Banning M2M: The Worst Mistake in History

Yesterday the house Financial Services Subcommittee run by Paul E. Kanjorski (D-PA) discussed mark-to-market accounting.

Why do you care? Some misguided wicks out there (i.e. Warren Buffett and Steve Forbes) have asked for the M2M (yes, we have a silly text friendly symbol for mark-to-market now, twitters rejoice!) to be banned. On one hand I say yes, but only if it applies to me as well. It would allow me to ask my clients to stop using their current portfolio balances and simply use the balances from 2007. This would make me look spectacular, my referrals would shoot though the roof, and nobody would call concerned about the future of their retirement. The problem with this is that it is a fraud. People seeking to ban the M2M rule are asking the investing public to support the next great Ponzi scheme. The only difference in this scenario is that trades are placed and the money is invested in bank debt.

Now that I have everyone worked up, let’s take a step back to remind ourselves why this is important. While most banks don’t have large amounts of debt subject to M2M rules, the big guys (BAC, WFC, JPM, C) have a serious issue with it. Why? They borrowed money to make dangerous investments that have not worked out. There is nothing illegal with incompetence or making bad bets. However, now they are upset because the M2M exposes their incompetence. At least they all were doing it, right?

Banks need new money all the time, and they get that by convincing investors that if they buy their debt now, they will be paid back in the future. Investors want to see the true value of the assets, including the bad debt. Remember that junk still has some value, but you can’t let management lie to you about it. That is what they are asking the government to do right now: legally hide the current value of their mistakes. I would consider lending to banks as an investor, but you have to come clean and show me the books. If not, I will take a pass. If this happens on a wide scale by banning the M2M rule, we could freeze the credit markets all over again.

Now, for those conspiracy theorists out there, listen up. Could banning the M2M rule, thus causing a new credit freeze, make it easier for banks to beg the Fed to give them more free money? I don’t think it is that evil. My take is that the big banks just want to cover up their tracks while they collect a handsome spread on the free money the Fed is lending them right now “in their time of need.” They should be careful about what they ask for. Their cure could kill them.

Disclosure: no positions

Comments

[springfieldlp:]

Firstly how could it possibly be the worst mistake in history? FASB 157 or M2M as you call it has only been in existence since 2007 - only 2 shorts years. What did we do all those years before FASB 157 ? How was it that our banking system functioned so smoothly for so many years ?

There are two problems with M2M tha are execerabting this financial crisis.

1) Many times there are no liquid markets for longer term financial assets and as a result they are mis-valued at bids which cannot be considered market clearing.

2) Long term illiquid financial assets that are intended to be held to maturity and are indeed performing - and most of it is even though it may be labelled sub-prime - should not be valued at market but rather discounted based upon net present value of the risk adjusted future cash flows. It was taught in Finance 101.

We could continue to apply M2M to a bank's short term assets but it makes no sense to paint all these assets with the same distorted market valuation in applying it to regulated capital ratios if these assets are long term and are held to maturity. There are other valuaion methods that properly value longer term performing financial assets for which there is no market. Ignoring that fact and applying only M2M is the problem.

Mar 13 05:40 AM

[SugarDaddy:]

M2M was initiated for a reason don't you think. The policy should stand as written.

Mar 13 05:41 AM

[Moon Kil Woong:]

Actually, the worst financial mistake in history is probably the revocation of Glass Stegall and unfortunately we already made it.

The reason banks need to mark to market is because banks no longer abide by Glass Stegall and don't hold loans to maturity and throw investments into bonds derivatives and other brokerage products. This necessitated market to market since banks were no longer holding mortgages.

The world was so much better when banks did what they were suppose to do and brokerages took the risks and paid the price with little government regulation. After all back then brokerages would never have gotten taxpayer money nor FDIC insurance, nor government guarantees.

There is a reason for this. Brokerages need to take risks to operate efficiently. The price they pay is no taxpayer umbrella. Instead the government has decided to protect brokerages even though they don't abide by any risk regulations and didn't ever pay into FDIC. Likewise banks have essentially entered into brokerage risk taking territory. The financial industry is now begging for umbrellas.

That's why we need market to market.

On the side note, beginzwithz is correct about Buffet.

As for unmarketable and highly illiquid securities, they do need some efficient way of valuation. Wasn't TARP suppose to do that? The previous solutions basically gave away tons of money and solves essentially nothing. To adequately value the derivatives you need to find out which companies will default on their obligations. To do that you must force everyone to disclose their positions, estimate the 20-30 bond default rate, figure out who will pay and receive what when, and then make sure no one makes more of these bets unless they are in an exchangeable organized market with adequate collateral to guarantee payment.

The problem is, once everyone shows their hands all investors will start dumping their stocks. Then everyone is more likely apt to rush for the exits and demand payment or refuse to pay than try to figure out anything. The contracts are in the tens of trillions.

Although the author is simplifying the problem, if the US should go the way of Japan and say simply you can record your assets at purchase value until sold or they come due, it would be the worst mistake in US history. It would effectively plunge the US into a Japan like recession that won't end until banks finally clear off all this bad assets off their books decades later.

I am happy to say, I don't think people are actually going to do this. If they are, please show me the exit before the circus starts.

Mar 13 06:01 AM

[oceansmike:]

How can you compare WFC with Bad Loans and Betting on Derivatives,, try asking why the Glas Steagal was abolished by Repub-by Banking secter ,,how about a link to glas Steagal and you can write an article(copy Paste from Wikipedia,,
en.wikipedia.org/wiki/...
,, ok kids read this and try a different approached it even has more about Loans,,ooops ,, can you read and comprhend in english,,read and weep ,,shorty

Mar 13 06:16 AM

[oceansmike:]

sorry link try this copy again

en.wikipedia.org/wiki/...


See also Depository Institutions Deregulation and Monetary Control Act of 1980, the Garn-St. Germain Depository Institutions Act of 1982, and the Gramm-Leach-Bliley Act of 1999.
The bill that ultimately repealed the Act was introduced in the Senate by Phil Gramm (Republican of Texas) and in the House of Representatives by Jim Leach (R-Iowa) in 1999. The bills were passed by Republican majorities on party lines by a 54-44 vote in the Senate[12] and by a 343-86 vote in the House of Representatives[13]. After passing both the Senate and House the bill was moved to a conference committee to work out the differences between the Senate and House versions. The final bipartisan bill resolving the differences was passed in the Senate 90-8 (1 not voting) and in the House: 362-57 (15 not voting). Having majorities large enough to override any possible Presidential veto, the legislation was signed into law by President Bill Clinton on November 12, 1999. [14

Mar 13 06:18 AM

[Dave Wrixon:]

Create an uncontrollable financial bubble, by any chance?


On Mar 13 05:40 AM springfieldlp wrote:

> Firstly how could it possibly be the worst mistake in history? FASB
> 157 or M2M as you call it has only been in existence since 2007 -
> only 2 shorts years. What did we do all those years before FASB 157
> ? How was it that our banking system functioned so smoothly for so
> many years ?

Mar 13 07:43 AM

[Iknownothing:]

According to his dubious profile Munson is a graduate of (according to him) the "prestigious" St. John's college in Sante Fe.

What a load.

Mar 13 08:08 AM

[john s. gordon:]

moon kil - yes restore glass-steagal, a lot of mischief could be avoided if you do.
> jack

Mar 13 08:24 AM

[scousi:]

If I sell my house (an illiquid market) it will be priced based on similar sales in the neighbourhood - even if there was only 1 and it was a foreclosure. No one will give be a M2M break.

Same thing goes for a HELOC - the bank will give me one based on M2M value of my house.

A bank`s assets should be of majority liquid assets. If a proportion of it is illiquid to the point of making it hard to value due to M2M - then the bank has been involved in schemes it should not have.

I think they will simply modify M2M so that it is relaxed for capital requirement purposes and not for reporting or accounting purposes. Basically - 2 balance sheets; one for reporting and one for the regulatory framework.

On Mar 13 05:08 AM Alexander Evergreen wrote:

> How can you compare a portfolio statement with simple investments
> to complex securities on the balance sheet of banks? Your client's
> portfolio only consists of stocks, etfs, or whatever you invested
> in. Those HAVE a market. Its called New York Stock Exchange. The
> ETF for the S&P500 (seekingalpha.com/symbo...) traded
> over 300 million shares yesterday. Thats called a liquid market.
> The more liquid a market, in normal conditions, the more efficient
> it is in pricing securities. Even the bear market we are in now does
> not compare to what banks are facing for their assets. Those have
> no market right now or highly distressed markets. And thats fine
> with most banks, since they still produce income. Marking assets
> to 20 cents on the dollar does not reflect the reflect the real estate
> market and the other assets they represent.
>
> But good luck on attempting to build a false case so you can continue
> shorting Financials.

Mar 13 08:36 AM

[Steve in Gr...:]

Great article, Mr. Munson. Any change in SFAS 157/159 that moves us further away from transparency is a move in the wrong direction.

And, as you correctly point out, the loss of transparency created by such a modification would make it more difficult for investors to evaluate the bank.

This is a regulatory problem, not an accounting problem.

And any rally founded on an accounting change is doomed.

Mar 13 08:55 AM

[Analyst Mayank:]

Price of a security is a function of so many factors; default risk being an important one, however is not the only one. The current market turmoil took such an ugly shape as a result of lack of liquidity rather than increased default risk. What else could explain widening of spreads at all levels of the so called rating ladder.

One such example would be monoline insurers. Although, i partially support Bill Ackman's arguments on the viability of their business model, I at the same time do believe that rating agencies got a bit too harsh on them.

M2M for a monoline is what I believe is the violation of the very basic accounting principal of Going Concern. For an investor, M2M makes sense to know the current position (which is supposed to be the net present value of future cash flows). However, for a monoline, they don't need to make an upfron payment even if the issuer defaults; the payment is done as and when it comes due on the interest payment / repayment date.

Therefore, although M2M is a very important indicator, it should be treated differently for different market participants.

Mar 13 10:07 AM

[Ranger:]

Sir, you are an idiot, reinforcing my opinion that the responders to folks like you are usually much more informed. JHang it up and see if you can find a nice mild delivery route, which with M2M accounting rules are real cheap now. Makes no difference that people need milk and will keep buying it. No, the main thing is the market has determined that due to a crash in banks and bank-like other companies, nothing is worth anything anymore.

I'll take two whites and one chocolate.

Mar 13 10:27 AM

[User 371080:]

M2M creates instant positive balance sheets for Banks. Whats not to love?

Mar 13 10:39 AM

[henarl:]

Mark to market is not the sole culprit of our banking problems but it is certainly a big part of the them. In spite of the M2M nazis, we need to suspend it now so we can put the banks back in the lending business and get the economy moving again. We can argue about a better pricing method for loans later.

Mar 13 01:00 PM

[Alexander E...:]

I appreciate the response to my comment. I think your right about banks having a majority of assets fairly liquid. But I think that deals more with regulatory policies such as fractional reserve banking.

I do not agree with your analogy of real estate being an illiquid market just as securities. In 2006, at the height of real estate activity, there were roughly 6.5 million sales of existing homes monthly. Now in the last quarter and throughout 2008 it has averaged 4.5 million monthly. Please try to grasp that for a minute. 4.5 million sales monthly from 6.5 million. Thats a drop of 30%. The real estate market is not illiquid, it has only slowed down.

On the other hand, the commercial paper market went from over 200 billion in 2007 to 25 billion in 2008. Thats a drop of over 85%. That IS an illquid market.

Don't believe me, look for yourself.
www.dallasfed.org/rese...



On Mar 13 08:36 AM scousi wrote:

>
>
> If I sell my house (an illiquid market) it will be priced based on
> similar sales in the neighbourhood - even if there was only 1 and
> it was a foreclosure. No one will give be a M2M break.
>
> Same thing goes for a HELOC - the bank will give me one based on
> M2M value of my house.
>
> A bank`s assets should be of majority liquid assets. If a proportion
> of it is illiquid to the point of making it hard to value due to
> M2M - then the bank has been involved in schemes it should not have.
>
>
> I think they will simply modify M2M so that it is relaxed for capital
> requirement purposes and not for reporting or accounting purposes.
> Basically - 2 balance sheets; one for reporting and one for the regulatory
> framework.
>
> On Mar 13 05:08 AM Alexander Evergreen wrote:

Mar 13 01:12 PM

[logicalman:]

I'm not sure if you're 100% right but your logic concerning mark to market seems to make a lot of sense.It should be something that most decision-makers can understand..let's hope they do and do the right thing.


On Mar 13 06:01 AM Moon Kil Woong wrote:

> Actually, the worst financial mistake in history is probably the
> revocation of Glass Stegall and unfortunately we already made it.
>
>
> The reason banks need to mark to market is because banks no longer
> abide by Glass Stegall and don't hold loans to maturity and throw
> investments into bonds derivatives and other brokerage products.
> This necessitated market to market since banks were no longer holding
> mortgages.
>
> The world was so much better when banks did what they were suppose
> to do and brokerages took the risks and paid the price with little
> government regulation. After all back then brokerages would never
> have gotten taxpayer money nor FDIC insurance, nor government guarantees.
>
>
> There is a reason for this. Brokerages need to take risks to operate
> efficiently. The price they pay is no taxpayer umbrella. Instead
> the government has decided to protect brokerages even though they
> don't abide by any risk regulations and didn't ever pay into FDIC.
> Likewise banks have essentially entered into brokerage risk taking
> territory. The financial industry is now begging for umbrellas.<br/>
>
> That's why we need market to market.
>
> On the side note, beginzwithz is correct about Buffet.
>
> As for unmarketable and highly illiquid securities, they do need
> some efficient way of valuation. Wasn't TARP suppose to do that?
> The previous solutions basically gave away tons of money and solves
> essentially nothing. To adequately value the derivatives you need
> to find out which companies will default on their obligations. To
> do that you must force everyone to disclose their positions, estimate
> the 20-30 bond default rate, figure out who will pay and receive
> what when, and then make sure no one makes more of these bets unless
> they are in an exchangeable organized market with adequate collateral
> to guarantee payment.
>
> The problem is, once everyone shows their hands all investors will
> start dumping their stocks. Then everyone is more likely apt to rush
> for the exits and demand payment or refuse to pay than try to figure
> out anything. The contracts are in the tens of trillions.
>
> Although the author is simplifying the problem, if the US should
> go the way of Japan and say simply you can record your assets at
> purchase value until sold or they come due, it would be the worst
> mistake in US history. It would effectively plunge the US into a
> Japan like recession that won't end until banks finally clear off
> all this bad assets off their books decades later.
>
> I am happy to say, I don't think people are actually going to do
> this. If they are, please show me the exit before the circus starts.

Mar 13 01:41 PM

[Willie Makeit:]

HERE is a great example of sheer lunacy : ( from another board article ) Why ? Because they sure as hell aren't going to lend in this environment. THE TED spread is the key gentlemen. It is now trending back to the upside. Not good news.

On Mar 13 01:00 PM henarl wrote:

> Mark to market is not the sole culprit of our banking problems but
> it is certainly a big part of the them. In spite of the M2M nazis,
> we need to suspend it now so we can put the banks back in the lending
> business and get the economy moving again. We can argue about a better
> pricing method for loans later.

Mar 13 01:54 PM

[ifuwish2:]

look guys if you like mark to market or not just look what has happened to the market ,,it may not be allM2M fault but it had a great part in it and if you can not see that you are really stupid.all they have to do is relax the rule for 8 to 12 months and see what happens,,i BET the economy as a whole will start to recover,,if you like it or not everything revolves around the financials,,you get the banks moving and the economy does also,,just look at this weeks little rally the banks go up the market does,,did any of you bleed heart shorters see what happens when the banks drop,,of course you did you was shorting them,,,the stock market dropped big time..i hope the stop shorting them see what tou guys do,,i can tell who is by their comments cause they like the market like this,,they lining their pockets why the economy goes to hell..so i hope they do the M2M and i KNOW AND BET the whole economy will start back to recovery which we need,,not more shorters

Mar 13 08:13 PM

[alaskaeagle:]

You are correct. It will create the next bubble because the banks will make the decision on marking. Do we need anymore bubbles?


On Mar 13 07:43 AM Dave Wrixon wrote:

> Create an uncontrollable financial bubble, by any chance?

Mar 14 12:23 AM

[rr0710:]

Woong has it right. Also, what's the bigger issue? M2M or the fact that the assets are indeed worthless. And with underlying real estate continuing to fall in value are we focusing on the right issues or the political hot bed issues? You decide.

Apr 08 03:28 PM