From http://twocents.blogs.com/weblog/2008/12/the-last-waltz.html
December 05, 2008
Much has been written recently about the losses caused to banks and corporations from the necessity of marking mortgages and other derivative debt to the current market price on a regular "fair value" basis. If a bank owned a mortgage, or whatever type of package or derivative, some of the FASB and international bank rules required carrying the asset on the books at its current market value even if it was still making regular payments, and regardless of credit rating (with some adjustments permitted there). So as prices of good and bad debt fell off the table this year, the asset side of the balance sheet was being decimated.
But what about the liability side of the balance sheet? With interest rates collapsing this year, and particularly in the past three months, what is the effect on the "fair value" of higher rate debt? If a bank or corporation issued debt at 7% and the rate is now 4%, the market value of the debt has risen dramatically. If a bond was issued at $1000 per bond at 7%, and ignoring credit and other considerations, and the interest rate falls to 4% (just for example), the bond would theoretically rise to $1750, all else being equal. Of course all sorts of factors enter into bond prices, so let's say the current value of the bond in the market is only $1500. Still, the mark to market rule would seem to demand marking the liability to $1500, not the $1000 due at maturity. Why? Because that IS the market price, and if the company had to redeem its bond early to reduce debt for loan coverage or other reasons, that's what it would have to pay in the market, unless they have preferential early redemption clauses, just as it would get less than face value for the depreciating mortgage bond it bought at par if forced to sell it. In this case of a liability during falling interest rates, if forced to redeem it early, the company or bank would have to pay 50% more than what it sold it for.
If they have enough bad assets marked to market lower, and appreciated liabilities marked to market higher, they'd be bankrupt in no time. And so many corporations really are bankrupt at present and some have been for years. But they are not as rigidly required to mark their liabilities to market. FASB 157 says this: "This Statement clarifies that a fair value measurement for a liability reflects its nonperformance risk (the risk that the obligation will not be fulfilled). Because nonperformance risk includes the reporting entity’s credit risk, the reporting entity should consider the effect of its credit risk (credit standing) on the fair value of the liability in all periods in which the liability is measured at fair value under other accounting pronouncements, including FASB Statement No. 133, Accounting for Derivative Instruments and Hedging Activities." So the "non performance risk" at maturity or before is at the discretion of the reporting corporation, and the market price NOW is not used. So if the bond is trading at $1500 and payoff at maturity is $1000, the liability will be rated at $1000 or lower, not at $1500 which is the current market price. The net effect is to overestimate assets and underestimate liabilities. This in turn makes it look like the corporation has a lot more capital than in fact it has. It may be bankrupt, but it has phantom capital on the books as will be apparent when it goes bankrupt or merges and its bonds are due and payable or must be realistically valued or assumed.
Your eyes are glazing over, but that is how crooks pull one over on you. The corporation (or bank) has an asset they bought for $1000 that pays 12% but is now worth $500 because of credit risk in a bad market, and a liability they issued at $1000 that they pay 7% on that is now worth $1500. But they are carrying the liability at $1000 on the books. So they are not losing just $500 but $1000 on the transaction. The real clearing or liquidating loss is $1000 on a $1000 investment. Nothing has been bought or sold so they have $1000 less net capital than they are reporting. Multiply this by billions. That's where we are.
Collapsing interest rates are bleeding the capital out of companies via their debt. The lower the rates, the higher the market or liquidating value of their debt, bearing in mind the spreads between corporate and government debt which continue to rise. The point simply is that corporate liabilities keep increasing as interest rates fall while bad assets are falling. At some point the curtain is pulled and the corporation fails. The creditors of the corporation's debt are left only with the bad assets. Big deal you say, but the corporation appeared to have adequate capital and it actually didn't.
This is a highly simplified explanation, but the principles are valid and clear
The US Treasury issues its debt in US Dollars and the debt is non-callable, unlike the situation with some or much corporate debt, so when its interest rate falls in half, the market value of its debt doubles. Its interest rates fall during deflation when its tax inflow also falls due to a falling GDP. If the long bond interest rate falls from 6% to 3%, which it has nearly has done since 1999, its book debt value doubles in price even as its ability to pay that debt falls. The same is true for a householder with large debt/income or debt/asset ratios. This is why deflation and falling rates (same thing) are self-replicating or reinforcing. This has been going on for 27 years since long term bonds were issued at over 15% in 1981! The US Treasury has been bankrupting itself for 27 years and is increasing the pace recently as bond rates collapse. It's great for people who own long term government bonds unless they have bonds about to expire. They were getting 6-8% ten to twelve years ago, but could only get about 3.25% now if they had to reinvest the payoff. So bond investors have less value (due to inflation) and will earn less income on it if they reinvest in similar current bonds. It's a financial loss in every way, except for bond speculators. They can borrow short term at falling rates and gain long term at magnified falling rates all the while earning the high coupon payment on the original debt.
This is exactly what happened in the US in the 1930's and 40's, and has been happening in the US since 1981 and in Japan since 1990. AND therefore US T Bond total returns (capital gains + coupon payments) have outperformed the total return SP500 (including reinvested dividends and NO paid taxes deducted) for 20 years! Who says bonds are boring and stupid?
http://twocents.blogs.com/weblog/2008/11/lost-decade-or-lost-generation.html
Given all of this, tell me, if you can, WHY the FED and government are trying to push interest rates even lower? Most corporations are actually bankrupt already, and the US and most other governments are also bankrupt when "marked to market" on both the asset and liability sides of the ledger. Oooooops, the waltz band is about to stop playing and are leaving the stage playing since they haven't been paid.
Bottom line: Own zero coupon long US treasury bonds with a large offsetting cash gold position. I'll leave it to you when and how to buy. I'm not an adviser.
http://www.bloomberg.com/apps/news?pid=20602007&sid=aW9fPWXu13_g&refer=govt_bonds
http://www.professorfekete.com/articles/AEFIsOurAccountingSystemFlawed.pdf
December 05, 2008