Mark to Market, Mark to Fantasy

The idea that mark to market is widely used still persists.

Mark to fantasy is the current model for all things considered "toxic."

For tens of trillions of bonds, stocks and other securities, mark to market does exist, and rightfully so. In a true Free Market, no asset should be claimed to have more value than what the highest bidder is willing to pay for it. All prices for stocks, bonds, commercial paper and any other investment vehicles should have a clear bid/ask system, so that anyone, at anytime, can place a true value on on any asset to determine value.

For hundreds of trillions of bonds and other securities, there is no mark to market. Off shore shell corporations and level 3 accounting allow accounting books to claim virtually any value on a security because there exists no clear bid/ask system for these assets. There are still many credit derivatives that have little or no value that are in level 3 accounting with a claim for the full purchase price as the current value.

The reason they are called derivatives is they "derive" their value from something else. In the case of a CDO, it "derives" its value from the performance of several Mortgage Backed Securities, which themselves own maybe thousands of mortgages.

A home loan in most cases, is only serviced by the bank. Some other entity either put up the money for purchase (FNMA, FHLMC, GNMA) or the bank used its own money, for a short period lasting usually a few weeks, then sold the loan to someone else. That someone else then packages that loan, with hundreds of others, into an MBS. The bank is paid a small fee for servicing (acting as the bookkeeper) the loan through maturity. When a mortgage defaults, the bank servicing that loan must rectify the difference between what is owed on the mortgage, and what they receive through short-sale or foreclosure.That difference is a loss in principle to the MBS, and is also a loss in revenue from the lost interest. The MBS realizes a loss, but only for the difference between what was borrowed and what was received in foreclosure, plus the interest lost.

The CDO receives nothing from a short-sale or foreclosure.

Since the CDO, which is a credit derivative, is a bet on the positive performance of the MBS and has no claim of ownership of the MBS or the mortgages in it, the loss in the tranche which holds that defaulted mortgage is 100%. The CDO is a contract whose model was, more often than not, based on that mortgage actually paying off early, which meant more fees due to prepayment penalties in mortgage contracts. Since fewer houses are being paid off early, and many more are in foreclosure, the losses within these CDO's are massive. Every loan modification reduces the value of that mortgage in a MBS, yet it is a 100% loss in the tranche of the CDO.

Almost all of these credit derivatives are being held by large corporations in level 3 accounting.

From Tracy Alloway writing for ft.com;

Mark-to-market has been around for years but the FASB’s Statement 157 the current scapegoat for banking woes, was introduced in November 2007. The rule changed the definition of fair value and required financial institutions to identify how they determine that value, by creating a three-tiered hierarchy for classifying their assets:

• Level 1 - Financial assets and liabilities whose values are based on unadjusted, quoted prices for identical assets or liabilities in an active market.
• Level 2 - Financial assets and liabilities whose values are based on quoted prices in inactive markets, or whose values are based on models - but the inputs to those models are observable either directly or indirectly for substantially the full term of the asset or liability.
• Level 3 - Financial assets and liabilities whose values are based on prices or valuation techniques that require inputs that are both unobservable and significant to the overall fair value measurement.

As Alloway explains, the adjustments for this accounting hierarchy occurred in 2007, just after the collapse of these toxic assets began. Before 2005, the amount any financial institution was allowed to leverage was a maximum 14:1. In 2005, Henry Paulson went before congress, explained the economy would begin to suffer and jobs would be lost, if more credit was not allowed to enter the system. Congress then lifted the rule of 14:1, and allowed Wall Street and the banks to leverage with no limit.

Every single bank and broker that has gone out of business since 2005 had leverage ratios of 30:1 or greater. So much for deregulation and allowing Wall Street to police itself.

Level 3 assets are known in the financial world not as being marked to market, but being marked to fantasy. Marked to fantasy because the losses in a tranche of a CDO, CMO, CLO or the like can never be recovered. Once a default in the underlying security is realized, it is a 100% loss for the derivative. And now, these level 3 accounts are growing due to CDS, which is supposedly insurance against losses of credit derivatives. Funny thing is, many of the companies writing the CDS do not have the funds to pay off against losses in credit derivatives, yet are still writing them. The companies accepting them then claim all of their credit derivatives are good at full value, even though they know they will never get paid on a CDS, unless the government steps in.

This is exactly what is happening with AIG. They wrote hundreds of billions in CDS they could never pay off on. If the largest insurer in the world can't pay off on them, who can? Well, thanks to Paulson, Bernanke and Bush, the American taxpayer is paying off the CDS of AIG. Wall Street believes the taxpayers should pay for their profits, no matter how fraudulent the asset is.

As Karl Denninger in Market Ticker writes;

"Congress and prosecutors across the board, both State and Federal, need to start bringing indictments, starting with the fraudulent accounting.'

"You can't value something at "par" when you are well-aware that the underlying credit quality has gone straight in the toilet and that there is not a snowball's chance in hell that the "insurance" you bought to protect yourself has no chance of being "money good." As soon as you become aware of the impairment under the law you are required to reserve against it!'

"Everyone in the marketplace today now has proof that these swaps in aggregate are worthless, with proof of this found in the fact that The Fed claimed under oath exactly that as justification for the Bear Stearns bailout!'

"So you have a situation here where the entire banking regulatory system has declared these contracts worthless in the aggregate and yet company after company continues to claim in their financial statements and results that these contracts are "money good"!'

"This is out and out fraud and must be stopped."

The banks and brokers and hedge funds that own these credit derivatives know if mark to market were to truly begin, they would be bankrupt immediately, some several times over. This is why they are making a charge against mark to market, in hopes of keeping the FASB from removing the three-tiered hierarchy allowing level 3, which they plan to do this coming November.

If there are no observable inputs, ie a clear bid/ask system, then the asset can be put in level 3. If it is in level 3, there cannot be a fair market value measurement. Because the debt derivatives have no chance to recover the losses represented by defaults of mortgages they bet would be paid off, should these corporations be allowed to claim full value? Should they be allowed to claim, on national television, that their credit derivatives might someday gain back that value, when it is clear they cannot?

Do you believe it is a coincidence that there is no clear bid/ask system for these credit derivatives?

In our current system, the Free Market is no more. We have the Federal Reserve and Treasury injecting money into a select, small group of companies, that without the aid from the government, would be bankrupt. There is no mark to market for level 3 assets. And now we have corporate CEO's, CNBC, Fox Business and many other media helping to create fears that mark to market isn't fair. These are the same people who over the last 15 years claimed removing regulation and oversight of Wall Street would strengthen our economy.

These same people now say that government money must help the big banks, so the Federal Reserve has increased the money supply by $2 Trillion, and has almost $2 Trillion in toxic assets now on its books. The mechanism for accomplishing this is through printing more US Treasury bonds. Smarter people than I now believe we are creating a bubble with US Treasury notes. With $2 Trillion already diluting the US Bond market, and another $10-20 Trillion committed, or soon to be, all going to a select few companies that would otherwise be bankrupt, the bubble may burst sooner than most think.

China and the EU may start selling their Treasuries while the dollar still has high value versus other currencies. No investor uses their money to lose money. To limit their losses, any investor will sell what is losing value. Should the value of the dollar start to drop, massive sell off of Treasuries will probably happen.

It is rather ironic that the biggest voices for "Free Market Capitalism" are now endorsing corporate socialism, but only for a few. It is also ironic these same people championed deregulation, the lifting of leverage limits and creation of level 3. In retrospect, all three of these ideas have been a catastrophe for our economy. Their support for government intervention via increasing the money supply is looking to be another tremendous mistake.

To put this in perspective - Global GDP for 2007, that means all commerce counting everything that was bought and sold, was around $52 Trillion. The global amount of credit derivatives still sitting in off-shore accounts and level 3 accounting may exceed $500 Trillion. So... the amount of debt, that may have more than a 50% loss at today's valuation, with little to no chance of recovery, is ten times global GDP.

I don't know about you, but I believe it is beyond time to be worried. If we don't get the true value of all credit derivatives out in the open, today, the losses will only grow with every mortgage, commercial loan, credit card, student loan and boat loan that defaults. The problem began with credit derivatives having too much value placed on them. How can placing too much value now on credit derivatives be the solution?