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Sunday, March 29, 2009

Mark to Market

I'm watching the comedians on the Communism Channel, and they like to talk about "mark-to-market".

Banks invest in illiquid level 3 assets. It is hard or impossible to determine a "fair market price" unless the bank actually sells the asset. Accounting rules and State banking regulations encourage banks to invest as much as possible in complicated derivate transactions or hard-to-price assets.

Consider two mortgage collateralized debt obligations (CDOs) A and B. Each CDO has 100,000 mortgages in it, and the terms are otherwise identical. Even if CDO A is sold for $1B, that can't be used to evaluate CDO B. CDO B has 100,000 different mortgages than A. There isn't going to be an exact comparison.

If banks are forced to rigidly mark-to-market, then banks might be forced to value assets at less than they're actually worth.

If banks aren't forced to mark-to-market, then they can make up whatever price they want. They use a model to price the asset, and then they can tweak the model's assumptions.

For these complicated derivative transactions and CDOs, there may be no comparable security that can be used as the basis for mark-to-market accounting.

During the recession/depression, small banks go bankrupt while large banks get a bailout. During the inflationary boom, banks make huge profits. Banks borrow at the Fed Funds Rate and make loans, profiting from the spread between the Fed Funds Rate and the loan rate. For example, the Fed Funds Rate is 4%, mortgage rates are 6%, and banks use 30x leverage ratios. Under those assumptions, banks make a guaranteed riskless profit of 60% during the economic boom. During the ecnomic bust, banks get a free put option to declare bankruptcy and cheat their creditors. To avoid that disaster, a bailout occurs.

Bailouts provide the illusion that the banking system is sound. The Federal government intervened to protect the interest of depostors. In reality, a checking account at a bank is the worst possible investment. Your principal is protected (via the FDIC or other State bailouts), but you're guaranteed to get ripped off by inflation over time. The credit interest rate on a money market account or on bonds is much less than true inflation.

Consider the Hunt Brothers' Silver Corner. As they bought silver, they drove the price up. Mark-to-market accounting meant that they were allowed more and more margin borrowing power as they drove up the price. Then, when the silver market crash occurred, they had more debts than assets.

Suppose you buy a house for $300k. You make a downpayment of $30k and have a mortgage of $270k. Two years later, the house is worth $500k. You can now refinance for a $450k mortgage, and pocket/spend $180k. Two years later, the housing market crashes and your house is only worth $100k. You are stuck. You default on your mortgage and declare bankruptcy.

Mark-to-market meant that your house was worth $300k, then $500k, and now $100k.

What's the problem? The problem is fiat money and negative real interest rates.

In the context of a fiat monetary system, there is no fair benchmark for price. During booms, prices get inflated. During busts, prices crash. Insiders benefit from inflation, or they qualify for a bailout. Individuals lose their homes and their savings.

Negative real interest rates provide the illusion that it's beneficial to load up on as much leverage as you can. During the inflationary boom, this seems like a winning strategy. During the bust, non-insiders lose everything. The Compound Interest Paradox guarantees that periodic busts occur. Non-insiders get ruined during the busts. Insiders get a bailout. The bailout can come indirectly, via a Fed Funds Rate cut. The bailout can come directly, as occurred in the current bust.

It is a statistical necessity that someone gets screwed over during each recession/depression. In 2000, it was the .com investors. In 2007-2008, it was the people who bought housing. Next time, it'll be something else. Another boom is guaranteed, but you can't predict where it will be and how long it will last. Each boom/bust is treated as completely unrelated to the previous one. A corrupt monetary system is always the real problem, but the mainstream media treats the Federal Reserve and a corrupt financial/monetary system as blameless.

As a non-insider, you're tempted to load up on leverage during the boom. Such a policy means that you will lose everything during the next recession/depression.

It's a no-win situation for non-insiders. If you don't load up on debt, you'll lose out to inflation during the boom. If you load up on debt, you'll be bankrupted during the next recession/depression. As a non-insider, you don't know how severe the boom/bust will be and how long it will last. The current bust is pretty severe, and the last boom (housing bubble) was mild. The next boom phase might last 2 years, or it might last 10 years. You don't know. The rules of the monetary system guarantee that another boom will occur soon.

Negative real interest rates encourage insiders to load up on as much leverage as they can during the boom. During the bust, limited liability incorporation offers corporate management a free put option to declare bankruptcy and cheat creditors. Alternatively, a bailout will occur. During the bust, all non-insiders are forced to deleverage. At the bottom of the recession/depression, insiders start to re-leverage and re-inflate. They benefit by printing new money to buy real assets cheaply during the recession/depression. Insiders are always the first to buy with newly printed money at the start of the next boom.

The Federal Reserve and a corrupt monetary system are never blamed for economic problems. In the current crisis, the comedians on the Communism channel blame mark-to-market accounting requirements as a cause of the bust. At the exact same time, those same comedians blame a lack of mark-to-market accounting that allowed banks to carry assets at values unrelated to their true value.

Fiat money is intrinsically worthless. There's a division by zero error whenever a bank uses fiat money to buy tangible assets. The banksters merely print new money and buy up as many tangible assets as they can. State regulations allow this leeching to occur. State regulations also try to ensure that the rate of leeching is not too fast, lest the entire scam collapse. Whenever their gravy train starts running dry, the banksters can always lobby for greater leeching power.

In the context of a fiat debt-based monetary system, there's no fair benchmark for determining price. It's silly that the same house can double in value and then lose 80%+ of its value. The problem is not that the real value of the house changed. The problem is that a corrupt monetary system guarantees periodic booms and busts.


Kiba said...

Fiat money is not worth anything intrincrastically. It is just a whole lot easier to inflate with fiat money. Bankers and insider like that because it mean that they can print money at will.

It might be fine that people don't run the turning press, but people are easily tempted to print money because it is so easy to cheat.

With gold, it is kinda hard to inflate unless you mine an asteroid or something.

Sovereign said...

I agree with pretty much the entirety of this post, except the idea that there will be another boom. Even if the pyramid scheme that is our economy wasn't unwinding, there won't be the energy necessary to generate another boom.

We're stuck in another paradox now between economic growth and energy availability. If the economy grows, demand for energy goes up, and thus does the price. The high price puts too much stress on the economy, which then suffers, halting growth.

If somehow a recovery actually gains steam, there will be an energy price spike which will kill it.

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