Make Believe Assets

by Larry Levin

In yet another lackluster low volume trading environment stocks churned - mostly. After multiple hours of garbage the market finally chose a direction: down. As if pouring water from a glass, the S&P futures plummeted without warning. The majority of the low volume churning is due to the fact that today and tomorrow traders are positioning themselves from the December contract to March '09. The rug being pulled out from under it in the afternoon was certainly a surprise.

Perhaps the afternoon plunge was caused by the CEO of J.P. Morgan? Jamie Dimon said many things this afternoon, most of which sounded like this: It's bad and probably getting worse.

Even with the government pledging your tax dollars (without your consent) to help Mr. Dimon steal Bear Stearns, he's not too happy. He said that reducing the risk of the remaining assets on Bear's balance sheet has been more expensive than anticipated because of the collapse in equity and credit markets. Question: How did he not see that coming? The cost of de-risking... in this market has been more expensive, he said in the CNBC interview. It's been painful.

I mentioned a few days ago that the government's attempt to make lemonade from rotten lemons hasn't faired too well: modified mortgages have re-defaulted at a rate of about 58% nationally. Jamie Dimon says JPM is not immune; it's re-default rate is roughly 30%.

However, since bankers have a DNA defect that prevents them from being truthful, I'd bet the re-default rate at JPM is roughly 50%. Come to think of it, bankers are so truth-challenged; they must be cut from the same cloth as politicians.

Speaking of bankers and their inability to tell the truth, they are now piling on more lies to their already massive piles of Level III assets (read: lies).

Banks are, if nothing else, entirely predictable. If there is a way to game the system, they will avail themselves of it. If there is no way to game the system, they will invent one. Take, for example, when times are good banks are capable of miraculously beating Wall Street's earnings estimates by one penny per share quarter after quarter after quarter. Their accounting monkey business was a way of availing themselves of in-place ways to game the system. Now that the economy has soured, they're not even attempting to beat estimates via in-the-open accounting shenanigans, they're demanding taxpayer handouts and abusing an invention of theirs that egregiously games the system: Level III assets.

Level I assets are assets where there is a market price; it is easily tradable. They are referred to as marked to market. Level II assets are those where there may not be much of a market, but they can nevertheless be priced in reference to similar assets that have a market price, and may be referred to as marked to model. Level III assets are a joke and are referred to as marked to myth.

What's more, Level III assets are off the books. This garbage isn't counted in the bank's balance sheets - it's essentially make-believe. Does Enron accounting come to mind? But guess what - it's legal. That's right; the idiots in CONgress say it's OK for the government, and the banks to play this game. But you? Not so much. If you try it, the IRS will throw you in jail!

Why do I and even Wall Street itself say that Level III assets are marked to myth, or marked to make believe? Because these assets are priced using unobservable inputs. What? Is that a joke you ask? No - and it's legal! I have never understood this concept, because the use of sunspots, skirt lengths, the Mayan calendar, or a model using, say, a ratio of bullish versus bearish stories on Bloomberg would be an observable input. So what the hell is an unobservable input? We'll never know because much like the Federal Reserve printing money up out of thin air, the values are simply made up.

In the first quarter of 2007, Wells Fargo created $1.21 billion of Level 3 gains. Without them, it would have posted a loss. Lehman Brother's added more assets to the Level 3 category at a time when better trading conditions said it should have been lowering them.

But that was a long time ago and the bankers have surely come clean - right? They have learned that playing fast and loose with leverage and the truth was bad and now they want to help the economy get on its feet as fast as possible by having balance sheets as clear as glass - right? Haaaahahahahahaaaa! If you believe that, you better get off the dope Johnny Boy!

What do we see now? The financial services industry has a world-class bad quarter and instead of having a kitchen sink, come to Jesus type of quarterly release (divulging everything), they INCREASE the amount of bull$#*! assets it considers to be Level III so that they can assign them more favorable prices. Did I mention this is legal? Moreover, year end financials are audited and accountants have been much less accommodating of late. Moving a lot of assets into the Level III puke-bucket right before your auditor walks in might not pass the smell test, but it's better to do it at least a quarter in advance. The smell isn't so rank then.

My friends, this is a MAJOR reason why the credit markets are so tight. All of the banks know what toxic sludge is in their own Level III asset account, so do you think they want to lend to another bank or commercial institution with a huge & hidden Level III asset account? And what if these BS assets are growing? Hell no - no loans for you! The scummy politicians on TV have never mentioned this once, and probably never will.

Yes, these banks are becoming LESS transparent and truthful, and more opaque.

From the Financial Times:

The biggest US financial institutions reported a sharp increase to $610bn in so-called hard-to-value assets during the third quarter, raising concerns about the hidden dangers on balance sheets.

So-called level-three assets, classified as hard to value and hard to sell, rose 15.5 per cent from the second quarter, according to analysis by the Market, Credit and Risk Strategies group of Standard & Poor's.

Level-three assets have risen all year for most banks as they have found it virtually impossible to sell mortgage-backed securities and collateralized debt obligations.

"A lot of banks are saying: 'I am going to move securities to level-three assets because I have more control over, and confidence in, the model used for their valuations'," said Gregg Berman, head of the risk management unit at Risk Metrics. (Un-huh, risk management can do a good job with make believe valuations? Where have I heard that before?)

The study is based on regulatory filings by the biggest underwriters and traders of mortgage-backed securities and CDOs. These asset classes have plunged in value amid a wave of house price falls and foreclosures and are at the centre of the crisis.

Michael Thompson, managing director of MCRS, said he would be "surprised if we did not see write-downs of these level-three assets" in the fourth quarter.

Already, level-three assets are many times bigger than the market cap of the banks.

Read that last paragraph again. The Level III toxic slime assets (why else are they in the make-believe account?) are now larger than the ENTIRE market caps of the banks. That is sickening folks, because it's all BS - and ALL LEGAL.

Until this is either completely divulged or made illegal, the credit crisis will not end.

Previous Day's Trading Room Results:

Trade Date: 12/11/08

E-Mini S&P Trades*
(before fees and commissions):

1) VA sell @ 8:30am at 890.00 = +4.25 (1 lot)

2) OTF buy @ 10:00am at 896.75 = +3.00 (1 lot)

3) OTF sell @ 10:50am at 901.50 = -1.75 (1 lot)

4) VA buy @ 1:10pm at 890.00 = -1.50 (1 lot)

5) TP buy @ 1:25pm at 890.50 = -2.25 (1 lot)

6) Algorithm positions (4)...combined daily total...-0.50

ZB (30 Year Bond) Trades*
(before fees and commissions):


1) No trades today.



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