Credit Crisis Solution

The Future of Fraud

If it looks like a fraud, smells like fraud, and smells like fraud…it is fraud? Is it legal?

Below this post are a few notes on mark to market, the FASB changing the rules, and the banks buying more of the “toxic assets” to mark up their earnings. CITI bank issued a statement stating that the accounting changes would not affect their Q1 earnings, this says one of two things 1) the rule change wasn’t necessary, or 2) CITI banks lying, which would lead to better than expected earnings.

Like the potential fraud in the mark to market, credit default swaps (CDS) may not be what we thought they were. Ritholtz.com did an investigation on CDS and AIG and made some surprising finds:

1) There was a significant diverge between the risk assumed and the premium paid for CDS.

2) There were indications that AIG believed that a lot of the companies CDS’s were issued for were beyond going concerns.

3) Indicators show that AIG may not have had any original intention to make good on the CDS contracts.

4) As a result of the regulation on mark to market, essentially these securities would be “dressed up” to fool regulators and meet liquidity ratio’s. Replacing the revocable “side letters” of the past.

5) It was essentially a global ponzi scheme.

The government is assuming 100% of the risk, on these CDS, however knowledge is power, and once this information is more popular, there will be action.

The FASB is easing the rules on Mark to Market accounting. As the rules are now, assets are currently valued at their market price, demand of “toxic” mortgage assets were down which lead to a decrease in value. Many of these assets are still generating cash flows and banks often use internal valuation to place “more realistic” value on the assets internally. Under the proposed changes, the valuation would be done based on internal company models vs. the market price.

Proponents believe that the easing in the rules will allow banks to true up the balance sheets allowing them to lend more based because of better ratio’s. Which has a good amount of validity because a lot of these held to maturity assets suffered other than temporary impairment (OTI), which cannot be trued up if market conditions change. Additionally, their liquidity and debt ratios will become more favorable allowing more lending.

Conversely, many of the large banks have been covertly buying up these assets on the inactive markets under the expectation of these changes. This completely undermines the efforts of the government to rid the banks of the “toxic assets”. The point of market to market accounting is transparency and for the banks to do this will potentially lead to inflated balance sheets, part of the original problem.

Note: Keep in mind that the Fed put out a plan to rid the bank of the assets discussed. This will potentially have a significant impact on the value of those assets, benefiting the banks beyond their share price.

“The key to change… is to let go of fear.” ~ Rosanne Cash

Barrack Obama promised change, that was a forgone conclusion. These changes are going to be: obvious and/or unintended, long term and/or short term, good and/or bad, small and/or big, and inevitable.

The macro-economy:

1) Inflation and interest rates- The money supply and interest rates share a cause and effect relationship. As the money supply increases (current situation) law of supply and demand dictates a decrease in value. Additionally, interest rates are at near all time lows, thus increasing access to money. Masked by the recession and oversupply of goods being discounted, there will be inflation, and pressure to increase interest rates. The G-20 is convening later this week, and among their discussion topics is reform of the current global financial structure, including a global reserve currency, which would have significant impact on interest rates.

2) Inflation and interest will slow growth rates within the economy; credit access will be limited for consumer spending, access to higher education, and investment, companies will adjust to meet consumer demands, and survive accordingly. This trend will continue domestically, but eventually be mitigated by global demand. Highly leveraged corporations will be the first to fall, lowering the barriers to entry, and creating opportunities for the ambitious unemployed to create new companies.

3) The decrease in the dollar will make goods more attractive abroad, significantly impacting exports, and foreign investment in the US. This will give way to emergence of new industries, more stable financial structure, and stable long-term growth.

4) The financial crisis was primarily a result of poor regulation and greed. Assuming we learn from our mistakes, there will be more appropriate dispersion of wealth, and reemergence of a strong middle class, and increased focus on small business.

End of the golden years

Those nearing retirement are the most vulnerable, many lost 40% of their investment in real estate equity and growth investments. Promised life lines including the unfunded liabilities of medicade/medicare, and social security are going to face reform. Experienced workers are going to look to work longer than expected, increasing the unemployment levels, and causing downward pressure on real wages.

Real Estate

Real estate demand was fueled by increased accessibility to loans (unqualified buyers, low interests rates, deregulation, etc.), this caused a steep increase in housing supply. The markets are still correcting, and there is still a significant diverge between where real estate prices were expected to be, and where they are now. This diverge will be exacerbated by the increase in supply, decrease in demand, and future decrease in real wages. Home “real” values will continue to adjust until full occupancy is met, primarily impacting the suburbs; off-set by inflation.

Commodity Prices, Investment in Clean Technology, Development of Cities

Currently most commodities are traded in USD, assuming the G-20 proceeds as expected to develop a global currency, there will be a shift in how commodities (precious medals, energy, etc.) are traded. The devaluation of the dollar, regulatory changes, demand from developing countries, and limited supply will create significant price increases against the dollar. Energy commodities will be most susceptible, which will lead to investment in efficiency and sustainability 1) Economies of scale will lead to increased investment in metropolitan area’s, most notably public transportation 2) Market forces will lead increased investment in Clean Technology (much like the one $150 oil created).

Suburbia and Time

America will remain a productive nation; people will most likely shift into part-time work to ease unemployment levels. Additionally, market forces will dictate changes in spending habits and shift focus to needs vs. wants. As there has been a significant increase in agricultural dependence from other nations, suburban homes will begin to convert to farming because of decreases in value caused the shift to the cities and efficient use of resources, “act local, think global mentality’.

Increased Government Power and Reliance

The most appropriate way the measure the power of the government is the taxes collected relative to the GDP. The contraction of the GDP and the increase in debt will result in a significant increase in the GDP to tax ratio. The affects of increased government power will lead to increased expectations as a nations and eventual conversion to socialism.

Conflict followed by peace

On the micro and macro level, self-interest is king. The co-dependency of nations is slowly revealing itself, and as alliances develop, self-interest will be debated. There will be a period of conflict, as needs and desires are contradictory, and power and influence is more evenly distributed. The agreements will eventually be worked out and enforced through the dependance, leading to peace and growth as a world.

Note:

These expectations are based on the assumption of fiscal responsibility.