Fragile Fantasy

Don't get me wrong
If I come and go like fashion
I might be great tomorrow
But hopeless yesterday
--The Pretenders

This past week saw FASB finally bow to pressures from Wall Street and Washington to ease accounting standards. Mark-to-imagination seems eminent.

Three conditions are contributing towards the move towards fantasy:

Illiquid assets. Assets that don't trade every day are harder to price. Perhaps more importantly, the spread between the bid and ask on illiquid assets is usually quite wide. Quick sale of an illiquid asset, such as a house, usually means that the seller must settle for a significantly lower price.

Declining prices. Again, quick sale of an illiquid asset falling in value usually means bigger losses.

Leverage. This is the biggie. Let's say you're debt free and have $100K in cash. You take the cash and buy $100K in illiquid mortgage-backed securities (MBS). Prices subsequently fall an estimated 5%. That stings but no immediate action is required. If you can stomach the 'paper loss', you might rough it out in hopes of a rebound in prices.

Now let's say you run an investment fund and you have $100K to invest. Your 'prime broker,' basically a high powered lender, will loan you money so that you can borrow $9 for every $1 in capital that you have, as long as you maintain a 9:1 debt:capital ratio. You do so and prices of the MBS subsequently decline 5%. Your original $1 million in MBS assets is now worth $950K, your equity is now $50K, and your debt:capital ratio is now 18:1. Your prime broker calls and demands that you either a) come up with an additional $50K to make up for the loss in capital, or b) sell $450K in assets to get your debt:capital ratio back to 9:1. This is known as a 'margin call.'

Note how leverage magnifies the loss. In this case the nomial 5% loss turns into a -50% return on capital. Note also that at a greater than 10% price decline in the leveraged scenario above, the investor would have negative equity (a.k.a. being 'upside down') and effectively wiped out in a margin call.

Worldwide financial markets currently fall into some variation of the leveraged scenario portrayed above. In some markets, however, financial asset prices have fallen at least 20-30%. And the leverage employed was 20 to one or more.

As such, much of the global faces a huge margin call. Rather than coping with it like adults, we're skipping off to the land of make believe like children.