October 2009 Newsletter
Issue Eight, Volume Two

A WONDERFUL FICTION

By Mike Gasior

This newsletter will be much shorter than what is typical of my editions because it is actually an editorial I have written and sent to several large U.S. and international newspapers. Please feel free to cut and paste the editorial part of this and send it to any newspaper or media outlet you would like as well as forwarding this entire email to anyone you think will appreciate hearing the honest truth. The subject matter is important and I have only grown increasingly dissatisfied and angry at the portrayal of the state of the economy by both the media and politicians. The truth, while unpleasant, is important for Americans to understand this truth so they can better plan for their personal futures and assess the performance of the people they elect to office.

Also, if you haven't found my blog or me on Twitter, here are those respective links:

http://afs-seminars.com/blog/

http://twitter.com/MikeGasior

I have also posted a video commentary on the website on this same topic "A Wonderful Fiction" and you can view it at the following link:

http://www.afs-seminars.com/v-commentary.html

A WONDERUL FICTION

Americans are hearing from many sources that the recession is ending, that markets and businesses are rebounding and the financial system was saved from the brink of collapse thanks to swift action by the government and Federal Reserve. It would all be wonderful if any of it were true. What is sad and dangerous is that it is not at all true and nothing more than a wonderful fiction being perpetrated upon the masses by an assortment of extremely powerful people with a range of different motives.

A surprisingly simple conspiracy of silence and collusion has been undertaken in the United States and abroad spanning the past 18 months to convince the general public that the financial system is safe and solvent. Amazingly, this conspiracy isn't particularly complex, difficult to detect or surprising when laid out for anyone's consideration, which is what this editorial will attempt to do.

What brought the U.S. economy to its knees was the rapid increase of debt taken on by both consumers and corporations over the past 20 years. This debt bubble accelerated greatly during its final seven years, ending in 2007. This explosion of debt is at the center of our current economic situation because over the coming years many of these borrowers will ultimately be unable to pay this money back. The basis for the conspiracy is to try to keep investors and the public from knowing how bad these losses will be in the future.

At the heart of all of this lies an arcane accounting rule that came into existence after the events of Enron, Worldcom and other financial scandals: FAS 157. Thanks to massive coverage in the media, many Americans may recognize the expression "mark to market accounting", but don't know the full story behind the rule.

Simply stated, the most accurate presentation an institution can place upon any investment they own is the asset's "fair value", which is what another investor would be willing to pay for that particular investment in the current marketplace. The central point of FAS 157 is that it requires investors to mark the value of all their holdings to the current market value and place them in one of three categories dependant upon how the market price was attained.

Category One is for securities that trade in an open market such as the New York Stock Exchange and where market values are easily observed.

Category Two is for securities that trade in an over-the-counter market, as do most bonds and many derivative contracts. While there is no observable open market transaction, estimates of value can be attained by surveying several broker dealers who make markets in these products. The investor can then use one or an average of these third party quotes.

Category Three is the most troubling to accountants because these are securities for which there is no active marketplace to observe and no third party quotes to rely upon. For these types of products the investor is required to use mathematics to calculate what the value would be under current market conditions.

These Category Three investments are where this conspiracy begins since nearly all the "toxic" assets (now referred to more politely as "legacy" assets) contain the bad loans given out during the past 10 years. You may recall that just over a year ago many of the largest banks in the United States seemed headed for certain bankruptcy but suddenly became quite solvent and even profitable literally overnight. Was this due to a dramatic turnaround in the markets or economy? Perhaps it was grand decisions made by management to turn their institutions around? Unfortunately it was neither.

Thanks to massive political pressure from Washington, the accounting profession, via The Financial Accounting Standards Board (FASB), was forced to relax their standards for Category Three assets, giving the investors more "flexibility" in how their market values are calculated. In truth, the American landscape is now littered with institutions who appear solvent and healthy but who would be absolutely bankrupt if it were not for this bending of the rule. The simple bending of this accounting rule, which now allows these companies to completely fabricate and inflate the market values of their holdings, has taken them from the precipice of failure to apparent glorious success. Many people in positions of great authority know too well the peril that still exists for the economy and perpetuate this wonderful fiction for a variety of reasons. JPMorgan just announced their third quarter earnings, which were much better than investors expected and their stock rose nicely on the news. Also in the announcement was the fact that JPMorgan had roughly doubled their loan loss reserves and CEO Jamie Dimon said "Credit costs remain high and are expected to stay elevated for the foreseeable future in the consumer lending and card services loan portfolios." This part of the news was largely ignored, however.

The public is told that there is no market for these "legacy" assets and thus the investors are forced to hold onto them because there are no bids to be had. This is patently false. True, there are no bids being made from large Wall Street broker dealers because they already hold massive positions in these horrible investments and have no desire to hold more. But many within the financial industry know too well there are many investors out there, such as hedge fund managers, who would love to acquire these assets and actively make bids for them on a daily basis. Unfortunately these bids are not observable by accountants and auditors since they are not that of a large, "trustworthy" brokerage firm and thus no Category Two price is possible. The brokers and other large institutions have an additional problem that will involve FAS 157, which would occur if any of them were to actually sell even some of these holdings because that would create an observable transaction. These assets aren't worthless, but many of them aren't worth very much, often only pennies on the dollar to a savvy investor looking to acquire them. The problem for larger U.S. institutions, who hold trillions of dollars of these sorts of assets, is that the sale of even a small amount of them will give the accountants the ability to force them to write the remaining holdings down to this actual market transaction value. If I have been holding an asset class on my books at 60 cents on the dollar and I sell some of those assets at 8 cents on the dollar I am very probably going to suffer a large write-down on my portfolio. This would be the moment when many of America's largest institutions would become instantly bankrupt. But the brokers won't give any pricing and the institutions won't sell any of their holdings, amounting to a vast conspiracy of silence and inactivity to avoid the inevitable write-downs that would have to occur if the truth were publicly known. All these institutions can do is delay the losses as long as they can and hopefully stockpile as much money as they can in the meantime. Luckily these institutions have powerful allies in Washington who are doing all they can to help that take place.

Politicians might wring their hands and pound their fists over the lack of lending that is being done by America's large banks, but the fact of the matter is the banks simply can't make new loans right now. The CEO's of these banks are acutely aware of the scenario painted above and are also aware their institutions are functionally bankrupt. They already hold a boatload of illiquid and almost worthless assets and have no desire to acquire any more. To a large degree there is almost no commercial lending being done at the bank level since these types of loans usually carry terms of 5 to 15 years and are now illiquid due to a non-existent CMBS marketplace. Also aware of all of this is Federal Reserve Chairman Bernanke, Treasury Secretary Geithner and presidential advisor Summers who have all taken massive steps to keep U.S. zombie banks limping along any way they can, as long as they can. The medication the U.S. Government and Federal Reserve have prescribed for these sick banks is the most simple you could imagine. Print dollars at the Federal Reserve. Lend the new dollars to the banks at zero interest rates. Let the banks lend the money back to the U.S. Government by buying 10-year Treasury Notes paying 3.25%. Rinse and repeat. The banks are now making an easy 3.25% and they are holding extremely liquid, high-quality investments rather than potentially illiquid, credit risky commerical loans. Now three percent is not a very large rate of return, but it is a positive number nontheless and the bank can now stockpile the nickels and dimes they are earning for the rainy day they know is lurking in the future and they will ultimately have to write down their legacy assets. The CEO's of the institutions, along with Messrs. Bernanke, Geithner and Summers can only pray that another cataclysm, such as a meltdown in the commercial real estate market, can be avoided in the near term since all bets will be off then. And this new credit crisis will make the original one look like Pee Wee's Big Adventure by comparison.

On October 12th, Lloyd Blankfein, CEO of Goldman Sachs had an editorial published in the Financial Times urging more transparency in the way financial institutions report the market values of their holdings in the hope of preventing systemic risk from institutions that are "too big to fail". As the head of one of the largest broker-dealers in the world, Mr. Blankfein boasts that Goldman Sachs diligently marks all their holdings to market every day. If their market values are truly honest and representitive, Goldman Sachs could do America and the accounting profession a tremendous service by letting us all know what the true price of these legacy assets would be in this marketplace. The only question then is whether or not Americans or the U.S. financial system can actually bear to know the truth.

Copyright 2009, Michael Gasior. All Rights Reserved

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