Pet Rocks as a Paradigm for Mark-to-Market Accounting

Allowing for the fact all analogies limp to some degree and mark-to-market accounting is not purely a black or white issue, assume we are running a small chain of department stores in the 1970’s. The chain experiences a great run selling pet rocks. Pet rocks have become so popular banks are willing to loan money to private investors for the purpose of buying them (leverage). The profits are coming in and bonuses are big. The department store’s crack due diligence team assures management their elaborate forecasting models say the price of pet rocks will never go down. Even the general public knows the price of pet rocks "always goes up over time". Pet rocks are tangible assets – at least "you own something". The department store’s management team gets a little too excited about the pet rock’s staying power and places an order for one million pet rocks. Like most fads or bubbles, the run for the pet rock comes to an end just after we (department store management) order a million of them. Since the market already has an enormous supply of pet rocks (they were very popular), we have a great deal of difficulty finding even so much as a bid from a potential buyer. With prices falling, it is no longer possible to get loans to buy pet rocks – as a result demand drops. The market for pet rocks has become "illiquid" and "ceases to function". The lack of "liquidity" in the pet rock market becomes "problematic" for our department store. In fact, carrying one million pet rocks in our inventory has investors questioning the impact on our entire business model. Our stock price suffers. Our bonuses are much smaller! The department store management team decides the market for pet rocks must be fixed! We hire lobbyists to ask Congress to change the accounting rules for valuing pet rocks. We have friends in Washington who can help us out of this jam. The market has already decided our pet rocks are effectively worthless, based on the glut of supply and the greatly diminished demand. Changing an accounting rule will not magically create demand for pet rocks, it will simply allow us to keep fooling ourselves rather than admitting to our mistakes and moving on. Even if the accounting rule is changed and we are allowed to "assign a value" to the pet rocks in our inventory, the investing public will know what the rocks are worth – nothing or next to nothing. After the craze was over in the 1970’s, people used pet rocks as doorstops. In 2009, maybe we can use some of these "oddball" mortgage-backed securities as bookmarks or cabinet liners.

Banks and financial services firms are hoping they can cover up years of incompetent risk management with a simple change of an accounting rule. It is ironic that no one complained about mark-to-market accounting when asset prices were soaring and firms happily marked up the value of their assets. Mark-to-market accounting allowed business leaders to claim gigantic bonuses for years. Suddenly, now that times are tough, mark-to-market accounting, rather than incompetence, is to blame. Do not believe it. Do our leaders in Washington really think the general public is dumb enough to believe we can fix this whole mess by changing an accounting rule? Are you kidding me? Let’s call this what it is – a way for powerful people to cover up their mistakes.

Since mark-to-market rules are complex, some changes may be helpful given current circumstances. However, any suspension of mark-to-market rules or radical changes to the basic concepts would do nothing but undermine the already weak confidence of private investors.

Two administrations (Bush and Obama) have attempted to craft a plan to buy bad assets to spur lending and restore confidence. The idea sounds good on paper. The recurring problem is determining how much to pay for the bad assets. Overpay and the taxpayers are left holding the bag. Pay what the market is willing to bear or fair market value and the banks will have to take a loss. If the taxpayers or private parties pay what the market will bear it creates "accounting problems for the banks". "Accounting problems" is the politically correct way of saying "solvency problems" for many banks. If a buyer pays what the market will bear for the securities, then it will become clear many banks are indeed insolvent or lack sufficient capital. If that were not the case, then the government would have started buying bad assets a long time ago. The banks now want to change fair market value accounting rules to hide their insolvency and/or lack of capital from the public. Changing accounting rules will put us in the express lane to the Japanese "lost decade" scenario. Changing accounting rules will give us banks that appear solvent and well capitalized on paper, but will be insolvent and/or undercapitalized in reality (a.k.a. "zombie banks").

Changing market-to-market will greatly reduce transparency (a big problem already). Lack of transparency is a major reason private capital wants no part of banks. If banks are allowed to assign hypothetical values to assets, is that going to somehow magically make the bad assets go away? Investors will know the bad assets are still there. If mark-to-market is suspended, investors and private equity firms will be even less willing to supply capital to banks, which will place an even greater burden on U.S. taxpayers to supply capital. The level of distrust of both political and business leaders is already at a high level. Changing mark-to-market will only increase the anger concerning bailouts and poor leadership.

The value of any asset (a car, a home, or a mortgage-backed security) is what the market is willing to pay for it at any given time. If we assign any other value to any asset then we are guilty of self-delusion. If these securities are worth so much more than fair market value then why is no one willing to pay that price for them? If these securities were worth more than current market prices, demand would exist based purely on greed and the motive for profits. There is a reason "many of these oddball investments are not being traded at all" - nobody wants them. There is no demand for them…..no demand equals no bid….no bid means no worth. Use of leverage in the free market to buy these assets is not coming back anytime soon, which means demand has been permanently reduced. Lower demand leads to lower prices regardless of various states of denial in boardrooms. The financial naiveté of our leaders in Washington could hit an all time high with mark-to-market. The financial markets have known for some time changes to mark-to-market may be forthcoming. The S&P 500 is down 20.13% YTD. The market does not like the government’s approach to much of anything, including "restoring confidence" with accounting tricks. Let’s hope cooler and wiser heads prevail.

Comments

[market ace:]

You have certainly hit the nail on the head with this article. The simple fact is that banks must meet their current liabilities (including depositors withdrawals) with current assets - not the value of those assets years from now.

To put it simply if I hold a $1,000 bond due in 5 years that has a market value of $700 today and I owe a debt of $1,000 next week or next year I am BK no matter what the bond I claim I will hold to maturity is worth in the future. To present financial statements in any other manner is deceitful to say the least.

I see no problem footnoting the banks intentions and their estimate of future value, but to record such amounts on the financial statements is more than misleading.

However, it certainly would not surprise me to see the desperate members of congress want to further cover up their prior incompentecy in regulating banks with more deviousa accounting that will only make markets more suspicious.

On the other hand congress why not make the banks disclose their derivative positions and report their M2M value of those instruments so we can really see hat is going on. That would be worth your time and effort.

Mar 12 03:52 PM

[InnocentsAb...:]

Pet rocks are appealing. At some point (maybe even now) they might be considered retro.

Also, I suspect a mint Pet Rock would be a good product to be sold on E Bay. Ideally, in the original container. (Question: were the originals shrink wrapped ?).

It's quite hard to make the argument that the quasi assets of the big US and European banks are any where as appealing as Pet Rocks.

In addition, I suspect that, in retrospect, investing in Pet Rocks (vs. shares of BAC or Citibank) would have been a better bet, especially if you kept them in a dry and cool place.

Mar 12 03:55 PM

[Fueled By R...:]

This is a false analogy. A pet rock, like a baseball card or a tulip bulb, produces no cash flow. It has no intrinsic value aside from whatever the greatest fool in the current market chooses to pay for it at any given time. Conversely, many of the so-called toxic debt obligations are supported by performing mortgages; the intrinsic value may not be 100 cents on the dollar but they may still be non-zero. But the logic of "no bid, no worth" is incorrect. Mark to market means we know the price of everything but the value of nothing.

Mar 12 04:45 PM

[InnocentsAb...:]

I resemble that comment. Tulips grow back every year. Kids love baseball cards. And a pet rock loves you back, even if you don't know it. All real value.


On Mar 12 04:45 PM Fueled By Randomness wrote:

> This is a false analogy. A pet rock, like a baseball card or a tulip
> bulb, produces no cash flow. It has no intrinsic value aside from
> whatever the greatest fool in the current market chooses to pay for
> it at any given time. Conversely, many of the so-called toxic debt
> obligations are supported by performing mortgages; the intrinsic
> value may not be 100 cents on the dollar but they may still be non-zero.
> But the logic of "no bid, no worth" is incorrect. Mark to market
> means we know the price of everything but the value of nothing.

Mar 12 05:01 PM

[donzelion:]

"The recurring problem is determining how much to pay for the bad assets. "

Hmmm...a better analogy than 'pet rocks' is 'pet fish' . Leave a barrel full of rocks at someone's doorstep for a month, and no one will complain. Leave a barrel of pet fish on someone's doorstep...well, you can imagine the smell. The problems for banks isn't precisely a matter of risk analysis - it's a 'Shrodinger's fish' problem: the fish in the barrel are both living and dead.

"The value of any asset...is what the market is willing to pay for it at any given time."

Perhaps, but if you want to go back to an archaic definition of value, you also have to accept the assumptions that made it operable (e.g., the market is infinite and omniscient, and clears instantaneously without transaction costs - that is, the value of an asset in capitalist heaven = the price the market will pay at any given time, but we all live on messy planet earth.

Mar 12 06:29 PM

[THofler:]

Were companies complaining about MTM rules during the boom? One company I follow had the worst of these rules imposed on them by the SEC on March 2008. Yup, those were the good old days.

And private capital is so afraid of the lack of transparency caused by a potential partial repeal of MTM rules, that the stock price of BofA is up 95% since the talk of said repeal has gained momentum.

Mar 12 08:55 PM

[mSquare:]

Excellent article.

As to your comment of 'leaders in Washington really think the general public is dumb enough to believe we can fix this whole mess by changing an accounting rule?' I would say overwhelming YES.

The 'General Public' is fed lies by TV (like CNBC), and they really think the problem is the consumers who took the sub-prime loans rather than the bankers who levered up on the levered up packaged CDOs of them!

Mar 13 09:01 AM

[Chris Ciovacco:]

Author's reply to Fueled By Randomness - we agree with critical comments - the analogy is far from perfect. In the version of the article on our website (www.ciovaccocapital.co.../), we have added the following: "Yes, we understand that pet rocks do not produce any cash flow - as stated, it is not a perfect analogy... Since many mortgage-backed securities are producing positive cash flow, there is obviously some value in owning them. The question is how much value...In most cases, we assign any other value [other than market value] to any asset then we are guilty of self-delusion. Admittedly, assets which produce positive cash flows do have some intrinsic value above and beyond what the market is willing to pay. This is an area where changes to mark-to-market do make some sense...There is a reason "many of these oddball investments are not being traded at all" - nobody wants them. There is no demand for them…..no demand equals no bid...no bid means potential buyers and sellers are significantly far apart on their perception of price - based on the state of affairs, we believe the benefit of the doubt goes to the uninterested buyers on the perception of value....The market does not like the government’s approach to much of anything, including "restoring confidence" with accounting tricks. If mark-to-market is suspended or altered significantly, we can expect to see financial stocks move higher. However, once the initial reaction fades, the market may decide changing mark-to-market was not such a good idea after all." We appreciate the feedback and respect this is a complex topic with many moving parts.

Mar 13 11:01 AM