Suspending Mark-to-Market Accounting: A Tale of Two Cows

It's been a while since I blogged anything - many projects for the day job keep me away from it. Before February slides into the past however, I'd like to share with you a "Tale of Two Cows." It's a fable about suspending mark-to-market accounting... from "Clusterstock," a site I'd never heard of before someone sent me the link.

I will not touch the name of that site.

But I will reproduce the fable here, full attribution to John Carney. Prepare to laugh. Or cry.

Talking about accounting rules is famously obscure, my-eyes-glaze over stuff. But much of what happens inside of investment banks--including all those writedowns you've heard so much about--turns on accounting rules. Now there are reports that the SEC is planning to give banks "flexibility" on mark-to-market accounting rules. It may even suspend mark to market rules. What on earth could that mean?

Let's go to the cows.

You have two cows.

You write down on a piece of paper that the cows are worth $100 each.

You notice the cows are on fire.

Your paper still says $100.

Fortunately, mark to market has been suspended so you don't have to pay attention to the fire.

Your cows are dead from fire.

Your paper still says $100.

Fortunately, mark to market has been suspended so you don't have to pay attention to the dead cows.

You notice that you aren't getting as much milk as expected, so you adjust the model and mark the cows down to $98.

You are confident, however, that the dislocated stream of milk revenue will quickly revert to expectations.

You need to borrow some money so you ask investors for a loan against the cows. The investors tell you the cows are
dead, and you already owe them $200 dollars you borrowed to buy them in the first place. You show them the paper that says the cows are worth $98 each.

They light your paper on fire.

You ask the government to buy the dead cows at $98 each.

The government holds meetings all weekend and finally comes up with a plan to inject $45 dollars into your cattle ranch. In exchange, the government gets a right to milk generated from the cows at some point in the future. It expects you'll buy a new cow with the $45.

You have two dead cows, $45 and $200 in debt to your investors. You have no plans to buy new cows.

Comments

[CuriousMonkey5:]

There is a saying that "every analogy limps." While analogies can be illustrative, the fact is that a cow is simply not a bank. A dead cow will never come back to life. Frozen markets, however, eventually will.

Mar 01 03:07 AM

[mavericks:]

Yeah, he kind of lost me when the cow's caught fire somehow. I mean, using his analogy...why wouldn't the farmer just butcher the cows and at least get paid $50 for a one-time cash in on the meat? THAT seems to be more of an analogy of what is happening in reality with home foreclosures.

Mar 01 11:35 AM

[mavericks:]

Actually, a more appropriate analogy might be as follows. 2 of your 10 cows are on fire (again, picturing a cow on fire is rather difficult but I'll go along with it). Your other cows have also suffered due to smoke inhalation and aren't producing as much milk and so your milk revenue stream is down 50%.

You decide you've had enough of cows which can spontaneously self-combust and want to sell all 10 cows since you're not able to cover your expenses. The market says all the cows should be worth close to nothing since this trend of cows catching fire may continue, in which case there is a threat of NO income stream from the milk. You say, well I'm not going to sell my cows at a "fire-sale" price since at least I'm still getting some revenue from the herd and for all I know, my other cows might get better and start producing more milk. And so we are at a stalemate with nobody quite sure of how to value the cows since nobody knows what the future holds.

Finally, the Dairy Farmers of America decide they have to do something and have come up with a solution to get the bovine market moving again. They are offering to buy the self-combusting cows at 50 cents on the dollar in exchange for the farmers being required to install a sprinkler system on their farm. Since the DFOA figures over time, the price of a sprinkler protected cow will go back up along with milk production, this could be a win-win situation for them. So now with an established price for the cows on hand and a safety net for any future self-combusting cows, the bovine market may slowly get back to normal.

Mar 01 12:42 PM

[henarl:]

You have two cows. ONE cow catches fire and becomes worthless. Nobody will buy your dead cow - its worth zero. But mark to market says that because both of your cows were in the same barn when the one caught fire, all of your cows are now worthless, even tho the live one is still producing milk.

Mar 01 03:57 PM

[ain't no fo...:]

I don't understand. Why can't you just open a rib joint and make your money on the booze?

Mar 01 05:29 PM

[Xorthfred:]

You have 100 cows. Nine get very sick and stop producing milk (9% default rate). You write off 78 cows. Your banker declares you must be saved, so he loans you more money and complains when you don't a) sell the sick cows and b) don't go buy more cows.

Mar 02 03:56 PM

[morph366:]

Hopefully no actual cows were harmed in any way during the construction of this illustration

Mar 10 03:01 AM

[HCSKnight:]

Or maybe the analogy simply shows how much cows and accountants have in common....

May 08 03:43 PM