Mark-to-Market Debate Continues 21 comments
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A follow-up to my recent post.
To my point- it isn't just the market for stocks and snow shovels which exhibit cyclical / predictable patterns. These patterns are also apparent in the market for physical business assets - plant and equipment.
Pick a major steel company, a paper company, a chemical company (without loss of generality)- if the company had to dispose of all their plants at the bid side of today's market, would any of these companies be solvent. Why? Because the bid / ask spread for these physical assets is exceedingly wide in a recession. If you marked all of U.S. Steel's assets to the price where they can sell a marginal ton of capacity, X would be bankrupt. Fortunately, X is under no pressure to liquidate assets - so we can all play along with the assumption that the company is solvent, with a very substantial net worth.
Ah, but what about the banks? No such benefit of the doubt is given to banks. We assume that if a bank has assets with a wide bid / ask, the bank must be camouflaging the fact that they are insolvent and most of their assets are 'toxic'. The market is broken, illiquidity premiums are enormous, bid / ask spreads on bank assets are in disequilibrium, and mark-to-market account rules need to be repealed, ASAP. I expect the accounting rules to change, probably within a week.
My two cents:
There have been rumors all week that some repeal of it is in the works. Not a full reversal of the policy, but one that deals with illiquid securities that essentially have no market. When forced to liquidate, the seller takes whatever the buyer offers. That then sets the market for all other securities held by all whether they need to sell or not.
In its basic essence, mark to market empowers the weakest holder of securities to set the value of the strongest's, thus dragging down the whole system to its level. That is not what capitalism is about. The strong are supposed to survive and prosper while the weak fall by themselves to the wayside.
What has happened now is the weak, far from falling by the wayside, have become a massive anchor on the whole system... not good.
Disclosure: No position
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This article has 21 comments:
Its rarely mentioned how interstate banking has caused many of these immediate problems.Now that the obscene Vegas,Phoenix,Calif. bubble has spread to healthy markets,the unintended consequences are becoming apparent.
IMHO
You answer your own comment about M2M. Because a steel plant is not a bundled security, its value can reasonably be ascertained. Right now one can factor in the long term productivity of a steel plant in today's market and for for future output. Can you do that with a CDO? With a tranche? Again, it's a matter of mis-measure.
The securities are illiquid because they are structurally flawed. As a bundle, they break the market. They are inscrutable black boxes. They are the Heisenberg Uncertainty Principle of securities.
The logic is circular here. M2M is not the factor denying asset liquidity by setting a too low benchmark. If that was the case, why are Citi, and BoA the prime victims right now? Why was huge AIG laid low? And the iBanks? They were dragged low precisely because they over-leveraged on poorly designed products with terrible risk management, not some accounting method.
Capitalism is about transparent pricing mechanisms. M2M is providing a very clear window to show just how valueless a bundled mortgage product is. Rightly so. Playing with the accounting methodology does nothing to solve the underlying problem. Without M2M we would not know how bad the problem truly is, and it would continue to fester and suck capital. Instead of locking up the market with a big warning sign, we'd have a long slow bleed from a million different holes. M2M is quick trauma. It shows a blocked artery. That is easier to fix than a shotgun wound.
Break them up and locally evaluate. Markets will find value then as they could for over 200 years of mortgage pricing. Anything else is just cover for Wall St. who want to preserve this unnecessary, intermediary, capital-sucking market model.
SFAS 157 defines fair value accounting. SFAS 159 provides an OPTION to adopt fair value accounting for financial assets.
Some of the little girls who run U.S. banks decided to comply with "Banking Queen" Barney Frank's direction to loan to indigents. Some of these same little girls decided to CHOOSE fair value accounting.
If these same little girls find themselves insolvent, tough luck for them. They should declare bankruptcy and their shareholders should be impoverished.
These little girls should not come begging me, the U.S. taxpayer, for tax money to bail them out.
SFAS 159:
9. An entity may decide whether to elect the fair value option for each eligible item on its election date. Alternatively, an entity may elect the fair value option according to a preexisting policy for specified types of eligible items. An entity may choose to elect the fair value option for an eligible item only on the date that one of the following occurs:
a. The entity first recognizes the eligible item.
b. The entity enters into an eligible firm commitment.
c. Financial assets that have been reported at fair value with unrealized gains and losses included in earnings because of specialized accounting principles cease to qualify for that specialized accounting. (An example is a transfer of assets from a subsidiary subject to the AICPA Audit and Accounting Guide, Investment Companies, to another entity within the consolidated reporting entity not subject to that Guide.)
d. The accounting treatment for an investment in another entity changes because:
(1) The investment becomes subject to the equity method of accounting. (For example, the investment may previously have been reported as a security accounted for under either FASB Statement No. 115, accounting for Certain Investments in Debt and Equity Securities, or the fair value option in this Statement.)
(2) The investor ceases to consolidate a subsidiary or variable interest entity but retains an interest (for example, because the investor no longer holds a majority voting interest but continues to hold some common stock).
e. An event that requires an eligible item to be measured at fair value at the time of the event but does not require fair value measurement at each reporting date after that, excluding the recognition of impairment under lower-of-cost-ormarket accounting or other-than-temporary impairment. (See paragraph 10.)
10. Some of the events that require remeasurement of eligible items at fair value, initial recognition of eligible items, or both, and thereby create an election date for the fair value option as discussed in paragraph 9(e) are:
a. Business combinations, as defined in FASB Statement No. 141, Business Combinations
b. Consolidation or deconsolidation of a subsidiary or variable interest entity
c. Significant modifications of debt, as defined in EITF Issue No. 96-19, “Debtor’s Accounting for a Modification or Exchange of Debt Instruments.”
That Jamie Dimon.
The continuing credit crisis is just that until the truth in value is really revealed- in mortgages, commercial real estate, credit cards, consumer loans; compare current default rates to previous years and then multiply (2x, 3x, 4x......). The Obama stringent test (although not yet defined) may help- but we have eight years of the government looking the "other way" to be undone. I expect bitter medicine for all , not just the stockholders and executives.
If the toxic assets are later worth more, shareholders win. If not, they loose ( but probably less than they would have).
Life isn't that complicated, lets not try to make it so!
On Feb 15 08:39 AM Aristophanes wrote:
> But steel plans and the like are not regulated to use M2M because
> their transactions are infrequent. Their market is tested and unwindings
> take time and staged processes, with adequate, transparent oversight.
> Comparing assets specifically designed to be liquid with physical
> plants like comparing apples to the tree they fell from.
>
> You answer your own comment about M2M. Because a steel plant is not
> a bundled security, its value can reasonably be ascertained. Right
> now one can factor in the long term productivity of a steel plant
> in today's market and for for future output. Can you do that with
> a CDO? With a tranche? Again, it's a matter of mis-measure.
>
> The securities are illiquid because they are structurally flawed.
> As a bundle, they break the market. They are inscrutable black boxes.
> They are the Heisenberg Uncertainty Principle of securities.
>
> The logic is circular here. M2M is not the factor denying asset liquidity
> by setting a too low benchmark. If that was the case, why are Citi,
> and BoA the prime victims right now? Why was huge AIG laid low? And
> the iBanks? They were dragged low precisely because they over-leveraged
> on poorly designed products with terrible risk management, not some
> accounting method.
>
> Capitalism is about transparent pricing mechanisms. M2M is providing
> a very clear window to show just how valueless a bundled mortgage
> product is. Rightly so. Playing with the accounting methodology does
> nothing to solve the underlying problem. Without M2M we would not
> know how bad the problem truly is, and it would continue to fester
> and suck capital. Instead of locking up the market with a big warning
> sign, we'd have a long slow bleed from a million different holes.
> M2M is quick trauma. It shows a blocked artery. That is easier to
> fix than a shotgun wound.
>
> Break them up and locally evaluate. Markets will find value then
> as they could for over 200 years of mortgage pricing. Anything else
> is just cover for Wall St. who want to preserve this unnecessary,
> intermediary, capital-sucking market model.
On Feb 15 08:40 AM Steve in Greensboro wrote:
> Listen, girls.
>
> SFAS 157 defines fair value accounting. SFAS 159 provides an OPTION
> to adopt fair value accounting for financial assets.
>
> Some of the little girls who run U.S. banks decided to comply with
> "Banking Queen" Barney Frank's direction to loan to indigents. Some
> of these same little girls decided to CHOOSE fair value accounting.
>
>
> If these same little girls find themselves insolvent, tough luck
> for them. They should declare bankruptcy and their shareholders
> should be impoverished.
>
> These little girls should not come begging me, the U.S. taxpayer,
> for tax money to bail them out.
And that is also where the solution lies. When the people still in Washington and Wall Street that are responsible for this debacle are made accountable..........t... a whole lot of very clear information (with finger pointing) is likely to come out. Only the attorney general of the state of New York has yet to force any major capitulation from Wall Street (making them take back huge sums of bad securities).
It is the fear of prosecution that is the greater control. But when people are walking on one of the greatest debacles in our time..........do not expect any real change.
M2M is a rule of how to do it , is a capital sucking right now yes, it is, but changing it just as solution of today problems is nosense.
Actual problems are for lack of aplication in regulation specially lack of reaction to the "creativity" of modern banquers, M2M is not the problem is part of the solution.
What's the alternative? mark to model perhaps? Let the model tell us we wish the assets were worth more so we could sell our bank stock at a profit.
Or another alternative? mark to book value? That would be a perfect world in which there were never any losses.
How is anyone but insiders to know the value of a bank's or fund's holdings? Mark to Market, that's how.
It is real inconvenient in thinly traded securities, but you'd better have adequate reserves if you're going to trade thinly-traded securities.
There are more cogent arguments for Mark to Market than there are excuses for eliminating it.
Basically he says that criticisms of Mark to Market come from two directions: "The first is that the actual application of fair value accounting in some cases does not actually result in the best valuation of the asset. The second, which is misguided, is that even if it results in the best measure of actual value it should not be used because it contributes to undesirable pro-cyclical swings in bank capital."
To the first he says: "Earlier SEC FASB interpretations of the rules for valuing MBSs leaned much more heavily toward current market prices as long as there were any at all, while the new clarification admits that current market conditions are not orderly and thus internal expected cash flow estimates may be appropriate. "Fannie has an underwriting and valuation shop with models for valuing mortgages that are up and running."4 They forecast default rates for different assumptions about price declines and have a good track record. They might be deployed to establish valuations in lieu of reliable market prices until markets return to normal. This new SEC clarification is welcomed and should increase bank capital in much the way the Treasury's new $700 billion TARP program was expected to.5 It should also do much to diminish the misguided call to abandon mark to market accounting."
To the second he says: "The pro-cyclical behavior of asset values is an economic reality. No good policy purpose would be served by attempting to hide the fact by corrupting accounting standards. Full transparency is desirable." and... "European central banks resisted the adoption of IAS with regard to the reporting of these gains and losses because their laws required them to surrender profits above some minimum to their Finance Ministries and during the first two or three decades after World War II they generally enjoyed valuation gains from their foreign exchange reserves because of the tendency for European currencies to depreciate against the U.S. dollar in which most of their reserves were held. They did not wish to report these unrealized gains because they did not wish to pay them to their Finance Ministries. Thus they hid them by not including them in income. However, in the 1980s the German mark and some other European currencies appreciated against the dollar for a number of years causing the famous Bundesbank to become insolvent. The Bundesbank was recapitalized by the German Government and there after led the field by amending its accounting standards to reflect unrealized as well as realized valuation gains and losses."
The suspension of MTM will make the discount rate used by the market to value bank earnings go up because of a reduction in information and consequent increase in uncertainty/risk. A market value pop in bank stocks may result at first... but once a failure results in a bank that reported its condition as "just fine" under suspended MTM ...look out below for the rest of the banks that jump on that reporting bandwagon. There is indeed some evidence that banks will not even take advantage of a suspension of MTM, if it is offered.... see here for the example of the European banks: www.iht.com/articles/2...
Capitalism will work. Controlled failure via the bankruptcy laws is a valid, tried and true option, especially for the banks that are 'too big to fail'. Yes, I'm talking about Bank of America, Citigroup, and JPMorgan. Let the well-managed companies (and funds) have their reward by buying the profitable divisions of these failed institutions at auction. Yes, the shareholders and bondholders of the banks will be wiped out. For Citigroup, that means the sovereign wealth funds from the Middle East. 'But it's an Illiquid asset with no price' arguments are for the weak and the whining, those who didn't believe the prospectus was telling the truth when it says there is no guarantee.
Price discovery is one of the best features of the free market. We'll get a lot of that with the new Mortgage-backed security ETFs. I hope they succeed and become huge, and then we'll be closer to putting this mess behind us.
Whether it is regulatory or not is frankly, irrelevant. The market will now and forever price the assets themselves, and the stock of their holders, using M2M anyway. Change M2M and suddenly hidden risk will require hidden price discovery. As investors, is this what you want? In the age of the Internet, will this stick? Not at all. We'll be reading OTC data (soon to be regulated anyway) and account for the measure same as now.
Another factor with securitized mortgages is the yardstick is constantly moving. So much data in one security all tightly contractual means that even a small, local wave of foreclosures can unravel the whole pyramid. Remember when Merrill-Lynch said that if China were to unwind even 1% of its US bonds, they would kill the entire market? Same thing with securitized products. They''re like a WWI treaty system. Talk to one guy and while you're doing that someone else has called up their army. Moving targets are a poor investment.
If current holders of toxic assets claim the market is broken because the bid price is too low for their balance sheet, I will gladly buy all of them for my total net worth tomorrow. Anyone with me? That's a market. What I hear from M2M detractors is:
"The market is broken because I don't like the price!" There is a market…full of brutal, institution-ending losses.
I understand how frustrating it is, but M2M backers tend to be those who are long in financial stocks or companies that are tied up in toxic assets. These apologists claim that the accounting is creating the valuation problem, when that is nothing more than an attack on the symptom and not the cause. The markets are locked because these constructs are brutally hard to value and the banks are walking away fom price discovery like schoolkids taking their ball when they are losing the game badly. If this was real money, we'd all be in a lot more trouble. These products were designed to be difficult if not impossible to re-price. In a time of low interest rate spreads, they were created to lock in the yields on the blind assumption that the underlying collateral could not succumb to large scale price correction. The ratings system was manipulated to triple A most of them with this in mind. Blaming M2M for a chaotic decline is nonsense.
The time to have factored in the possibility of a market going into a severe downturn (nuclear confrontation between India and Pakistan, maybe?) was when creating and purchasing these things in the first place. It's called risk assessment. This was not done. The models were wildly incorrect.
Failure MUST be the option for those who gamed the system and bought these things. Unravel the contracts, sell locally, then ban them. If banks fail, then move with all haste using a special FDIC receivership on the largest bans as necessary and be done with it.
P.S. Bad banks are stupid unless the remnant bank is completely wiped of management, shareholders, and unsecured creditors in favour of the taxpayer.
The FASB accountants need to have their heads examined for lack of common sense. They also need to be banned from shorting or investing in hedge funds (to avoid conflict of interest) , because the hedge funds really want to keep this rule in place to wipe out banks' capital and to drive the stock market down!
"7./ AB will be expected to work aggressively to strike a balance between: a./ keep houses from being foreclosed b./ acting in the interest of the common shareholders. "
sounds like another public/private partnership related to mortgages and wearing two hats...since Fannie and Freddie worked so well, let's do it again. Where do these people come from? Geez!
If you were to "Mark to Market-ize" (M2M-ize) the cruise control on your car you would need to reverse the action it now takes when your car slows down or speeds up. ---- As your car slows down instead of pushing the accelerator pedal down to speed the car back up, as a normal cruise control does, the M2M-ized version would instead let up on the pedal.
Thus your car would slow down even more causing the M2M-ized cruise control to lift the pedal up even more. This cycle would be repeated until the engine eventually was at idle and the car stopped moving or it was moving along at minimum speed (assuming a flat road).
Of course the reverse is also true which, as now applied to the banking system via FAS-157, will help induce boom and bust cycles into our economy. It’s feedback systems 101.