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Quelle Surprise! Banks Increase "Mark to Make-Believe" Assets to $610 Billion

Banks are, if nothing else, entirely predictable. If there is a way to game the system, they will avail themselves of it.

Readers may recall that the Financial Standards Accounting Board implemented Statement 157, which required financial firms to identify how they arrived at the “fair value” for their assets. Level 1 are ones where there is a market price. Level 2 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.

Then we have Level 3. They are priced using “unobservable inputs.” 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. And fittingly, Level 3 is colloquially called “mark to make believe.”

And there are indeed signs that indicate that financial firms have playes fast and loose with this rule:

1. In the first quarter of 2007, Wells Fargo created $1.21 billion of Level 3 gains. Without them, it would have posted a loss.

2. Lehman added more assets to the Level 3 category at a time when better trading conditions said it should have been lowering them

However, it is now completely kosher to play games. While the three-level hierarchy became effective on January 1 of this year (some firms chose to comply early), the SEC largely gutted it in the wake of the Bear collapse. From its March press release:

Fair value assumes the exchange of assets or liabilities in orderly transactions. Under SFAS 157, it is appropriate for you to consider actual market prices, or observable inputs, even when the market is less liquid than historical market volumes, unless those prices are the result of a forced liquidation or distress sale (boldface ours).

We noted back then:

But now the SEC has given banks and brokers a huge out. No matter how small or easily absorbed by the market a forced sale might be (think of a hedge fund hit by a margin call), a financial institution can ignore the price realized. In fact, they get to determine what trades constitute a forced sale.

Fast forward to today. What do we see now? The financial services industry has a world-class bad quarter. So what does it do? increase the amount of assets it considers to be Level 3 so it can assign them more favorable prices.

And there is possibly a second reason for this move. Year end financials are audited. Accountants have been much less accommodating of late. Moving a lot of assets into the Level 3 bucket right before your auditor walks in might not pass the smell test (although once you have done that, they really cannot question how they are marked). Better to do it at least a quarter in advance.

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 collateralised 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.

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 writedowns of these level-three assets” in the fourth quarter.

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

Ahem, the whole point of this exercise is to take lower writedowns than you would have otherwise.

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41 comments

  1. ndk

    I think FairEconomist’s points, particularly about the collateral damage from the breakdown of pricing functions, were pretty good. This continued obfuscation of information just inflicts further damage on the real economy, as agents can’t make rational decisions. Given what’s probably rational now, though, maybe I should be thankful for that.

    To be honest, I’m not even sure why reported losses or marking assets are bothered with at this point. It’s theatre, and everyone knows it’s theatre, because nobody’s going down. They’re certainly not worth any time in analysis. When a thrift is finally too dead to ignore any longer, there’s been a fairly consistent 35-40% of total assets hit to the FDIC. I find that to be a more useful deflator than anything going through this meat grinder, but even that was many months ago, in better days.

    Bank assets should be treated as an OBS obligation of the USG at this point. 5yr Treasury CDS hit 67 bps, 16 wide to Campbell’s Soup. That’s because Campbell’s Soup isn’t studying Novel Approaches to selling even more debt.

    One of those novel approaches is having the Fed buy longer dated Treasuries, which means they still want the earlier trial balloon probably didn’t float very far.

  2. bg

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

    this is the key point. Level 3 assets are much larger than their net assets, then only a small write down puts them at negative net worth. Level 3 assets have been moving at distressed prices for a year, otherwise they would be level 1 or 2.

    As someone who continues to enter short positions against banks, I believe the obvious. No matter how much the government puts in, the equity holders are toast.

  3. bg

    ndk,

    “This continued obfuscation of information just inflicts further damage on the real economy”

    This is true only if the truth doesn’t kill us. The government is complicit in the obfuscation, which implies (to me) that the truth needs a bank holiday due to larger threats to the real economy.

  4. ndk

    This is true only if the truth doesn’t kill us. The government is complicit in the obfuscation, which implies (to me) that the truth needs a bank holiday due to larger threats to the real economy.

    I agree, but the vacation from reality continues to degrade the underlying situation. You have to presume you’re helping faster than you’re hurting and have an exit strategy in mind.

    There’s obviously no way to know, but I wish I could be in an alternate universe for a day where BSC was allowed to go down cleanly. I’d imagine there would be a quick chain cascade of defaults, and massive destruction of wealth. My gut is that, barring major unrest, it would lead to a much better and faster recovery.

    Something else in that Bloomberg article; the fails problem appears to have been ameliorated significantly. That’s positive, at least.

  5. bg

    “I wish I could be in an alternate universe for a day where BSC was allowed to go down cleanly. I’d imagine there would be a quick chain cascade of defaults”

    I have had the same fantasy. The problem is that a decision maker weighs things differently than a thinker. Unknowns and risks tend to clog up the neural networks, and the less opaque solution begins to look good.

    Historians are thinkers, and your conclusion will probably be what is written later.

  6. kfunck1

    Usually, the firm that does the quarterly reviews is also the auditor (at least that’s what they teach us in school), so you would HOPE that they wouldn’t just let them move crap around without justification. I can see them justifying moving pretty much anything into L3 given how tumultuous the market has been. If the Fed succeeds in unfreezing the market for the various now L3 “assets,” they could potentially cause the banks to move those back out of L3 and recognize those FV changes, assuming they aren’t bought by someone (*cough* Fed/Treasury *cough*).

  7. ndk

    Historians are thinkers, and your conclusion will probably be what is written later.

    Speaking of which, I’d like to wave and say hello to the future historian who will exhume these comment sections in 2050 in an attempt to capture the dialogue and feelings of the era. The revelations of modern science are rarely those of a single individual, but instead the collective work of a community. We’re all naked, and far more moral than those with Emperor’s clothes.

  8. wintermute

    Steve Forbes was interviewed recently (CNBC I think) and he savaged mark-to-market valuation as the single biggest cause prolonging the credit crisis. I could not believe him spouting such stupidity.

    For 20 years our equity trading positions (thousands of them) have been religously marked-to-market every single day. Official exchange closing prices are used (unless we are perfectly hedged with a fully fungible equivalent such as ADRs/Ords)

    If mark-to-market was used properly before the credit crisis – then there would be less leverage and smaller bubbles and less illiquid markets forcing “distressed prices”. There has been a positive feedback cycle into bad valuations. It is a failure of proper regulation allowing even the concept of Tier 3 capital to exist.

    We will not learn the lessons of this crisis listening to detractors of MTM like Forbes.

  9. BMH

    @ndk re mellon. Now basically everybody is crying for bailout and fiscal stimulus. Very few voice the idea of debt liqidation. It has come up as an idea at this blog and at Hellasious sudden debt.
    As I have only my common sense working for me lacking training in the field of economy I do have difficulties to think of a roadmap to stability of the financial system without addressing the debt/insolvency issues first.
    Mellon could not have been a complete moron, see quote below. I whish there would have been powerful voices with regard to the injustice of taxing income earned through paid work higher than income on capital gains.

    “The fairness of taxing more lightly income from wages, salaries or from investments is beyond question. In the first case, the income is uncertain and limited in duration; sickness or death destroys it and old age diminishes it; in the other, the source of income continues; the income may be disposed of during a man’s life and it descends to his heirs. Surely we can afford to make a distinction between the people whose only capital is their mettle and physical energy and the people whose income is derived
    from investments. Such a distinction would mean much to millions of American workers and would be an added inspiration to the man who must provide a competence during his few productive years to care for himself and his family when his earnings capacity is at an end.”

  10. ndk

    Honestly, BMH, I have a soft spot in my heart for a few of the old robber barons. While their exploit of capitalism was grotesque in its own time, it seems they had community, philanthropy, and the best interest of the country still in their hearts. True patriotic spirit is worth more than any dollar issued under its regime.

    I want to see both America and humanity in general thrive under the auspices of both wise regulators and ethical greed — and yes, I still believe in both such things.

    Wake me when Greenberg or Geithner University opens its doors.

  11. Ginger Yellow

    “For 20 years our equity trading positions (thousands of them) have been religously marked-to-market every single day. Official exchange closing prices are used (unless we are perfectly hedged with a fully fungible equivalent such as ADRs/Ords).”

    That’s fine, but the whole point is that official exchange closing prices aren’t available for these over the counter products, and in many cases no firm prices are available whatsoever.

    I’ve got to say, Yves, I think your interpretations are a little off base in this post. Certainly mark to market should be used where possible, but the fact is that for huge numbers of instruments there simply hasn’t been any trading, especially since the Lehman bankruptcy. What market are you going to mark them to?

    Also, I’m certainly not saying there isn’t room to game the system or that it hasn’t been gamed, but distressed sales have never been used in fair value measurements since fair value was introduced. And there’s plenty of guidance as to what constitutes a distressed sale.

    Here’s how the FASB describes an entity appropriately moving a CDO tranche to level 3:

    “A32B. Since June 30, 20X8, the market for collateralized debt obligation securities has become increasingly inactive. The inactivity was evidenced first
    by a significant widening of the bid-ask spread in the brokered markets in which collateralized debt obligation securities trade and then by a significant decrease
    in the volume of trades relative to historical levels as well as other relevant factors. At September 30, 20X8 (the measurement date), Entity A determines that the market for its collateralized debt obligation security is not active and that markets for similar collateralized debt obligation securities (such as higherrated tranches within the same collateralized debt obligation security vehicle)
    also are not active. That determination was made considering that there are few observable transactions for the collateralized debt obligation security or similar collateralized debt obligation securities, the prices for those transactions that
    have occurred are not current, and the observable prices for those transactions vary substantially either over time or among market makers, thus reducing the potential relevance of those observations. Consequently, while Entity A appropriately considers those observable inputs, ultimately, Entity A’s collateralized debt obligation security will be classified within Level 3 of the fair value hierarchy because Entity A determines that significant adjustments
    using unobservable inputs are required to determine fair value at the
    measurement date.
    A32C. Entity A determines that an income approach valuation technique
    (present value technique) that maximizes the use of relevant observable inputs and minimizes the use of unobservable inputs will be equally or more representative of fair value than the market approach valuation technique used at prior measurement dates, which would now require significant adjustments.21a
    Specifically, Entity A uses the discount rate adjustment technique described in Appendix B of Statement 157 to determine fair value.”

    What’s really so objectionable about that? Sure, it’s less transparent than using the most recent market price, but it’s far more likely to represent the exit price at the measurement date, which is the whole point of fair value measurement.

  12. fresno dan

    As I am not as learned as the rest of the readers, can someone explain what a level 3 asset is by definition, and give a few examples?
    What in the world would the rationale for such a seemingly ethereal construct be in what I have always taken to be the real world of accounting – dollars and cents, bottom line, objective measurement?

  13. wintermute

    If mark-to-market valuations are not possible because the market has seized up – then this is again regulatory failure to keep orderly markets. It can happen in equities too – Russia, Pakistan, Iceland are recent examples. Market failure results from underlying systemic faults which are allowed to fester for years e.g. excessive leverage, relying on commodity exports…

    The US market for CDOs is having the equivalent of a “Russia/Pakistan/Iceland moment” in equities. Again leverage is at fault – but also valuation methodologies themselves. A combination of ratings agencies paid by sellers – not buyers – and use of Gaussian distributions to measure tail-risk. LTCM was proof, 10 years ago of failed valuation models which led to today’s problems.

    The bottom-line is that if a product can not be valued in extreme market conditions – then the product should not be taken as a risk position – by anyone – investors or issuers.

  14. joebek

    The government is complicit in the obfuscation…” It is sad to say but people need to begin to think about what the alternatives are if the Federal government fails. Certainly the first recourse would be to the states but how many governors are prepared to take up the responsibility.

    For 20 years our equity trading positions (thousands of them) have been religously marked-to-market every single day.” Yes and No. Ever hear of the Greenspan put. The extent of the corruption is so pervasive that it is possibly terminal.

    Steve Forbes was interviewed recently (CNBC I think) and he savaged mark-to-market valuation as the single biggest cause prolonging the credit crisis.” If we replace mark-to-market with mark-to-make-believe (already happening) the value of the institutions reporting in these terms is dependent upon their general credibility, which is zero. The Repubs have been abysmal in addressing this crisis. The consequence is that the capitalist system will be strangled in regulation. If Alan Paton hadn’t taken the title someone could write a book.

    It’s all over now baby blue.

  15. bobby99

    In general, as a user of financial information, I too am adamantly opposed to level assets or anything else that obfuscates a company’s underlying economic activity, which is what financials are supposed to show. However, I would point out that banks are a different animal, central to the functioning of an economy as a whole. Thus, although I am opposed to bailouts in general (and the Big Three losers in particular), I believe that banks deserves special treatment, although stakeholders and management should feel some pain.

    If we allow banks to carry these crappy assets at inflated values on their balance sheets, their need for capital raises (very hard in this market, except from G), will be less. Over the course of the next few quarters or years, they will do their banker thing, and make money, albeit less than previously. Their balance sheets and capital structure will be stronger. At that point, they much more easily will be able to take the marks. Also, two years from now there will be much more clarity about the true values of some of these exotics. Some asset classes may not suffer the huge losses many seem to expect now (although some will suffer more).

    In effect, this is repeating what happened with the Latin American debt crisis in the ‘80s. Basically, Brady said that sovereign issuers be definition cannot default, that their problems stemmed from liquidity, no solvency issues (sound familiar?) Banks had Latin American bonds on their books with ridiculous marks (where have I seen that lately?) After years of negotiations, creditors wound up writing down the principal (and/or extending duration and/or lowering yields) in exchange for a lower probability of eventual default backed by assurances of economic reform.

    If I remember correctly, when this whole mess below up, the US banking system equity was negative, or nearly so. In the years that negotiations dragged on, US banks rebuilt their capital bases, and when the exchange for Brady bonds happened, they were able to take the losses, which turned out to be much less that initially feared.

    I would say the Brady plan was fairly successful. It saved the US banking system and put Latin American on a path for economic growth (and got rid of a few dictators on the way!) Even though level III is a disgusting adoration of the essence of financial accounting, the alternative is worse. I think we just have to hold our noses for a while.

  16. Richard Kline

    I’ve called it ‘mark to mendacity’ for a year and a half, but AIG has shown me that I’ve gotten it wrong: it’s ‘mark to audacity,’ now.

  17. ruetheday

    We’re quickly approaching a point where the powers that be will recognize that all of the stopgap measures are futile and that there are only 3 real options:

    1. The liquidationist/laissez-faire approach. Result: Great Depression II.

    2. Unlimited government commitment to keep zombie banks afloat. Result: Lost decade (or more) ala Japan.

    3. Nationalization of the banks with the creation of a mechanism for the orderly disposal of bad assets (Swedish solution, RTC, some combination thereof). Result: Sharp recession lasting a couple of years.

    The third choice seems to me to be the obvious one.

  18. Richard Kline

    Oh and btw Bobby99, I expect that the excess of US debt will ultimately be handled _externally_ in a way similar to which Brady bonds functioned _internally_. Our debt is now or will soon become enough to bankrupt our sovereign creditors when we reach the point that they can’t afford to roll it either, while at the same time they need our economy functioning in the global system to keep the whole thing from turning turtle. The obvious solution will be to do a bundle-and-writedown, likely in return for accelerated repayment of smaller principle. _WE_ will be the next Argentina. If we are lucky, I might add. But this may take ten years to reach that point.

  19. Anonymous

    “Mark to Audacity”, so true.

    All these mythical valuations, may tick the right boxs in the auditors reports and more than likely in the regulators one’s as well….but it ain’t fooling the mkt and that is the one judge, that truly has no mercy.

    PS

    Winterminute. They didn’t give a damn as to whether any of this stuff had value, they just wanted the bonus’.

  20. Guttersnipe

    Given the current poor state of ethics and honesty in this country today can/should we consider any financial accounting data prepared for public consumption to be remotely reliable?

  21. Anonymous

    Wintermute
    Steve Forbes, were it not for his father's setting him up, would have trouble selling coffee & donuts from a wagon parked in the street. The guy is a full of shit "free marketer" as long as he benefits. The moment it works against him he squeals like the pig he is.

  22. Anonymous

    Well you know every time an investor says “I don’t believe in Level 3 assets,” one is mortally wounded. Cue government officials to start clapping.

  23. kfunck1

    I think they need to treat them as something other than assets when their values become indiscernible. Move them off balance sheet, disclose them in the notes. If you can’t remotely figure out what they’re worth, you shouldn’t be counting them at all.

  24. bobby99

    @Richard Kline

    You may well be right. I hope the excess US consumption/US saving scarcity imbalance will be righted, so we don’t have that scenario. And the timeframe is unclear. 10 years? 20? But the people who think that the US is going to devalue the currency/hyper inflate the debt away tomorrow are crazy, in my opinion. The status quo will continue for some time because everyone likes it: Americans indulge beyond their means and foreigners (particularly EM) have somewhere to sell their goods, and thus can expand their economies and standard of living. All the other ways, such as growing Chinese domestic demand, will take time and be difficult to accomplish in the absence of US demand.
    ++
    btw, I think the comparison with Japanese zombie banks is a little off the mark, at least for now. The problem there is that they kept that crap on the books at inflated prices for 10+ years. The Brady bond negotiations lasted only a few years.

    Again, I am totally opposed to level III assets and other similar dishonest accounting practices, but I think it is preferable in this case to throwing huge amounts of taxpayer $ into bank equity, as long as it lasts only a few years. The longer-term solution is regulation and realignment of economic actors’ interests (great Vanity Fair article). The down side is less trust towards and among banks, but they’re really not lending anyway. (Is there no honor among thieves?)

  25. Krakpotkin

    I’ve been saying since August 2007 that the only way to deal with this mess (ie, “mess” means the existence of trillions worth of (ahem) lightly traded structured finance securities in the crisis tipped off by the Bear High Grade fund failures) is PRICE CONTROLS on the wounded segments of the universe.

    Price controls would mean marking to a model set by the feds. I suppose they would be accomplished via accounting regulation (rather than policing actual transaactions). This would open up a new arbitrage system, but problems there would under-weigh those currently.

    Price controls would be better than simply yanking 157 in that doing the latter would allow individiual institutions to model as they please again. The better and more transparent alternative is a public model.

    This would require a ton of spreadsheeting by the feds. But given the outlay of close to a trillion so far in ineffective … yadda yadda yadda.

    Precisely how segmented this regime would be I don’t have a clear idea. But when eg MBS are issued, there’s a ton of “demographic” description of the underlying pool in the offering documentaiton. The new Price Control law would allow the feds access to this material, which in turn would allow for responsible segmentation.

    The underlying fact here is that many of these securities — CDO tranches in particular — were never expected to trade in size sufficient to produce “price discovery”. And they haven’t.

    The aim of price controls would be to stabilize and make transparent the balance sheets, and to allow the wounded bonds to live out their miserable lives in peace, probably returning more than current depressed “market levels” suggest. (Although not likely more than current Level III marks.)

    How long, Adonai, how long, are we going to allow these things to burn down the city? The market for these securities such as it ever was broke last year.

    Society is a higher value than the Market. But we are in the grip of finance ministers bred on Age of Reagan television. And that Obama has nominated one for Treasury is as discouraging as the fact that he has nominated a Marine general to be national security advisor who thinks “war” can be “won” in the wastes of Pakghanistan. The technocracy marches on … over the cliff.

  26. gloomboom.com

    Also known as “mark to myth”, these so-called assets are a joke. I wish I could call my house a lever three asset. I could borrow as much as I want!

  27. Anonymous

    I’m sure the probabilities formulas project a winning hand in about 25 years. It’s either that or declare bankruptcy today.

    No wonder banks don’t trust each other.

  28. artichoke

    Unobservable inputs can be things like correlations.

    Suppose you are valuing an electric generating plant that’s in your portfolio. The value depends, among other things, on the correlation between the price of the input (fuel) and output (electricity). This correlation is not observable with any accuracy, the only way to mark it would be by the value of other generating plants (rarely traded, hence few price signals), or derivatives like “heat rate options”. These options don’t trade at long maturities, so the long-term correlation is unobservable.

    There are other unobservable inputs, like the volatility of electricity prices in 15 years.

    So to value a generating plant, you might have a vague idea what the long-range correlation and volatilities should be, and it may be that the best you can do is to use those vague numbers, or to average over a range of such numbers.

  29. artichoke

    @bobby99

    You say banks are special. As a category yes, but I do not think specific banks are special. Let the bust ones go bust. There are other smaller ones waiting for a chance to “do their banker thing” in the big leagues, now that space is available there.

    Similarly auto companies as a class are special. They are an essential part of the economy and essential for national security! Since it’s much harder to start an auto company from scratch, and there are no “little” US auto companies as far as I know, I think we’re stuck with the Big 3. They should be preserved through the Chapter 11 Bankruptcy process. Nothing to fear there, the judge will not want them to cease operations either.

  30. Anonymous

    @gloomboom:

    If I understand level 3 assets correctly, I’m pretty sure my property-taxing authorities are now going to calculate my house value that way. Easier for them than taking the hit on falling revenues…

  31. crackpotemkim

    bobby99 said:”creditors wound up writing down the principal (and/or extending duration and/or lowering yields) in exchange for a lower probability of eventual default backed by assurances of economic reform.”

    This should be what happens on the mortgage issue, but has been like pulling teeth (I know someone who’s been in negotiations).

    As for level 3 assets, the “smart guys” bought 5 lbs of crap, repackaged it in sandwich bags and sold for way more (labeled “pate”) and leveraged the vast income (making $100 for pate from $1 of crap) to go buy 99 more sacks of crap to continue this wonderful process. Except some unfortunate soul put some of this “pate” on his cracker and found that it was crap. And he told his friends, and even CNBC reported that crap was everywhere. But the smart guys now had 99 bags of crap (and no money left) and they still needed to get their bonus! So they came up with a plan to value what they had. It was agreed that if it was in the fridge and looked like pate at a distance, then it could be called pate (the fridge had a AAA rating).

    Sorry, had too much fun with that analogy. Thanks to deregulation (bye bye Glass-Steagal) and greed, supposedly “conservative” organizations were holding stuff that only the most foolhardy hedgies or entrepreneurs should play with. And they stopped doing what they did best, because it was giving only boring returns.

    As awful as the confronting of the truth of this crisis may be, ultimately that is the only solution.

  32. Anonymous

    crackpotemkin

    We are yrs away from any solution, as hardly anyone in authority thinks anything wrong was done and the banking/financial community haven’t even begun to change their ways.

  33. Anonymous

    The only way out of this mess is to force the banks through bankruptcy reorganization. This is necessary if the essential community banking functions of these institutions are to be preserved. There is no other solution. The magnitude of the banks’ insolvency is such that the Fed and Treasury cannot possibly bail them out. The big problem is that we do not have much time. The longer we delay the inevitable bankruptcy proceedings, the more the real economy will disintegrate. The collapse of the real economy (trade, industrial production, agricultural production) is accelerating. The banking system no longer functions, and in the attempt to resuscitate the corpse, the government is killing the real economy. We must change this if we are going to save our country.

  34. john bougearel

    Your headline brings a smile to my face!

    @ ndk “It’s theatre, and everyone knows it’s theatre, because nobody’s going down!”

    Spot on my man!

  35. Juan

    bobby99,

    from a better late than never, i’d suggest you reconsider the notion that the brady plan put ‘latin america on a path for economic growth’ when that regions growth was very substantially better prior to the debt crisis and supposed resolution.

    for most, the debt crisis was not resolved but ‘merely’ transformed into fewer and lower quality social services, wages squeeze, greater casualization of unemployment and give aways of public resources… all to conform with imf and wb diktats.

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