Wednesday, December 3, 2008


The New Economy

I watched closely a TV program with two analysts verbally slugging it out about the "mark-to-market" controversy which I have been repeatedly calling the accounting practice that has made us commit economic hara kiri. Fortunately the two were on split screens so they were not able to actually trade blows. The pro-mark-to-market man argued that the mortgage based assets, which remain at the core of our economic plight, have no value,since no one is trading them. The anti-mark-to-market man said that these assets have value since they continue to pay income because an overwhelming majority of mortgages are being paid on time, about 94% according to the Mortgage Bankers Association.

So what is the truth? Let us look at the "pro" side. The argument here is that these assets must be marked to a non-existent market. If this is the case they should be marked to zero. However, as we have seen, no one is marking to zero. Rather they are marking to notional markets. I believe they are marking to the depressed property market, a belief confirmed by one large investment firm, Black Rock, that stated it is marking to the depressed property market in Southern California. My belief is also supported by the fact that all commentators agree that the economy will not recover until the housing market turns upwards. The theory here is that as property values increase, the value of mortgage based assets, now valued to the property market, will go up and thereby improve the balance sheets of those holding these assets. Therein lies the contradiction of those insisting on "mark-to-market," there really is no value, since there is no market, i.e. there are no sales, but they say the value will increase if the housing market recovers, which may or may not induce sales of mortgage based assets. As I have been saying this is sheer nonsense, a point made by the anti-mark-to-market man.

The "anti" man said that the mortgage based assets still pay their expected return since most mortgages are being repaid. To illustrate, say we hold mortgage based assets with a face value of $10 million. At an average 6.5% mortgage interest we will collect $650,000 per year in income from these assets. At today's default rate of about 6.5% this income would be reduced by $42,250 leaving us with $607,750, not what I would call a serious hit and certainly not a cause for"panic" selling.

Let's use another analogy to see how this works. Say you have a trust fund set up by your rich uncle Harry. The fund pays you a certain amount each year but you cannot draw more from the fund nor may you sell it. What is the value of the fund? Clearly it is the income stream it provides to you. Valuing the fund to a "market" would be sheer folly since it may not be sold.

So what is happening now? The Feds are buying Fannie Mae funds and mortgages and perhaps other mortgage based assets, investing in banks, lendingto banks, and planning to guarantee mortgages. All of this serves to improve lenders balance sheets and allow them to once more extend credit. The Feds are using procedures that cater to the "mark-to-market" crowd by creating a market, Fed purchases, for mortgages and mortgage based assets. But the reason they are doing so is that they recognize the argument of the "anti-mark-to-market" side, the assets actuallyhave a good value.

Where does all this lead? As I have stated, the Feds are borrowing (T Bills) at all time low rates, 2-3%. They are buying assets that pay far higher returns, e.g. mortgages that pay an average 6-7%. They are lending at 5%+ interest rates. They are buying shares in major banks that could double in vlaue or more when the economy recovers. In short, the Feds are taking a position in the markets that gives very attractive current returns and incredible future earnings. Enter the "New Economy."

And what do I mean by the "New Economy?" Well we will have one in which the Federal Government will be a co-owner with private investors of our economy. Is this bad? Many cry, "socialism." But the reality will be that the organization that makes the rules will be the main player. Do I expect the rules to reflect this stake in the "game," you betcha. We will have a Federal Government that will be more business friendly since it will be the major benefactor of friendly behavior. The other major result is that with this new source of revenue, i.e. income from business ownership, the Feds will have less need to raise taxes, a distinct plus for the incoming Obama administration and its plans to cut taxes for the middle class, invest heavily in infrastructure to put people to work, and address the health care problem.

Now before you start crying that government ownership will lead to ruinous management of the businesses, remember, the Feds are not taking over management control, they are simply being investors. There is no reason to believe that the Feds will act differently from private investors. I would also point to the experience of Finland. In Finland the government owns several of its key industries and they work very well. While the Finnish government owns the businesses, they operate them as an investor seeking to maximize profits.



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