Mittwoch, August 10, 2011

Mark-to-Market, Instability & Just How Bad Are Things?

For those of you who have been following me for a while, you would know I am no fan of mark-to-market accounting.


Well, read why here, here, here, and here.

Seriously, mark-to-market is a disaster. There is one aspect of mark-to-market that has now emerged over the last several months that took me a while to notice: it leads to instability by inadvertently promoting what the Germans call "Beamten-Mikado". That's a version of the classic Mikado game, also known as "pick-up-sticks": dump a pile of elongated toothpicks on the table and try to remove them one by one without moving the other sticks.

In the German version called "Beamten-Mikado", played each and every day in German government offices, the one who makes the first move loses. Doesn't matter if you get any sticks, it is the inverse of the standard Mikado game. Move and you lose.

According to mark-to-market principles, if you see the value of an asset decline on the markets, you are required to re-assess your assets and change their value appropriately (well, not changing it all until you sell the asset would be the most appropriate thing to do, but you get what I mean). What happens when there is no market?

Hmmm. The mark-to-market people didn't think that one through.

What happens when markets start acting funny - and I scarcely think anyone can deny that this continues to be the case - is that companies cease acting within the market, deciding instead to see what the market will do. Given that every one of the bigger players is holding assets that may or may not turn toxic and, at the same time, take down those holding them if they were to revalue mark-to-market, what's a holding company to do?

Nothing, of course. Nothing that would require them to revalue their assets. Especially nothing that would require the revaluation of toxic assets.

As Brian Rogers of Fator Securities put it (link here to Zero Hedge):

The $60tr global economy can take a haircut on billions of dollars in Greek debt, but it simply cannot take a haircut on $700tr in global derivatives sitting on the balance sheet of every major government, hedge fund, financial services company, TBTF bank, insurance company and major corporation that engages in any hedging activity. 

In other words, anything that would require a change in valuation of the hedges that these companies hold destroys the world financial system.

Greece, Italy, Spain, Portugal and Ireland could all simply restructure their debt and life would go on were it not for the leverage of the banks that hold them.  In the US, real estate could be allowed to fall to its market clearing price or be written off by the lender were it not for the leverage of the banks that own it.  No matter which way you turn, all roads lead to the TBTF banks, their leverage and the $700tr derivatives market. 

Bingo: the system is fundamentally unstable because, at the end of the day, the markets are not being allowed to function. In the pursuit of some magic recovery, some strange and bizarre turn of events that would turn the game around from lose-lose to win-win, the powers-that-be have chosen not to allow markets to work, thus, in their eyes, removing the mark-to-market catastrophe that would otherwise loom, done in the name of stability.

In other words, in the name of stability, instability has been created, where the massive leveraging of finances means that any small change, anything that forces a major player to move, will instead bring down the system as a whole.

Right now, there is real incentive not to do anything: whoever moves first, loses.

The difference between this and Beamten-Mikado is that the latter doesn't actually exist as a game: it is a cynical observation.

Just how bad are things?

Consider the $700 tr derivatives markets. If these were to start to fail, it would represent the greatest destruction of capital bar a nuclear war. Not even the destruction of German and Japanese cities wholesale comes close to this. It is the inverse neutron bomb of the modern world: it would destroy capital, but leave the people alive.

Just how bad are things?

Consider the world population and the farm-to-person chain: disrupting logistics chains because of bankruptcies due to mark-to-market revaluations of derivatives. Millions starve because food can't move from farms to cities (and don't think that the government can "intervene" and get things running again: it doesn't work that way).

Just how bad are things?

I remember reading, back in the 1970s, some of the "get rich by financial manipulation" books that were the rage. One of them recommended living very frugally and maxing out your equity by leveraging your cash flow - aka income - as fully as possible. Keep on driving an older car, live in a small apartment, eat frugally, skip the movies, live off of 20% of your income in order to borrow as much as you could with the other 80%: "invest" the money in the stock market and you'd be a millionaire in 10 years tops. Of course, that meant that any small change in interest rates or returns would lead to personal bankruptcy, which, of course, back then wasn't that much of a problem (since changed). The major economic players out there apparently read those books, and as a result we have, speaking as a nation, no income for consumption, as it is so heavily leveraged.

Just how bad are things?

Consider this: growth in China, driven by politically determined prices to drive exports, has reached the point where additional debt no longer generates growth (see this for more). However, this hasn't stopped China from expanding debt and increasing investments with no regard to their profitability. This is the next catastrophe coming, one that will change the game and may even mean the end of China as we now know it.

Just how bad are things?

Keynes called for government intervention to improve worker's salaries during recessions. The governments, as they are wont to do, screwed that up royally and instead pumped money into the economy in the (vastly) mistaken expectation that vast amounts of really cheap money would lead to growth. It led, instead, to massive misallocation of capital - THE cardinal sin of economics as such - and a resulting landscape of financial ruins that are little more than empty shells behind a Potemkin-village-like facade.

Just how bad are things?

Consider this: the Fed interventions over the last several decades were made to stabilize the economy and dampen out negative effects, while allowing positive effects to expand (ending up in a series of bubbles). The cumulative effects of trapping corrections is that when the correction have to be made, they have to resolve not merely the current crisis, but rather any number of crises that haven't been resolved. Trying to impose stability on an unstable system - capitalism, after all, is fundamentally unstable,as it is designed to tear down and reconstruct on a continuing basis (Creative Destruction) - only leads to greater instabilities in the system, with new harmonics to the movements tearing the system apart from within.

We are heading to a new phase of creative destruction, one that will be, at best, a wild ride and, at worst, a write-off of debt that will make the Great Depression look like a minor accident. Writing off $700tr in derivatives means that the dollar will be worthless in its current form - there simply aren't that many dollars around - and that would mean the US taking a deadly, fell blow to the body in order to save the world economy.

Not going to happen, of course: that means that when push comes to shove, the same thing will happen.

Just how bad are things? Worse than you can imagine. Pretending anything else is naive at best and outright self-delusion at worst.

Gonna be a bumpy ride. Fasten your seat belts, put your tray in an upright position and review the safety manual in the seat pocket ahead of you. We will be turning off the entertainment system at this time.

Don't forget your air sickness bag as well.

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