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Nestmann: You’re Not As Rich As You Think

Guest post by Mark Nestmann from Nestmann.com:

Most wealth is imaginary. That could be seen as a provocative statement, but it’s true.

Consider your stock portfolio. Let’s pretend that you own 100 shares of IBM. At a trading price of $150 per share, your stock is worth around $15,000. And if you were to sell all of your shares tomorrow, you could reasonably expect to sell each of your shares – from the first share to the last one –for very close to the prevailing price.

But thanks to a concept known as “mark-to-market accounting,” companies calculate the value of all the ordinary shares in a publicly-traded company – the “float” – at the price at which those shares trade. Currently, IBM’s float amounts to 903.1 million shares. At $150 per share, those shares are worth more than $135 billion.

Let’s say that you’re massively bullish on IBM, and also very wealthy. You decide to purchase a huge block of those shares – perhaps 400 million of them. That would represent around 44% of the company’s shares and make you IBM’s largest shareholder by far.

At $150 per share, the value of 400 million shares would be $60 billion. But would you really be able to acquire 400 million shares of IBM for anywhere close to $60 billion?

You probably wouldn’t, and it’s easy to see why. Once you start buying a lot of shares – more than a tiny percentage of them – it’s likely the price would go up. You might be able to buy 1% of the float at a price reasonably close to the then-market price. But once you’ve bought all 200 million of them, you’d likely spend a lot more than $60 billion.

While we have no idea what the actual number would be, let’s say it’s $120 billion, representing a price of $300 per share. And that number – $120 billion – would, thanks to mark-to-market accounting, show up on your balance sheet as the fair market value of those shares.

But one day, you decide to sell. You quickly discover that the more shares you sell, the lower their market price falls. When you’re done, you wouldn’t realize anywhere close to $300 per share. You might get back $150 per share – the price before you started buying. On your personal balance sheet, you’d net a $60 billion loss.

This simple thought experiment assumes that between the time you buy and sell your IBM shares, there’s no material change in economic conditions, market psychology, or in the company’s profitability that would influence its price. That makes it easier to illustrate that mark-to-market accounting creates a wealth illusion when prices are going up. And when prices fall, that illusion can be shattered very quickly.

Consider the market for residential mortgage-backed securities (MBSs), for instance. You may recall that residential MBSs were the darlings of the investment world back in the early 2000s. But in the runup to the 2007-2009 financial crisis, they became toxic.

With MBSs, banks or mortgage brokers lending money to homebuyers didn’t need to worry if the mortgage would ever be repaid. That risk was transferred to MBS buyers. The lenders thus used very loose underwriting standards – or no standards at all – to issue mortgages because they knew they risked nothing.

As long as real estate prices went up, the risks looked manageable. Even if a homebuyer had poor credit and stopped making payments on their mortgage, the home could be foreclosed and resold at a profit.

In the meantime, MBSs became incredibly popular, especially with institutional investors. Financial institutions stuffed themselves on MBSs and generated enormous profits by collecting the mortgage payments. As the value of MBSs soared, mark-to-market accounting ensured that their market value was reflected in their balance sheets.

But in 2006, home prices started declining. And many of the highest-risk borrowers stopped paying on the mortgages that had been stuffed into MBS portfolios. That led to steep losses in those portfolios. The same financial institutions with huge MBS exposure now found themselves forced by mark-to-market accounting rules to write down the value of those investments to their market values.

One of the biggest players in the MBS market was investment bank Bear Stearns. On January 12, 2007, its shares closed at an all-time high of $171.51. With a float of 118 million shares, the market value of Bear Stearns stock exceeded $20 billion.

But only 14 months later, JP Morgan Chase, backed by the Federal Reserve, scooped up Bear Stearns for $236 million – around $2 per share. JP Morgan Chase later sweetened its offer to $10 per share. Still, that represented a $19 billion loss in the company’s value.

The mark-to-market wealth illusion is a well-known economic phenomenon. And it applies to all sorts of markets.

Take cryptocurrencies, for instance. Unlike the stock market, which is relatively transparent and highly regulated, cryptocurrency markets aren’t at all transparent. And at least in comparison to stocks, they’re very lightly regulated.

In the last 18 months, the market capitalization of the many thousands of cryptocurrencies that exist has fallen from around $3 trillion to $850 billion. The largest cryptocurrency by market cap is bitcoin, with a mark-to-market value of around $326 billion.

We must confess to not having any idea what the “real” value of bitcoin is. Indeed, we’ve read estimates ranging from zero to more than $500,000 per BTC. The only thing we’re reasonably certain of is that if “Satoshi Nakamoto” – the pseudonym used by bitcoin’s creator(s) – attempted to sell the 1.1 million BTC they hold, the realized price would likely be far less than the current $17,000 per BTC.

Personally, we favor more tangible forms of wealth than stocks or cryptocurrencies. An unmortgaged home, for instance, has considerable utility. You can live in it, of course, or rent it out. Or you can sell it – although the value it fetches might be less than what you’d like to think it’s worth.

We’re also fans of gold – in the form you can hold in your hand; not the gold ETFs that merely track gold prices. Gold’s price performance in the last year has been anything but impressive, but the metal that economist John Maynard Keynes called a “barbarous relic” has a 5,000-year-old history of protecting wealth.

Of course, if you somehow cornered a big chunk of the world’s homes or gold, then try to sell them quickly, you’d soon discover that the price buyers were willing to pay would fall. Even then, we’d still prefer those assets since they have intrinsic value; real estate as a place to live and gold as a medium of exchange.

That’s more than you can say for shares in Bear Stearns. Or in bitcoin, for that matter.

On another note, many clients first get to know us by accessing some of our well-researched courses and reports on important topics that affect you.

Guest post by Mark Nestmann from Nestmann.com.

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