Our nation's politicians like to lecture us about free markets whenever we lose our jobs. So maybe the news from yesterday surprised you a little.

The Financial Accounting Standards Board, under pressure from lawmakers, will reconsider its timeline for a controversial rule change that may force banks to bring trillions of dollars in off-balance sheet assets onto their books at its Wednesday meeting.

The rule changes would have put about $5 Trillion of off-balance sheet assets, mostly consisting of mortgage-backed securities, onto the books of the nation's financial institutions. It now appears that the start date for these new accounting rules won't go into effect until after November 15.

After years of efforts by regulators to force financial institutions to open their books to investors, why the sudden change of heart?
To understand that you have to understand what a derivative is, what a Level 3 asset is, and what the National Australia Bank did just a few days ago.

"[Derivatives are] financial weapons of mass destruction and pose a mega-catastrophic risk for the economy."
- Warren Buffett, multi-billionaire investor

First of all, let's address the notable action that the NAB took over the weekend.

NAB’s exposure to the US property market through the CDOs held in its conduits is relatively small – $1.2 billion worth of structured finance assets. The money is in 10 collateralised debt obligations (CDOs) in two conduits (off balance sheet vehicles to which NAB provides “liquidity”).

Leaving aside the dodgy nature of the vehicles, the assets themselves were all rated AAA, which technically means a one in 10,000 chance of default.

Stewart, Chaney and the NAB risk committee have now assessed the prospect of loss at 90 per cent, that is a 9,000 in 10,000 chance of default. In other words, the securities have turned out to be far worse than junk.

To repeat: NAB is now expecting 100 per cent loss on $900 million worth of AAA rated debt securities.

So what? So the aussies lost some money on American real estate like everyone else. What has this got to do with me? To answer that, let's look at what happened at Merrill Lynch just yesterday.

Merrill said it will sell a large portion of asset-backed securities and terminate hedges linked to bond insurers; those are two of its most troubled areas since the credit turmoil began last year. It reported earlier this month its fourth straight quarterly loss and write-downs from failed investments approaching $40 billion.

Lone Star Funds, a Dallas-based distressed-debt investors based run by John Grayken, will acquire asset-backed securities with a nominal value of $30.6 billion for $6.7 billion. The sale will help cut Merrill's exposure by $11.1 billion from its level on June 27, leaving $8.8 billion of these securities on its books.

For those of you who aren't very quick with math, Merrill is selling those securities for 22 cents on the dollar. Not quite as bad as the 100% write-off by NAB, but close enough. What the article didn't mention was that Merrill was also loaning Lone Star Funds 75% of the cash needed to "buy" these assets off of them.
So then you might ask, what does Merrill have to do with NAB? It turns out, everything.

The National Australia Bank's shock write-down of $830 million worth of collaterallised debt obligations (CDOs) can now be explained.

It was triggered by a move from struggling US investment bank Merrill Lynch to get rid of billions worth of CDOs in which the NAB was a co-investor.

Merrill's took a decision to sell the CDOs at a written-down value and the NAB had no option but to follow suit. Its larger write-down than Merrill Lynch (90% vs. 78%) reflects its lower ranking of security.

Welcome to counter-party risk, American-style.
Most of these mortgage-backed securities current live off-balance sheet, where they don't show up on a bank's quarterly report. The bank gets to play make-believe and keep giving huge bonuses to its executives, while telling its shareholders that its portfolio is still strong and solvent.
All the while these supposedly AAA-rated securities decay. At least until after the November election, that is.

Entering Level Three

Banks group their assets into three different levels of accounting.

1) Level 1: Mark-to-Market. These assets are liquid (like Treasuries) and their market values can be easily checked.

2) Level 2: Mark-to-Model.

"Assets that have quoted market prices for similar instruments in active markets, quoted prices for identical or similar instruments in markets that are not active, and model derived valuations in which all significant inputs and significant value drivers in active markets."

There are about $4 Trillion in Level II assets on bank balance sheets.

3) Level 3: Mark-to-Make-Believe.

Level Three assets are the least liquid of the firms' trading assets and therefore are valued using what are called "unobservable inputs."
Level Three assets include real estate, mortgage-backed securities, private equity investments and possibly even "undertakings of great advantage, but nobody to know what they are" (cf. South Sea Bubble).
The three magic words that make an asset a Level 3 asset are "no observable inputs." What this means is that not only are they hard to price, but nearly impossible to sell.

Level 3 assets aren't some tiny problem.
For instance, Bear Stearns had 314% more Level 3 assets than capital before it went bust. Merrill Lynch had 225% more Level 3 assets than capital before this latest fire sale. Morgan Stanley, Goldman Sachs, Lehman Brothers, Citigroup, and Fannie Mae all have much more non-liquid assets sitting in Level 3 than they have capital.

Speaking of Merrill Lynch, they are largely unable to raise new capital because of limitation on equity issues when they accepted capital from Temasek (the Singapore sovereign wealth fund) earlier this year. Thus they were forced into doing this fire sale of illiquid assets.
The one thing that the banks don't want to do is to have to find out the real price of these assets at market value. Once they know the value they have to acknowledge the losses.
Citigroup is also in a similar situation when it comes to raising capital.

It's this sort of worthless cr*p that the new regulations will effect. It's this sort of toxic waste that the banks want to keep off their books, and the Federal Reserve is doing everything it can to help in this regard.
The Fed has gutted its own portfolio by trading Treasuries for mortgage-backed securities and other illiquid assets from investment banks.

The Fed has qualified this by saying that it would only accept AAA-rated securities in exchange. This claim seems laughable when you consider that NAB just wrote off 100% losses on so-called AAA-rated securities.
More importantly, the Fed can't keep this up. According to their last report, their holdings of Treasury securities and "bills were nearly exhausted".

To understand the sheer magnitude of the problem, we must look at what a derivative is.

Weapons of Financial Mass Destruction

Derivative: a) measurement of how a function changes when the values of its inputs change, b) financial instruments whose value is derived from the value of something else.

" Derivatives generate reported earnings that are often wildly overstated and based on estimates whose inaccuracy may not be exposed for many years."
- Warren Buffett

I generally try to stay away from the speculative, doom-and-gloom topics because they tend to get associated with the tinfoil hat crowd. But when that topic shows up in the New York Times, it is no longer in the realm of tinfoil hats.

Credit default swaps form a large but obscure market that will be put to its first big test as a looming economic downturn strains companies’ finances. Like a homeowner’s policy that insures against a flood or fire, these instruments are intended to cover losses to banks and bondholders when companies fail to pay their debts.

To put it simply, a credit default swap (CDS) is a bet between two parties on whether or not a borrower will default on its bonds. The insurer collects premiums from the other party and only has to pay in the case of a default. The swap itself can be sold by either party to a third party.

So far so good? Not so fast.

But during the credit market upheaval in August, 14 percent of trades in these contracts were unconfirmed, meaning one of the parties in the resale transaction was unidentified in trade documents and remained unknown 30 days later. In December, that number stood at 13 percent. Because these trades are unregulated, there is no requirement that all parties to a contract be told when it is sold.

As investors who have purchased such swaps try to cash them in, they may have trouble tracking down who is supposed to pay their claims.

To put it another way, the market is almost completely opaque and unregulated.
No one necessarily knows about such investments because they exist off the books, and don't show up in the report or balance sheets of either party. This causes all sorts of problems. For instance, does the holder of the swap actually have the capital to cover a default? An even bigger problem is what happens when a deep recession hits and defaults skyrocket? By spreading the risk around with CDS no safe place remains.
If this sounds suspiciously like Enron, it's because derivatives were the main product that Enron dealt with.
There are other issues as well.

"PAI" (publicly available information) must generally be used to trigger the CDS contract. Recent credit events have been straightforward Chapter 11 filings and bankruptcy. For other credit events (failure to pay or restructuring), there may
be problems in establishing that the credit event took place.

This has a systemic dimension. A CDS protection buyer may have to put the reference entity into bankruptcy or Chapter 11 in order to be able to settle the contract. A study by academics Henry Hu and Bernard Black (from the University of Texas) concludes that CDS contracts may create incentives for creditors to push troubled companies into bankruptcy. This may exacerbate losses in case of defaults.

No one has any idea just how sound the market for these derivatives are is open to speculation. That isn't a big deal until you realize that 15 years ago there were no CDS, and now the CDS market is 4 times the size of America's GDP. So how could the government fix a market that is 4 times the size of the GDP if that market freezes up? It's impossible.

The global market for all derivatives is about $500 Trillion. The total global GDP is about $60 Trillion.

Who are the players?

What brought this obscure financial instrument to the attention of the media was troubles at American International Group Inc. (AIG), the world's largest insurer.
It seems their estimated losses had jumped from a $1.2 Billion to $4.88 Billion. The reason for the losses was their exposure to credit default swaps.

AIG's auditors found ``material weakness'' in its accounting for the contracts, and the firm doesn't know what they were worth at the end of 2007, the filing said.

The fact is that even AIG can't tell how much they lost, why they lost it, and how much their remaining CDS are worth.

Not once in its seven-paragraph narrative discussion did AIG say how or why the gross losses on these derivatives had soared after Sept. 30. Rather, in almost-unintelligible jargon, it told how in November it developed a new ability to value some large offsetting gains -- and how it then decided this month to exclude most of them because the data weren't reliable.

And that $4.88 Billion was only through November 30. Considering the credit market troubles of December and January, that number is likely to rise a great deal.

To put this into perspective, AIG only holds about $500 Billion of CDS.
The largest holder of CDS is JP Morgan Chase with $7.8 Trillion. Citibank holds $3 Trillion, and Bank of America another $1.6 Trillion of CDS.

While JPM, Citi, and BofA have been taking body blows from the current troubles in the credit markets, they have yet to acknowledge any significant losses from their CDS holdings. Doesn't that seem rather unlikely given the troubles at AIG?
It seems a lot more likely that the opacity of the CDS market is allowing these major banks to hide their losses. It's even possible that the banks don't even know how much they have lost.

Which brings us back to the NAB and the implications of their actions.

We are now way beyond sub-prime. NAB says that it is suffering a 55 per cent loss on American housing loans – an event that has never happened in the history of a developed country in recent memory. This is an unprecedented event and means that the cost of bailing out the US financial system is now far beyond the highest estimates. A US recession is now locked in, but more alarmingly, 55 per cent loan losses point to the possibility of a depression.

It means the cost of bailing out housing exposures to the two mortgage insurers will be so great that it will leave no room to bail out anything else and there are several US banks that are now in big trouble.

"Big trouble" is one way of putting it. "Insolvent" is another, more accurate way.