Mark-to-Market: A Rule That Begs to Be Broken 38 comments
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By Louis Basenese
Thursday a House Financial Services subcommittee will examine the hot-button accounting issue of mark-to-market, formally known as FASB 157.
The SEC’s already asserted its stubbornness. An anonymous source told Reuters this week, and I’m editorializing slightly, “There ain’t no way we’re suspending mark-to-market!”
But there are a lot of good reasons why they need to do exactly that. Unfortunately, the SEC doesn’t have a great history of proactive regulation. Here’s why we better hope our elected representatives see the situation differently.
Mark-to-Market - Increasing Transparency?
Proponents of mark-to-market contend, and rightfully so, that the rule increases transparency. It requires banks to “mark” or price assets based on the current market price. In other words, it forces banks to tell us what their assets would sell for in the current environment.
On paper, that’s a great principle. Who wouldn’t want to know what their investments are worth on a daily basis? If you’re like me, you probably mark your stocks to market every day - checking their prices after the closing bell.
However, doing the same for mortgage-backed securities - the assets at the center of this debate - is not as simple as punching in a symbol on Yahoo! Finance. You see, while stocks trade daily and by the hundreds of thousands of shares, these mortgage-backed securities might not trade for weeks or months at a time.
And when thousands of these investments exist, and only one trades in a month, can we really say a market exists? Not at all. So under the current conditions, mark-to-market is more like mark-to-make believe. Especially since the prices banks are forced to use are completely out of whack with reality.
Let me provide some examples to illustrate what I mean…
When FASB 157 Misses the Mark
In the fourth quarter, The Bank of New York Mellon (NYSE: BK) was forced to write down a $5 billion portfolio of Alt-A mortgages by $1.24 billion or (25%). Yet, based on the performance of the underlying loans - the principal and interest payments the bank was receiving - they only expected to lose about $208 million.
Granted the bank’s estimates of losses could be wrong. But the difference between the two methods - net realizable value and mark-to-market - is gargantuan. And it proves mark-to-market fails to do its job when virtually no market exists for these assets.
For good measure, here’s another example of its shortcomings…
The Federal Home Loan Bank of Atlanta holds three private mortgage-backed securities. But, it has no intention of selling any of them. Again, based on the actual performance of the loans, the bank estimates it will lose $44,000, beginning in 2025.
That’s not a typo. It will be another 16 years before any losses are incurred on these loans. Yet because of mark-to-market accounting, the bank was forced to write off a loss of $87.3 million - a figure almost 2,000 times greater than the actual losses.
One could argue that over time - as a market returns for these assets - the huge price differences would correct themselves. That’s true. But banks can’t simply wait it out.
Due to Mark-to-Market, Banks Out of Compliance
The write-downs required by mark-to-market put many banks out of compliance with capital requirements - the amount of cash and easily liquidated assets they need to hold to offset their liabilities (i.e. - loans to others). And the only way to become compliant again is to raise capital by either issuing more stock or selling off assets.
Bottom line - the current application of mark-to-market forces banks to raise billions upon billions in real capital to offset losses that are never going to occur. And that makes absolutely no sense.
As for questioning the authority of the Financial Accounting Standards Board, their track record warrants it. Remember, their rules on special purpose entities allowed Enron to pull-off its accounting shenanigans and later required revisions to adjust for the deficiencies.
- Mark-to-market rules were supposed to fix problems from Enron. Unfortunately, they created a large batch of new problems.
- Mark-to-market is simply another one of FASB’s rules that’s good in principle, bad in practice, in desperate need of a revision.
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This article has 38 comments:
"The fact that fair value measures have been difficult to determine for some illiquid instruments is not a cause of current problems but rather a symptom of the many problems that have contributed to the global crisis—including lax and fraudulent lending, excess leverage, the creation of complex and risky investments through securitization and derivatives, the global distribution of such investments across rapidly growing unregulated and opaque markets lacking a proper infrastructure for clearing mechanisms and price discovery, faulty ratings, and the absence of appropriate risk management and valuation processes at many financial institutions,” Herz said.
This article wants to treat the symptom rather than the disease. Replace Mark-to-Market with some other more refined vehicle if necessary, but please; you don't throw the baby out with the bathwater!
I respectfully beg to differ that Mark-to-Market simply isn't working. In most cases it is! As for 'toxic assets', or assets that have fallen so low as to be virtually unmarketable, I would suggest that the problem there goes way beyond any mere revision as you suggest.
Until we have something better, then let's not just blindly hand valuation back to the very banks that caused the problem in the first place!
> If suspending MTM will make banks more valuable, then maybe we should
> suspend ALL financial accounting of any kind, the we'll really get
> a good market pop!
I agree. Since we got into so much trouble with this accounting stuff lets just ban it altogether; Then we can all be Billionaires.
Accounting is not the issue; Crazy "Financial Engineering" and Ludicrous Underwriting is.
It is too bad the market has fallen so much that this is seem as a detriment to stability.
You have to have some sympathy but it doesn't sound like a solution to me.
The Herz quote is a croc. So all we really need is perfectly regulated and non-opaque markets that also have perfect infrastructure and clearing mechanisms; and oh, by the way, perfect price discovery. Heck, throw in perfect ratings agencies too. Then MTM would work great!
The whole point here is that we will always have weak spots in our financial system and certain times that are tough. Badly implemented MTM regulations, like the current one, greatly amplify the stress at the worst time, and needlessly break the weaker parts of the system.
When this recession or depression we are in goes down in history, the cause will be mark to market madness, a temporary aberration of accounting lunacy.
Mark to market is only applicable when the business is not a going concern, i.e., in the process of liquidation.
FASB forces going concern business to adopt the non-going concern accounting principle to value the assets in the name of transparency is a joke enjoyed by short sellers. No business can survive under mark to market accounting rule, especially those holding gargantuan assets, such as too large to fail banks, using the liquidation price to value the assets even in a normal business environment (there will always have a fire sale price somewhere in the market place for illiquid assets), not to mention in a distressed market induced by economic crisis.
Assume, for example, W utility company owning a nuclear power plant valued at xxx in the book. Now, another utility owning a similar nuclear power plant went bankrupt and the nuclear power plant was auctioned off in the bankruptcy procedure at 1/3 of the price. Now the 1/3 price becomes market price for the W utility company and must be marked down pursuant to mark to market which will then cause the W company having a negative equity which will then cause the violation of loan covenant which will then initiate another bankruptcy procedure.
Accounting is a man-made science based on the basic principles. The very basic principle of accounting is going concern assumption. Under that assumption, the value of assets held must be valued on the basis of continuing operation. While mark to market accounting is based on the principle of liquidation, not going concern, that is., the value one can fetch now and right now on the liquidation basis, fire sale or not.
On Mar 12 05:01 PM j_remington wrote:
> Untrue.
>
> "The fact that fair value measures have been difficult to determine
> for some illiquid instruments is not a cause of current problems
> but rather a symptom of the many problems that have contributed to
> the global crisis—including lax and fraudulent lending, excess leverage,
> the creation of complex and risky investments through securitization
> and derivatives, the global distribution of such investments across
> rapidly growing unregulated and opaque markets lacking a proper infrastructure
> for clearing mechanisms and price discovery, faulty ratings, and
> the absence of appropriate risk management and valuation processes
> at many financial institutions,” Herz said.
There is going to be a lot misallocation of resources as a result - the capital allocation is spoilt. I'm not saying it caused the current problems but its certainly no better (or in fact worse) that its predecessor - historical convention. At least, the latter has existed for centuries....
The fear is that if you suspend M2M then there is no external discipline to stop all accounting being done on a mark-to-make-believe basis.
thehatemongers.blogspo...
While the US government want to show the superioty of its market system, the truth is that The American system is nothing but self-serving too. This thing is just losing more respects to America from all around the world, well if there are still some left.
FDR did it. Was he wrong about anything?
On Mar 14 07:35 AM MJJP wrote:
> For everyone that is coming to the side of MTM isn't there a correllation
> that MTM was done away with in the 30's and we had no problems until
> it was introduced again in 2007?
The comparison is intellectually dishonest. Nuclear reactors seldom face mass depositor withdrawals or pledge their reactors 30:1 to trade other financial assets while banks have as going concerns.
I'm not a big fan of mtm but there must be some recognition of liquidity risks for illiquid financial assets. Maybe a footnote with the high, low and marked case? Some sort of liquidity risk recognition so in the event of undue stress investors have some sort of guide posts.
But you shouldn't go changing prudent accounting standards because some banks overpaid for some assets.
FASB, in its rigidity, is wrong not to allow this as an alternative.
If fully informed the wisdom of the market should punish over-reach in either direction, just as it is apparently doing now. Because my neighbor just had a fire sale I should mark my house to half price?
Mark to market seems like a metric that would be used in a bankruptcy when valuations are based on fire-sale prices with few buyers. Market speculators must love mark to market when the market is down because it lets them acquire assets at fire sale prices.
It seems a more realistic picture of long term "Hold-to-value" liquid type investments would include Mark to market, AND investment returns at say five year intervals, assuming the investment went to maturity. This would be accompanied with a statistically based default risk projection.
As a reasonably long term (15 – 20 years out, I hope) investor, member of the pedestrians, the general public, I do know so much these days: Many of the so called “assets” on the books of banks were never any such thing in the first place. Simply theoretical constructs, models, bets with perceived value of the beholder (or the snake oil sales men, the crooks?), without any base, no underlying, no contracts, no trustworthy appraisals, no traceable “value”. So mark them to market or DCF model it or any other way you want to show these “assets” in the books – I will not touch bank stocks. Period. I did buy some bonds, betting on the government, the de facto owners of these "banks", to pay me.
And just for arguments sake: Why just look at the asset side of the balance sheet? How about the liabilities and their “valuation”? Deflated? Inflated? Just take all the pending lawsuits and other, potentially unlimited liabilities hanging over these "banks"?
Have a good day
People supporting MTM base on one belief :
"Anyone who tell lie should be punished"
Let this 72 years old man tell you the true :
"Human is dirty,we need to cover some of our dirty
parts in order for this world to function normally
(I mean normally not perfectly)".
All bankers are dirty & greedy.They caused this crisis
but if MTM wasn't be restored on 07,there should be
no crisis or more precisely -- no one know there is
a crisis as on the last 70 years after Franklin Roosevelt suspended MTM in 1938.
The real world is about "COMPROMISE".You just can't totally kill all bad guy in
order for this world to function.
Under MTM,it is just like asking all our congressman to
report if anyone have a mistress.If anyone have,then
they have to go.I can assure you that 60-70% of the
congressman have to go & the government will collapse.
FASB restored MTM due to Enron.But no accounting rule
can prevent people like Enron CEO to cheat,this kind of
people just write any number in their book.Accounting
rules can only control honest people.MTM has no use
on company like Enron but too strict on all others.
MTM fuel (not caused) the great depression in the 30
& Franklin Roosevelt suspended MTM in 1938.I hope Obama
has the same courage.
Supporter of MTM will be equal to asking all women to be naked ,100% transparency for man to find a honest
wife.I don't think it will work in real world.
Human is dirty,we need to cover some of our dirty
parts in order for this world to function normally
(I mean normally not perfectly).
Considering their balance sheet is full of MBSs, CDOs CDSs which are all declining rapidly as their VALUES (derivatives) are derived from Home mortgages (values), Auto loans CC loans etc. You don't have to be Sherlock to fore see the decline in the value of latter assets in the coming months! So will be, Banks' capital base with regard to liability.
GE declared only 2% of their balance as MTM rest - 98% is opaque. Look at it's stock price!
Supposing one (applying for Life Ins) diagnosed with cancer, you start blaming the doctor for divulging the truth and want to find one who will agree that you are not 'that bad' re your health!
There is a word for it, DENIAL! We now, are collectively and insanely in denial! You think things are worse now. Wait, after removing or even 'modifying' MTM according to wishes of holders of these toxic assets.
Who is going to trust their numbers?
Really, what are you people thinking?? Why can people logically move from Point A (MTM sucks) to Point B (duh, what governance do I use now...er..nothing).
Until somebody has a *better* strategy rather that throwing darts what actually works then they are part of the cadre of fools that got us here in the first place. Ignore them.
M2M valuations are significantly less meaningful when the market is irrationally exuberant or depressed.
On the other hand, when banks intend to hold an illiquid asset long-term or until maturity, a DCF valuation seem more accurate because the bank does not intend to sell the asset, but rather is holding it as a long-term investment in order to receive the benefit of the cash flows it expects to receive over time.
DFC valuation is more subjective than M2M because it depends upon the discount factors that management chooses to select to estimate and account for the probability of losses, defaults, as well as changes in the rate of inflation and interest rates, often over long-periods of time.
At any rate, in theory, DCF value represents the economic benefit of holding the asset for the anticipated time period, and M2M represents the value that the market could be expected to pay for the asset if it was sold right now.
Both valuation methods are useful and meaningful, but not necessarily for the same purposes.
The problem at present is that M2M is being used as the exclusive basis for assessing regulatory compliance with bank capital requirements. This results in banks being forced to raise unnecessary capital in order to avoid being deemed insolvent under bank regulations -- even when their "toxic" long-term assets are actually performing as well as expected and producing cash flows that are otherwise sufficient to meet the bank's obligations.
The solution seems to be not a choice of M2M vs. DCF, but rather requiring banks to disclose both metrics as well as all of the data and assumptions used to calculate those values. This should provide sufficient transparency for the capital markets. On the other hand, bank regulators should adopt a policy of regulatory forebearance where, as now, the market for long-term assets crashes such that the M2M value diverges excessively from the DCF valuation, and a policy of regulatory strictness when the market may be overly exuberant.
In other words, there is nothing wrong with M2M or DCF valuations, per se, the devil is in the detail of how those valuations are actually used and applied for regulatory purposes.
Does anyone remember who said:
The mother of all FU*K UP is ASSUMING!
This is a big recession we had one in the 70's and one in 82. the world didn't end. If you want an idea of how inflated stock prices were read richard shaws article on this site showing the graphs. We aren't even on the bottom of a long term trend line for stocks and everyone is going nuts. the prices of stocks should have never gotten so out of hand, and now we have to pay the price. Currently, we are in the middle of what the normal asset price range should be.
Since what I said is the truth, why do we have to alter the rules so much when we are only right now back to historic norms!!!!
seekingalpha.com/artic...
Look, support the prices if they get low, but they haven't even normalized yet. Do we want to spend our taxpayer dollar supporting over inflated assets. the record on this is dismal and a waste of my hard earned money.
the only reason to support getting rid of mark to market is because you are going to make money from that happening. At least you should be honest about it instead of talking about how it is about helping the economy. It's like the credit card companies saying that high interest rates are good for consumers because it allows them to extend credit. Yeah Right!!!
If, for example, a bank has a actual policy or practice of holding bonds or mortgages to maturity, it is not unrealistic to expect them to do so, and then base the valuation of those assets by analyzing the cash flows that the bank expects to receive over the life of the bond.
Right now, with the incredible level of distrust, nobody wants to believe anything that anybody in the financial industry "assumes". Unfortunately, all valuation methods, including M2M, require the person estimating the value to make one or more assumptions. For example, M2M valuation requires one to "assume" that the asset you are valuing is comparable to a different asset that was "recently" sold, and that the price that that asset sold for is comparable to the price the asset you are appraising would sell for today.
So like it or not, you've got to make assumptions whenever you value any financial asset.
On Mar 14 10:10 PM sunny12945 wrote:
> 'ASSUMING the investment went to maturity'
>
>
> Does anyone remember who said:
>
> The mother of all FU*K UP is ASSUMING!
as is the Obama's Budget estimating GDP at 4%!!!
Geithner "the savior" was a disastor before and will
be again.Ever wonder how he got to be NY fed chairman?
Rep Jankoski who will chair the committee making the
recommandation is a well known extortionist.
In my opinion MTM should even be stricter,remember the
AOL collapse,booking their pseudo sales as "realized"
before they happen,how about GE meeting estimates,when
in fact they never did even during the big Jack's reign
of terror.MTM rules for rating agencies should also
be regulated,did you watch on C-Span one of the S&P's
guy stating they would rate a cow?
Your assets are worth what a willing buyer,not subsidized by TARP,is willing to give you for them.That
is MARK TO MARKET.
Express your OUTRAGE.
No wonder why the retail investor is skeptical.
Notice that there is much criticism, but few realistic suggestions. Perhaps companies should produce both 1) the present market value 'estimate', 2) the original cost (value), and 3) the guestimate of 'real value'.
No matter how presented, there would be a wide divergence of both opinion and actions as a result of any M2M changes. Perhaps that's why so many WS financial analysts make in the millions of dollars annually.
Look where are we now on that ASSUMPTION!
On Mar 14 11:39 PM Erik Murray-Knox wrote:
> I think what User 283977 meant by the phrase "assuming the investment
> went to maturity", was assuming that the investment went to maturity.
>
>
> If, for example, a bank has a actual policy or practice of holding
> bonds or mortgages to maturity, it is not unrealistic to expect them
> to do so, and then base the valuation of those assets by analyzing
> the cash flows that the bank expects to receive over the life of
> the bond.
>
> Right now, with the incredible level of distrust, nobody wants to
> believe anything that anybody in the financial industry "assumes".
> Unfortunately, all valuation methods, including M2M, require the
> person estimating the value to make one or more assumptions. For
> example, M2M valuation requires one to "assume" that the asset you
> are valuing is comparable to a different asset that was "recently"
> sold, and that the price that that asset sold for is comparable to
> the price the asset you are appraising would sell for today.
>
> So like it or not, you've got to make assumptions whenever you value
> any financial asset.
"M2M valuation may vastly over or understate the actual economic value that an asset will ultimately produce if and when it is held over the long-term."
According to Realtytrac.com, the total percent of US housing unit foreclosure filings was less then 2% in 2008. So because the immediate market is down we value all long term mortgage investments at current market value on the assumption that the remaining 98% of mortgages might go into immediate foreclosure, and/ or the market will not in any way recover in the next twenty to thirty years? Neither of those prospects seems probable, but those are two of the implicit assumptions associated with M2M valuation.
SO how do you value those assets? I think at the minimum you need two numbers - Percent risk associated with foreclosures, short sells and cram downs, and the Percent reduction in market valuation today. The latter is directly related to the M2M valuation if the investment was liquated today. If we were looking at the total US market, the risk would be close to the Realtytrac.com number.
Here is an example - Lets look at mortgages in a state where the total percent of homes at risk from foreclosures, short sells and cram downs is 20%, a high risk state. Lets also say that the M2M value of those investments at risk is 66% of the mortgage face values.
Then the percent total valuation of mortgages in that state is (1 - .2*.66) = 86.8%.
If you held 300M of mortgages in that state a best guess assessment of their full market value would be 300M * .868 = 260M. The M2M value would be .66 * 300M = 198M. So the valuation of the investment portfolio of mortgages would lie between the M2M value of 198M and the maximum likely value of 260M.
With the M2M valuation the portfolio faces a 33% loss. With the maximum likely valuation you have a 13.2 % loss (.2 * .66). So the maximum likely calculation is equal to the percent M2M valuation X the percent homes at risk.
Where do you get that percent homes at risk number from? It could come from the percent foreclosures in the previous year. Another source would come from the governments rescues plan. In order to budget their program, they had to have an idea of the percent of homes requiring help.
I am not saying this is an ideal system for valuation, but it is a start, and as I said before, I think a better way to value long term investments is to provide two numbers. One, M2M, the other a logic based estimate of the full term value of the investment taking into account likely losses.
This I believe is the argument that can win over those that don't 'get' the gist of the real debate here. The problem is from a PR perspective mark to market accounting 'sounds' very reasonable and those that argue against it are lableled as charlatans wanting a quick fix by hiding losses
The irony is that as it stands mark to mark accounting and lending ( again ) have and will make bubbles and busts exagerrated. Our society and economy need to take the opposite tack ( Jamie Dimon agrees ). Not only should accounting be based on cash flow models so should lending in all its variety of structures. Do this and 2008 does not occur as the real estate bubble has no way of forming. Neither does 1999 or 1929 as margin use would have not existed for stocks that did not meet the cash flow worth to allow the public and institutions to lever up. ( institutions should have the freedom to lend any dollar amount to anyone but the risk to lender and lendee should be flagged by some type of exclusion to normal lending resulting in higher rates and setasides by the lender for capital risk i.e. it should not be a normal course of business )
The business cycle will always exist but it could be significantly mitigated with applied common sense.
If successful, the modification of mark to market accounting and the application of a baseline of cash flow lending on all assets could alter the economic landscape in dramatic fashion and begin a new economic reality that could permanently alter the overly cyclical nature of the business cycle in a way that brings unprecedented prosperity.
In the end it could be that the huge flaws uncovered in fair value accounting may eventually lead to the realization of the embedded flaw that George Soros referred to in Alchemy of Finance as Reflexivity.
The theory that lending based on overvalued assets during booms and undervalued assets during busts is responsible for creating such havoc within the capitalist system and if left to its own devices leads to financial chaos.
But, once we emerge from the carnage, it may be helpful to
(a) move MTM to a required note, but get it off the statements. Transparency is served if (like the MD&A) MTM is a required disclosure. It can even be required as a separate detailed disclosure, like the Owners Equity section in the 10-K financials.
(b) by implication, remove increasing MTM values from a financial institution's lending ability. It's true, they may circumvent this by trading, but at least this removes the automatic expansion of credit caused by a bubble or inflation. Thus, it (to some small degree) creates a natural impediment to bubbles forming.
(c) limit it to assets that are marketable in the foreseeable future. In other words, for banks, the value of loans will be left alone.
(d) of course, prudent markdowns must still be required, as they are at present for all classes of assets, goodwill in particular.
The bottom line: now is not the time to eliminate MTM. If we do it, we have to wait till the toilet is completely flushed, else we'll sow the seeds for the next bubble right there.