Mark-to-Market Marches Towards Extinction 29 comments
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Mark-to-market is going to go the way of the dodo so let’s at least give it a decent eulogy.
The meme is that marks are at the heart of our banking problem, a convention dreamed up by diabolical accountants intent on making financial institutions' statements purer than Caesar's wife. Get rid of the convention, go back to historical cost accounting and presto our banks are fine.
To listen to the conversation you would think that most bank assets are subject to this unfair treatment. Otherwise, why would it be such a big deal. Well the truth is that it’s pretty much a tempest in a teapot.
David Reilly at Bloomberg did a little research. He found two intriguing factoids.
Of the $8.46 trillion in assets held by the 12 largest banks in the KBW Bank Index (KBE), only 29 percent is marked to market prices, according to my analysis of company data. General Electric Co. (GE), meanwhile, said last week that just 2 percent of assets were marked to market at its General Electric Capital Corp. subsidiary, which is similar in size to the sixth-biggest U.S. bank.
In other words, 70% of the loans on these banks’ books are carried at historical cost. The bank is free to make its own judgments about whether and to what extent they might be impaired and to make appropriate additions to reserves to account for those decisions.
Now mark-to-market is pretty much impossible to argue against intellectually if one is talking about applying it to trading portfolios. If you’re running a book and trading in and out of it the only way to realistically assess your financial condition at any point in time is to mark the securities in that book to the market. At the same time, if you’re making loans that you intend to hold till maturity marking them makes little sense. The process of reserving against losses in that portfolio is the logical accounting method. That does leave you at the mercy of the banker’s judgment but, hey, no world is perfect.
So caught in this trap what’s the argument for changing the rules for the banks? It’s the thesis that there is no market for these securities so marking them is illogical. Well, Mr. Reilly has some data on that.
Plus, the basics of marking-to-market often get confused. Consider the refrain that banks can’t mark assets to market prices because markets are frozen. Of the 12 banks in the KBW that I reviewed, only 5 percent of total assets on average were designated as being hard to value because market-based prices weren’t available.
These so-called mark-to-myth assets represented 58 percent on average of total shareholders’ equity among the banks. They fall, though, to just 16 percent of equity if the Big Four banks — Bank of America Corp. (BAC), Citigroup Inc. (C), JPMorgan Chase & Co. (JPM) and Wells Fargo & Co. (WFC) — are excluded.
Is it starting to make sense that this is an issue that’s related to a very small number of banks? And why might that be? Mr. Reilly hits the nail pretty much on the head. The big guys went into investment banking in a big way and piled up a lot of assets — trading assets — just like the real investment banks. And how do investment banks have to value this stuff? Mark-to-market.
Two conclusions come to my mind.
First, except for a handful of banks, this is not an issue. Remember this the next time the talking heads on CNBC start going off on this subject and say we have to get rid of mark-to-market in order to get banks lending again. It ain’t true.
Second, the big guys need it to go away because they are most likely insolvent under the convention. Note that doesn’t mean they can’t generate tons of cash flow. Whether all that money is enough to cover the losses though is the real question. They require the flexibility and yes artifice of historical cost to have a fighting chance of getting through this.
So as we see mark-to-market accounting either emasculated or killed outright remember that he was a good guy. He spoke the truth and you know how dangerous that can be.
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I am a big fan of simplicity. So, I like what besposito and TPoise say. These financials geniuses need to learn to keep things simple. If you can't handle the risks, don't dive into complicated assets. If you like the profits of capitalism, take the losses in stride as well. By marking these toxic assets to a low value, the capitalistic market is saying that these assets are not good, and wants to flush them out. It is urging us to go back to basics and find a new way to advance the finanical system.
The value of that loan is the net present value of the stream of cash flows it generates in the form of payments made on the loan until it is paid off. All that matters is the likelihood of that stream of payments happening as planned. For an individual loan, that is counterparty risk and should be built into the interest rate charged on the loan (higher likelihood of being repaid equals lower interest rate, riskier borrower equals higher interest rate, etc.).
The underlying value of the real estate is meaningless, except as a point-in-time reference used by the lender in deciding how much (if any) they should reasonably lend against the home. My guess is that reference point probably carries far less weight in the decision-making process than the perceived creditworthiness of the borrower. But regardless, it becomes totally moot once a decision is made and the loan paperwork is signed. The value of the collateral works its way into the mortgage process BEFORE the mortgage exists, and is irrelevant thereafter (except in the event of default).
The value of a bundle of loans is simply the sum of the net present values of all the individual loans in the bundle. I don't understand using market prices to value long-term assets. It makes no sense at all. Markets are frequently far too irrational at any given point in time. Sometimes they value things way too highly, and at other times they value things way below their intrinsic (or true) value. But it's the intrinsic value which matters, and that is what companies should use to do their accounting (with full disclosure of their assumptions, of course).
If I run an ad offering to buy a one-year old Rolls Royce for $1.00, and some lady involved in a nasty divorce agrees to sell me one for that (so that her soon-to-be ex-husband can't have the car), does that suddenly mean that all Rolls Royce's lose 100 percent of their value as soon as they're driven off the dealer's lot? And that, in the name of fairness, everyone who owns a Rolls must now mark the value of their car down to $1.00? That'd be insane, obviously. And yet, that's the situation M2M has created with our banks and insurance companies (and others).
And sadly, there are some people around who are trying to take advantage of a temporary market dislocation to transfer the wealth of others into their own pockets - no matter who loses how much, no matter what institutions get destroyed in the process, and no matter the price to our society as a whole. Those are not good people, and we should treat them as the thieves they are.
Excuse me, but the very term and concept of 'mark to market' was created PRECISELY because markets are inefficient and irrational, and therefore values of assets are fluid and must be accounted for.
Otherwise with static book or acquisition value, you have banks that pretend they are above water, planning shuffleboard games, even as the water rises above their heads.
On Mar 13 03:22 PM Poor Dude wrote:
> A mortgage is a loan. The home is collateral pledged against that
> loan, and nothing more. Some loans carry 100 percent collateral,
> some carry none, and most carry something in between. Whether the
> value of the collateral goes up or down should have no effect whatsoever
> on the value of a loan made against that collateral.
>
> The value of that loan is the net present value of the stream of
> cash flows it generates in the form of payments made on the loan
> until it is paid off. All that matters is the likelihood of that
> stream of payments happening as planned. For an individual loan,
> that is counterparty risk and should be built into the interest rate
> charged on the loan (higher likelihood of being repaid equals lower
> interest rate, riskier borrower equals higher interest rate, etc.).
>
>
> The underlying value of the real estate is meaningless, except as
> a point-in-time reference used by the lender in deciding how much
> (if any) they should reasonably lend against the home. My guess is
> that reference point probably carries far less weight in the decision-making
> process than the perceived creditworthiness of the borrower. But
> regardless, it becomes totally moot once a decision is made and the
> loan paperwork is signed. The value of the collateral works its way
> into the mortgage process BEFORE the mortgage exists, and is irrelevant
> thereafter (except in the event of default).
>
>
> The value of a bundle of loans is simply the sum of the net present
> values of all the individual loans in the bundle. I don't understand
> using market prices to value long-term assets. It makes no sense
> at all. Markets are frequently far too irrational at any given point
> in time. Sometimes they value things way too highly, and at other
> times they value things way below their intrinsic (or true) value.
> But it's the intrinsic value which matters, and that is what companies
> should use to do their accounting (with full disclosure of their
> assumptions, of course).
>
>
> If I run an ad offering to buy a one-year old Rolls Royce for $1.00,
> and some lady involved in a nasty divorce agrees to sell me one for
> that (so that her soon-to-be ex-husband can't have the car), does
> that suddenly mean that all Rolls Royce's lose 100 percent of their
> value as soon as they're driven off the dealer's lot? And that, in
> the name of fairness, everyone who owns a Rolls must now mark the
> value of their car down to $1.00? That'd be insane, obviously. And
> yet, that's the situation M2M has created with our banks and insurance
> companies (and others).
>
>
> And sadly, there are some people around who are trying to take advantage
> of a temporary market dislocation to transfer the wealth of others
> into their own pockets - no matter who loses how much, no matter
> what institutions get destroyed in the process, and no matter the
> price to our society as a whole. Those are not good people, and we
> should treat them as the thieves they are.
The proposed rule change is to force auditors not to use market price when the market price is not fair price generated from an active market.
On Mar 13 11:20 AM TPoise wrote:
> M2M is already "waived" when there is no liquid market. Read up on
> the FASB 157 clarification from September 2008 where they specifically
> state and cite the MBS market since it does not work when there is
> no "orderly transaction".
>
> M2M is just a political rallying cry for many banks so they can go
> back to Mark-to-whatever-I-fee... and have huge write-ups.
>
> And let's pop the myth now that M2M is for all assets. It's not,
> it's only for trading assets that are not intended to be held to
> maturity. Thus, if your neighbors are selling their houses all for
> $10k, and you are selling a very similar house for $200k, you're
> probably a little overpriced, and thus the market reflects that.
> If you aren't selling your house, you don't have to worry about any
> margin calls or anything like that since you are holding to "maturity".
>
>
> However, insurance companies are probably the only ones targeted
> unfairly in this case. Insurers are required to post all of their
> assets at fair value at any given time (since there may be a sudden
> outbreak of hurricanes or bird flu and they need to sell those assets
> immediately).
Is it very hard to imagine that these same tangible items may end up with notably different valuations courtesy of two different accountants or appraisers, (or perhaps even the same ones). Now try to imagine selling your small business. Your proposed selling price is at one end, the buyers at another and the outside audit will place it at another. If everyone is satisfied with the final figures, the sell takes place. If it doesn't the sell is cancelled and another buyer is sought, or perhpaps the original will compromise on the enterprise value, the goodwill value, or some other component of sell valuation.
In a third scenario, you are told that every week, or every month you have to value your entire business based on these asset assessments. From time to time, as circumstances fluctuate, your business is variously valued higher and lower, and in rare difficult times your business shows an extreme devaluation. Now lets say that this is all happening with a gun to your head, by which I mean, that you are told that you must be prepared to liquidate your business each week or else have the rug pulled out from under you by your bank. Doesn't look too good, nor fair. Your customers, for the most part are paying, you made a modest profit last quarter, but the accountant just told you to write down you Real Estate and inventory anyway and to call your bank and tell them your broke. Hmm. Not a very rational way to plan your next move.
It was recently said that mark to market endeavors to value assets in a market condition in which the seller doesn't want to sell and the buyer doesn't want to buy. As with most things in life, it's not black or white, it's mostly gray. Just try raising a teenager or owning a small business and you'll get the point.
You have hit the nail on the head. All assets had a price when sold. The pricing climbed because they became a security. Now they want to bring them out of security without loosing their clothes. They should be required to take the loss because they gambled and lost their clothes. Why should we be required to cover their losses?
On Mar 13 10:40 AM besposito wrote:
> If you don't want to mark mortgages to market, DON'T turn them into
> securities. IF they are securities, they should be marked to market,
> if there is no market, they aren't worth anything, if you want to
> hold them, DON'T MAKE THEM SECURITIES.
>
An accounting system that forces financial institutions to carry assets at values that, you agree, can be irrational (and what is worse, manipulated) is, well, irrational.
On Mar 13 09:31 PM Hillsfar wrote:
> Centvalu: "Mark to market accounting would be appropriate if markets
> were efficient, and rational."
>
> Excuse me, but the very term and concept of 'mark to market' was
> created PRECISELY because markets are inefficient and irrational,
> and therefore values of assets are fluid and must be accounted for.
>
>
> Otherwise with static book or acquisition value, you have banks that
> pretend they are above water, planning shuffleboard games, even as
> the water rises above their heads.