Why Should any Loss be Recognized?

As I had mentioned in the comments before I will be on vacation all next week at the beach. When I go on vacation I take nothing that can connect me with "the world", no cell phone, no computer, and I will tend not to read newspapers though I may this time due to the NFL season being so close at hand.

FOMC Roller Coaster Wednesday
Today was the FOMC announcement on policy. I was both surprised at their statement and then I was surprised by reaction across almost all markets. I will not recount the exact statement, by now you have seen a copy.

To start, I will have to say that I was wrong on this one. I fully expected the FED to change their quantitative easing (QE) stance to expand the program both by amount of money and time until end. Instead the FED just squeezed the time frame out a month and did not add to the 300 Billion already communicated. I was wrong about this, and I fully admit it. I am going to try and give the FED some credit here and say that perhaps ramping down this one support program may be for real. I hope this is correct.

As far as the reaction to the news, well, it was all over the place. Heading into the 2:15 headline the dollar was lower, gold and silver were higher, and the indices were breaking out and up ( much unlike the Asian markets overnight). All of this action pointed towards a "QE surprise" expansion.

After the new policy stance was out, things went about as you would expect:
-equities dropped
-gold and silver dropped
-the dollar spiked higher

But then all that turned around in about 20 minutes and equities surged, metals regrouped and the dollar gave back the upside move it had just made. An example of the whipsaw (today's dollar chart):

With this kind of noise I do not want to draw any big picture ideas right at this moment. You could argue that the market thinks the FED was only kidding about ending QE (where do they get those ideas?) or that the FED statement added to confidence about the economic "recovery". I will want to see how this all shakes out a bit longer to make a final call. In any case, everything and anything was all over the place today.

For more FED related writing, I would point you towards a piece today by The Mess That Greenspan Made author Tim Iacono. Since relocating Tim has been writing better than ever (and that is saying something) and today he brings attention to a never mentioned problem with ultra low interest rates; namely the punishment of savers. No excerpt, it is a must read:
The Federal Reserve is Immoral

Why Should any Loss be Recognized?
Current US economic policy regarding bad asset prices has been termed such colorful names as "pretend and extend", "delay and don't pay", "running out the clock", and "mark to model". Ok, that last one is an actual banking term! All are descriptive of a concept where prices of today are deemed either incorrect or temporary, not reflective of fundamentals or true market forces. As this is the unifying force (Star Wars really obscure reference) behind policy it may be a good time to take a look at both a real world application, and then a hypothetical one. All names will be changed to protect the innocent.

Real World Application
Country XYZ had a burst bubble in their stock market. Their central bank, the FAD, over-reacted and lowered rates to all time lows and left them there for a long time. A cheap credit fueled binge on real estate ensued. This may all sound familiar, so I will skip ahead.

Faced with collapsing real estate values which were made worse due to all kinds of creative tricks to expand mortgage lending, the banks of XYZ are in real trouble. Many have failed and any left are in bad shape. (Did I mention that country XYZ has a fractional reserve lending system and thus even minor losses can cause total wipeout? No? Well, I just did.)

The Central Bank, FAD, sees a scenario where tanks will be on the streets if the banking sector implodes, so they embark on a novel strategy to survive the crisis: They take potential losses onto their books (taxpayer funded books) in an attempt to wait until "correct values" return to the markets and then the FAD can sell off their holdings and be made whole once again.

The idea that things will rebound is so persuasive that all kinds of leveraged instruments are included in this mix, and the FAD exchanges cash (treasuries) for anything rated "AAA" by some agencies paid by the banks.

Benefits to this program:
-Banks do not have to suffer liquidity (not solvency?) problems as they have the cash equivalent of their bad assets at full or almost full value
-The FAD can create as much money as needed to backstop the difference in now vs. future values
-Everything can continue as before with no hiccups

Immediate problems with this program:
-Banks are not punished, they are in fact encouraged, to make the same kinds of credit extension as before (some banks are even blamed for sitting on excess reserves, the nerve!!)
-The program discourages any progress towards remediation of the underlying issues

Potential problems with the program:
-Bad asset values either never reach "real value" or will not reach that valuation for many years, thus exposing the FAD to shortfalls
-As county XYZ is totally dependent on foreign investment, creditors may balk at such an abuse of money
-At some point the numbers get so large (a trillion used to be a big number) the math breaks down as it relates to tax receipts and budget issues

Assume for a moment that the FAD sees their work, and now they get inspiration to expand the program to cover all kinds of losses that are rooted in "temporary market dislocations". At this point no one has called their game, and so they decide to press on.

Hypothetical Application
Trading house Gilded Socks (GDSK) has losses stemming from stock market losses related to many holdings, not the least of which is the ticker GUUG. GDSK sees these losses as a function of a silly market, and does not want to post a loss if they sell (it's never a loss until you sell!) but they would like to dump the stock to raise cash to buy into another government program to rebuy their own bad assets using only 10% of their own money. I mean, who would not?

The FAD, seeing the dilemma, checks with the XYZ's Treasury department, and they give the thumbs up to a new program.

The FAD will accept all stocks at the holders buy price, regardless of current market price, and supply the cash equivalent. Now banks like GDSK have even more "excess reserves" with which they can play fun types of games with.

The FAD makes it clear that small investors need not apply as they are not a systemic risk, plus GDSK needs to unload other securities on them through their brokerage accounts, 401k's, and pension plans. It is a rough world.

The FAD figures at some point in the future (when exactly?) they will be able to recoup their losses when the true market price of GUUG comes back. On an alternate timeline (if you buy Everett-Wheeler theory) stocks such as Pets.com and Bear Stearns never came back, but the FAD is not a physics club.

In this way, here and now, I would propose that losses at any level never really have to be recognized. As long as you have willing creditors (we do) and you have the reserve currency (we do), and a compliant government (do we ever) than all losses can be postponed, delayed, and ignored until they disappear. As long as real estate tracks inflation (it has in the long run, returning on average over time 0-2% yearly) at some point yesterdays prices become tomorrows. Stocks will do the same (unless they go totally bust) and thus any loss can be ignored until the even mark.

Of course this all implies these assets reach a dollar denominated "value" which would make the central bank whole. If this recovery happens in 5 years or less, this show just may work. Anything more and it is a crap shoot.

I could mention that stocks are around where they were 10 years ago. I could throw out that home prices after the late 1980's-early 90's bust took about a decade to reach even. I could do that.

I recognize this is a gross simplification that does not take into many aspects I am aware of, and many I am sure I am not. This is a thought exercise, so treat it as such. If we can hide losses in the banking system the way we are, why not hide all losses ever on any level? Identify what would be the limits and what would be the breaking points. The comments section should be the sounding board, and you never know if a prize will be awarded.

Have a good night.