price falls below the cost to produce an item the seller no longer has an incentive to produce that good or service and the company shuts down leaving the market short of that good or service. At this point, the money hoarded by the citizens cannot buy that good as it is no longer produced. Deflation incentivize us as market participants to do nothing and produce nothing so as to prevent losing money.

Another great example of the deflationary environment we currently are experiencing is watching citizens fill their gas tanks half way, because they know they can fill the other half for less later in the week. This behavior, while prudent, shall lead to gas stations to slow or cease ordering gasoline to avoid taking losses. Sellers of gasoline can buy their inventory for less the very next day, and are punished for holding inventory. This leaves the citizen with shortages or without the product altogether at any price as the incentive is to not produce for the seller.

While terrifying, there are fixes. Generally speaking one can see that an economy must place a firm bottom under prices so that sellers can feel confident in producing a good or service. From that point a controlled increase in that price is necessary for a market to function on its own, inflation. Once citizens understand that an item shall not be reduced further in price, and rather, that same item will cost them more money in the future, they will begin to purchase. This translates into a conscious decision by the citizen to use an amount of their money while it still is able to purchase the good or service as it will take a greater amount of money to purchase the same amount in the future. The price increases allow the seller to make a profit and the seller is able to spend in return on innovation, labor and capacity thus creating greater production.

How does a market get fixed? Two ways. The first is that people magically gain confidence and start spending, which generally substantiates prices and creates price appreciation. This whimsical solution is very inexpensive, but not reliable as there is no guarantee it will occur before the entire production of a market is destroyed. Perhaps if the media created a positive environment people would psychologically react and mirror that environment. Studies have proven that people tend to act out the prognosis and tone of the "general consensus" of a population. As the media is the artery that provides the population with its "general consensus," whether agreeable to us or not, its message under this solution is key to the confidence of citizens. In fact, in our current situation it is amazing to note that the substantial fear amongst the population at large is centered around a threat that impacts very few of the total citizens (less than 8% unemployment, less than 2% of homes in foreclosure, FDIC limits of $2ook per account). Moreover, as the media has become increasingly more negative, the overall health of society has diminished and suicides have increased in step with the message.

That said, it is common knowledge that fear sells. Demanding the media change its message to fix the deflationary environment would be challenged by every media source as a violation of the First Amendment. Therefore, short of the media providing this market intervention against its self interest to save the greater good, another solution must be sought.

The second solution is to increase the Money Supply. Government spending, loaning and stimulus shall make the money that citizens are holding less valuable and eventually promote spending which will provide a price floor and an increase in prices in future years. It is not clear how the general citizen comes to understand that the holding cost of their money becomes expensive, but generally as a population sees citizens enriching themselves with goods and services as a result of more money circulating in the market, an increase in the general standard of living occurs in the short run.

The largest challenge to this solution is that it requires diligent monitoring by the Government so as to not create an over supply of money in the long run creating a jolt in prices once they have bottomed instead of a controlled price appreciation as desired. That said, this form of intervention shall certainly increase prices and solve the deflationary situation.

The second solution has been undertaken by the United States and the approximately four trillion dollars of stimulus provided between the TARP, Federal Reserve lending, Guarantees of Fannie and Freddie and a stimulus plan by the next administration to create three million new jobs will reverse the death spiral of deflation. The management of these programs will be crucial in the upside of the price appreciation to follow.

That said, isn't it interesting that both solutions provided here as well as any solution the reader may create will all entail people to act against their financial self interest and act in the greater good of the society or market as a whole. Perhaps the give and take relationship between self interest and common good are more relevant in a capitalist, or free market based economy, than society currently recognizes.