Friday, April 3, 2009

Mark to Zombie

Yesterday marked a major turning point in the future of America's banking system. We received word that the much debated mark to market system is going to be "relaxed."

Up until this point, through all my rants about how terrible the situation was being handled by our leaders, my one positive comment was that they have refused to give in to the mark to market accounting system.

Yesterday they caved.

Imagine that a person walks into a bank to get a loan. He has a stable job, decent credit score, and a good history of payments. The banker likes what they see and then asks to look at their financial statement.

Looking down the banker sees that this person is a homeowner in California. The customer has a mortgage on a home of $750,000. The home today is currently worth $300,000, and a bank would probably lend no more than $250,000 on the home after a down payment. The home also has an option arm loan set to adjust in 6 months. His current interest rate on the loan is 1% that he received as a "teaser" rate five years ago.

His monthly payment on the home when this rate adjusts will go from a less than interest only payment of $2,500 per month to $7,000 per month after the loan adjusts to a principle and interest loan at 6%. He currently makes $6,000 per month before taxes.

The banker looks down at this loan and says, "I think we may have a problem here. I don't think we'll be able to lend you any new money based on your future ability to pay your debt."

The customer looks at the banker and says, "You've got be kidding me. I own a house that is worth $750,000 if I wanted to sell it today, and I have never been late on a payment. Therefore I will always continue to make my payments."

The banker then laughs at the customer as says, "You are marking to model, not marking to market. Come back and see me in a few years after you have declared bankruptcy and straightened your books. We will talk about lending some money then."

This is the problem with mark to "model" accounting. The banks will say that "x amount" is what the debt is worth based on past performance, but a new buyer of that debt is going to factor is what it is worth based on the likelihood of default in the future when they are the owners and they are counting on the interest payments every month.

The problem is not that there are no buyers for the bank's debt. The problem is that they have it priced too high. As I have discussed previously in length, if the major banks were forced to sell their debt at market prices they would instantly be further insolvent and bankrupt. (Needing additional tax payer money) If they do not want to declare bankruptcy, then just like our homeowner above, they will be in a position where no one will lend them new money. (Other than the government with our money)

Japan was faced with this decision back in the 1990's. The could have let the banks fail, forced the bad debt off their books, and moved on with new strong loans. The problem was that no one wanted to do business with the banks because they knew that all the bad debt was still sitting there. They knew at some point they would have to come clean and face the music.

We are now heading down the same path. If mark to market is taken away then all the bad debt will just sit on the banks balance sheets forever, and they will never heal. The free market (businesses other than the government) will not want to associate with them because they will not know what is hidden on the bank's balance sheets. This will cause the problems to go on forever. The United States will just be in a long slow perpetual decline with a crippled, insolvent, zombie banking system.

Tuesday, March 31, 2009

China's Preparation

I hear many people in the news and faces on television try to pinpoint where we currently are in this economic downturn. People try to decide if we have hit the stock market bottom or the real estate bottom and how close we are to getting back the good old days of only a few years ago.

Due to our credit bubble and bubble economy we built over the past 30 years there were two parts of this crisis that were built in and guaranteed:

1. The Financial Crisis
2. The Economic Crisis

The financial crisis could be seen by banks taking on trillions of dollars worth of debt through subprime mortgages or credit default swaps that were guaranteed to explode based on the underlying home owners paying on the debt.

The second part of the crisis was the ramifications of this financial meltdown as Americans were no longer able to borrow and spend to support our bubble economy.

These two events are part of a long term boom and bust cycle that has been seen throughout history. As a country experiences a tremendous boom, the ensuing bust is what cleanses the system of this bad debt and allows the country to rebuild itself as an emerging market based on a solid foundation.

However, something changed this time as I'm sure you have noticed. When the credit crisis washed upon our shores last September our government decided that they did not want to participate in the natural market forces seen throughout history.

This was a monumental moment in the history of our world. Up until that point it was uncertain to everyone what the final outcome would be because we had yet to see the government's response to the crisis.

Their choice since that point has been clear. No bank shall fail under any circumstance. With the banks crippled permanently, both the government and the Federal Reserve have now stepped in as the new lender of unlimited credit. They will get this money through borrowing and printing.

This decision has now ensured a new crisis (if we continue on our current path) that approaches us at some unknown date in our future:

3. The Currency Crisis

It is hard for me to describe what this crisis will look like when I talk to people. Try to imagine your monthly cost of living every month. For example, a person makes $5,000 per month before taxes and their monthly cost of living is $2,000 per month. In a currency crisis, their monthly cost of living may rise to $11,000 per month and it is rising every month.

Unfortunately, this will come at a time in our history where resources are extremely scarce. The recent pull back in commodity prices has shut down a large amount of new supply for oil companies, farmers, water producers, and miners. The credit crisis has cut off most credit available to new companies in these businesses because the money is being funneled back and forth between our politicians and the banking elite.

As the supply of new dollars currently being dumped from helicopters today explodes into the market, it will be met with an ever decreasing supply of new goods to chase.

China is watching this all play out from afar and they are currently putting strategies in place to prepare for the oncoming changes in our world. They currently hold about $2.4 trillion in American debt. While Chinese politicians announce to the press their long term desire to buy our worthless debt, behind the scenes they have put a plan in place to control over $500 billion in new natural resources this year.

They are setting up oil agreements with Russia to extend years out into the future. As people here are worried about AIG bonuses and GM j0bs, China is putting together an exit strategy out of the dollar completely.

The Fed's new program of purchasing treasuries has given China the opportunity it was waiting for to offload their worthless debt in exchange for new resources, country wide infrastructure projects, tax cuts focused on business growth, and a new plan to stimulate consumer spending. They are planning a life without the American consumer, and when their chess pieces are in place they will be able to just walk away.

However, China has to dump their dollars slowly and methodically in order to prevent a run on the currency sooner than they would like.

Meanwhile, Americans here continue to focus on our stock market and real estate bottom. They are focused on the financial and economic crisis, not even aware that there is a third crisis on its way.

It is the equivalent to someone standing on train tracks trying to swat bees away from their head. Meanwhile a train is approaching them full speed and they're not even paying attention.