market-to-market accounting

Companies such as Enron and likely many of the players in today's mortgage mess used “market-to-market accounting”.   Enron used these rules for the energy trading business in the mid-1990s and used it on an unprecedented scale for its trading transactions.  It looks like the players in the Mortgage mess also used market-to-market accounting.  Under market-to-market rules, whenever companies have outstanding derivative contracts (either assets or liabilities) on their balance sheets at the end of a particular quarter, they must adjust them to fair market value, booking unrealized gains or losses to the income statement of the period.  A difficulty with application of these rules in accounting for long-term futures contracts such as Mortgage Securities is that there are often no quoted prices upon which to base valuations. Companies having these types of derivative instruments are free to develop and use discretionary valuation models based on their own assumptions and methods.  The Financial Accounting Standards Board’s (FASB) emerging issues task force has debated the subject of how to value and disclose related contracts for several years. It has been able to conclude only that a one-size-fits-all approach will not work and that to require companies to disclose all of the assumptions and estimates underlying earnings would produce disclosures that were so voluminous they would be of little value. For a company such as Enron, under continuous pressure to beat earnings estimates, it is possible that valuation estimates might have considerably overstated earnings. Furthermore, unrealized trading gains accounted for slightly more than half of the company’s $1.41 billion reported pretax profit for 2000 and about one-third of its reported pretax profit for 1999.  

Citigroup 

Revenue   (2007)    80,707      (06) 88,453   (05) 82,1479

Net Income              3,617                21,538            24,589

When I look at these numbers I see something wrong.  Why did Citigroup show profits in 2007 of $3,617,000,000 a drop of about $18,000,000,000 from the previous.  In accounting everything will come out sooner or later.  Ask the Arthur Andersen accounting firm oh yeah the Enron debacle put them out of business.  Maybe you could visit the federal prison in Waseca, Minn. and ask Jeffrey Skilling.  

Derivatives and Swaps

Here's how derivatives derive their value - and their risk. Say you don't buy General Electric stock, but instead buy a call on GE, an option entitling you to buy GE for a specified time at a specified price. From then on the value of your call - your derivative - is going to be determined by what happens to the price of GE stock, which in trading lingo is known as ''the underlying.'' The cost of the call, or the premium, will be relatively small and give you great leverage if the stock does well. But if the stock loafs or falls, the call could be worthless. The meat and potatoes of the derivatives business is a kind of forward contract called a swap, which we will explain by momentarily benching the dealer community. Instead, imagine two homeowners, each holding a mortgage not entirely to his satisfaction. Joe's mortgage, whose principal value is $100,000, has a fixed 8% rate. Chuck's mortgage, also $100,000, has a floating rate, tied to Treasury bills and currently costing him 8% as well. But Chuck worries that interest rates are going to go up. Joe thinks they could go down. So they ''swap'' their interest positions (that is, swap floating for fixed), agreeing to settle up between themselves every quarter, depending on what interest rates have done in the meantime. In effect, the deal sets up a series of forward contracts, each covering a quarter. Chuck must pay money to Joe if interest rates go down, and Joe must pay off if they go up. Even if Chuck emerges the loser, he has eased his mind by putting a cap of 8% on the interest rate he will have to pay.

This is a simple explanation of derivates and swaps.  Since it can be complicated regulators are adamantly insisting these days that CEOs, and their boards, do understand what is going on in the derivatives operations beneath them. The Office of the Comptroller of the Currency issued 26 pages of guidelines last October as to how national banks should manage the risks of their derivatives business and specifically mentioned more than a dozen times how responsibilities for these fall on the banks' boards.

Let’s see if anyone goes to jail.  I wouldn’t take a derivative on this one.

The numbers don't add up. part 3

Predatory lending is defined as a type of lending that falls between appropriate risk-based pricing and blatant fraud and combines certain products, terms, prices and practices.  Ok lets think about this a loan is written to people with F type credit and  then 55.1% get a loan with little or no documentation required.   Then most of these people were written an ARM loan without concern if they would be able to pay the payment in the future. Many people are willing to do anything to get a home.  The practice of giving such a loan might be predatory lending.  Then again it could just be Mortgage fraud.  This happens when someone knowingly misrepresents the truth or concealment of a material fact in a mortgage application to induce another to approve the granting of a mortgage. Mortgage fraud refers solely to fraudulent schemes pertaining to residential mortgages.  Either way the question now is to bail the banks out or not to.  If you just paid all of the homes off it would sum up to $536,964,808,868.  But then if you pay off just those whose payments were late in the last twelve month which is 1,234,993 for a total of $227,136,207,581.  Maybe those in government should explain why they need $700,000,000,000.   

The numbers don't add up. part 2

Lets break down the numbers.  The subprime buyer has bought a home that cost $183,917 using a 30 year fixed mortgage not including any taxes or insurance their monthly payment would be $1,408.95.  If the home was written with an adjustable rate which most were their initial payments would be $1,353.37.  They would pay $1,454.76 when the interest rate changed to 8.81%.  Then there are those that chose an interest only loan they would pay $1,230.71 as an initial payment per month.  Once the interest only period ended they would pay the higher $1,454.76.  It is important to note that these people would not have paid anything to the principle.  Many of these people bought more home than they could afford especially with the changes.  If they bought a $250,000 dollar home at the same rates the initial payment would be $1672.92 using the interest only loan.  When the loan converted to a conventional ARM it would be $1,977.47.  Housing prices dropped 5.3% this year and 2.7% last year and the year before that it had dropped 1.7%.  So those that chose an ARM or an interest only have a home that is now worth $166,585.89 if they bought it in 2006.  Since they owe more than the house is worth and there is a prepayment penalty for two thirds of such home owners they really can’t refinance their loan. 

The numbers don't add up. part 1

As of August there had been 2,919,604 subprime loans in the United States.  The loans averaged 90.9% as owner occupied.  In addition these loans had an average interest rate of 8.46%.  Most of the homes bought had been occupied about 36 months.  These loans were written to people with an average FICO score of 618.  FICO scores are usually intended to show the likelihood that a borrower will default on a loan.  A FICO score is between 300 and 850.   Speaking of FICO scores 20 percent of people are below 620 and 80 percent of people are above it.  If you think about grading A - above 780, B - between 745 and 780, C - between 690 and 745, D - between 620 and 690, and F - below 620.  Of the subprime buyers 1,933,597 people got a loan that required a prepayment penalty if they paid the loan off early or chose to refinance.  The average home has a LTV of 84.77%.  The loan-to-value (LTV) ratio is a mathematical calculation which expresses the amount of a first mortgage lien as a percentage of the total appraised value.  So the average subprime buyer bought a home with an average price of $183,917 with equity of $28,010.56.  Then consider that 335,035 had an interest only loan with a variable interest rate and they would start paying their loan with principle usually in less than 5 years.  Many of the people using subprime mortgages were refinancing and taking cash out of their home at closing.  Due to the housing boom most buyers were told that their homes were worth more as were those that were refinancing their home so 1,065,412 of the subprime mortgages written.  Within a twelve month period 57.6% had at least one late payment.  There were 57.3% that were current with loan payment.  The percentage of people that were 30 – 59 days past due or late on their mortgage payment was 10.2%.  The percentage of people that were 60 – 89 days past due or late on their mortgage payment was 5.3%.  The percentage of people that were 90 + days past due or late on their mortgage payment was 9.7%.  Then there were the foreclosures at 10.7%.  It is sad but then again 55.1% received their loan with little or no documentation.  Then there are the ARM adjustable rate mortgage subprime buyers and 62.9% were in such a class.  Usually they had a low interest rate and most of the time it was lower than a fixed rate loan the average ARM was 8.03% and the fixed rate was 8.46%.  This meant that the variable rate would let them buy a larger or more spacious home.  Today the ARM's usually change their rates once a year.  In August the new interest rate was 8.81%. 

Bailouts ?

In recent days we the citizens of the United States of America have been asked to make an investment in poor quality mortgage backed securities.  If we make these investments as you already know it is to the tune of $700,000,000,000.  

The Federal Reserve Chairman Ben Bernanke and Treasury Secretary Henry Paulson in conjunction with President Bush have made the case that such an investment is needed now.  

The Federal Reserve System which was created in 1913 by the enactment of the Federal Reserve Act is one of the groups encouraging such a bailout. The Federal Reserve System and its Reserve Banks issue shares of stock to member banks. The Reserve Banks are not operated for profit, and ownership of a certain amount of stock is, by law, a condition of membership in the System. The stock may not be sold, traded, or pledged as security for a loan; dividends are, by law, 6 percent per year.  

After paying its expenses, including the 6 percent to the Federal Reserve's share holders, it then turns the balance of its earnings over to the U.S. Treasury.  The Federal Reserve's income is derived primarily from the interest on U.S. government securities that it has acquired through open market operations. 

So let’s look at what we know the U.S. Treasury makes available; $700,000,000,000 in securities. Many of the stock holders of the Federal Reserve System are banks themselves and it is unknown if any of the banks looking for a bail out are stock holders of said system.  

The banks that are in need of selling bad mortgage investments can dump these bad securities to the taxpayers at the taxpayers' expense.  Once this is done the shareholders of the Federal Reserve System stock holders will earn $42,000,000,000 a year until the securities are bought back by the U.S. Treasury.  

Is such a bailout really needed?

On a 30 day U.S. treasury note you get 0.13 percent.  The Federal Reserve shareholders get 6 percent.  Also one thing to remember a bailout has already been made to Freddie Mac, Fanny Mae and AIG to the tune of another $285,000,000,000.

US Federal Reserve
US Treasury