In Defense of Mark to Market

After weeks of handing over the microphone to anyone who wants to bash mark-to-market accounting on its op-ed page, the Wall Street Journal decides a little equal time is in order. They handed over the mike to Mr. James Chanos, who provided an excellent analysis of the problems facing investors and the FASB at this pivotal moment in its history. From the editorial:

"The FASB and Securities and Exchange Commission (SEC) must stand firm in their respective efforts to ensure that investors get a true sense of the losses facing banks and investment firms. To be sure, we should work to make MTM accounting more precise, following, for example, the counsel of the President's Working Group on Financial Markets and the SEC's December 2008 recommendations for achieving greater clarity in valuation approaches.

Unfortunately, the FASB proposal on March 16 represents capitulation. It calls for "significant judgment" by banks in determining if a market or an asset is "inactive" and if a transaction is "distressed." This would give banks more discretion to throw out "quotes" and use valuation alternatives, including cash-flow estimates, to determine value in illiquid markets. In other words, it allows banks to substitute their own wishful-thinking judgments of value for market prices."

He's hit the nail on the head, I believe. While FASB is being yoked by Congress to "do something about mark-to-market accounting" before legislators do, they don't have to do harm. They could "do something" by sharpening disclosures for investors, for one thing.

The stability of financial institutions' capital can be extremely dependent on the very same securities they'll now have much more leeway in valuing.

Given that these proposals will affect regulatory capital, I don't think that diddling with the figures investors use is the right way for regulators to handle their responsibility for setting capital limits. Chanos is dead right in his suggestion that regulators "temporarily relax the arbitrary levels of regulatory capital, rather than compromise the integrity of all financial statements."

Comments

[market ace:]

Obviously it is stupid to push more emphasis on regulating and brow beating the accounting profession that to stand up for honest financial reporting even when it discloses that banks are really broke.

It's time to focus on disclosure and regulation of derivatives if anyone is really interested in timely, accurate reporting.

Mar 24 03:53 PM

[Milton Recht:]

The current debate about mark to market accounting is really a debate about assessing the ongoing viability of a financial company, especially a bank. Financial institutions and other companies are more than just a portfolio of their assets and liabilities. They are also businesses. Mark to market and historical price valuation of a balance sheet provide little, if any, information about the continued viability of the company's operations. Overly focusing on balance sheet values confusingly compares an institution to a closed end mutual fund.

Truthful income statements that accurately reflect revenues and expenses provide a clearer picture to the world of a company's ability to sell products at a price to cover expenses and provide a return to the owners. Income statements tell us whether a company has a successful business model. Its balance sheet does not. If businesses were only their balance sheets, every company with investors would succeed. Every restaurant would be crowded and profitable. One problem is that an income statement can distort the view of a company's earning power if gains and losses from mark to market are included.

If the bank has insufficient regulatory capital, the government can close a bank even if the bank's future business model is valid and will be profitable. The reverse is also true. A bank with a bad business plan can stay open if it has sufficient capital to satisfy the regulators.

A little over a year ago, Bear Stearns ran into funding problems. It posted collateral against its borrowings. As its collateral value diminished, Bear ran out of collateral to allow its debt to roll over. It faced a liquidity crisis. Investment banks mark to market every night. Changing mark to market methodology is not currently an investment banking industry concern and changes would not have solved Bear Stearns' collateral and liquidity problems.

Bank regulatory capital at large institutions pose two threats. Insufficient regulatory capital depresses stock prices because of the very real threat of a government takeover of the bank. It also depresses stock prices because the bank has to raise new capital and diminish the earnings available to the previous capital investors. In the current environment, mark to market has increased these threats to the continuation of the bank and to the previous investors. Naturally, these threats have caused an increase in the banking industry and in investors in the call for a change to mark to market use.

Mark to market debates are red herrings. The real issues are when should the government takeover a large troubled bank? How should the government deal with large troubled banks? Should we force them to raise new capital? Should the government invest in them, nationalize them, close them, merge them, etc? What do the regulators do about systemic risk?

Let us get off the mark to market obsession and deal with the real underlying issues affecting our banking system.

Mar 24 05:19 PM

[Buy and Hol...:]

Here's what I don't understand. If we get rid of mark to market, won't that make balance sheets less, not more transparent? After all, we won't know what went into valuing an asset that's on the balance sheet. All we'll know is that the company that owns it is going to set the value for it.

And in the case of the banks, that's like my broker letting me determine what the price is of the assets I use for margin purposes. My broker will only allow me to lever up so much, and the FDIC only allows banks to lever up so much.

I don't get to tell them, well, the GE stock that's in my account is a long term holding of mine, and I'm not selling it at $10 a share, so I'm assigning a value of $20 to it because that's the price I'm willing to sell it for.

So why should we let a bank do the same?

Mar 24 06:04 PM

[Between The...:]

great comments so far. Will someone against mark-to-market come out and say the obvious:"If we didn't have MtM, then this entire financial crisis would not have occurred." The reason it hasn't happened (by anyone of significance) is because that it obviously would not have prevented any sort of crisis. MtM demonstrating that your toxic security is worthless is a symptom of making and purchasing bad loans, not the cause. I'd be all for banks using cash-flow models to help value illiquid securities, and making these models and predictions public. However, we cannot stop considering the current market price of the asset as a key indicator of actual value, now and forever. I'd be fine with regulators considering all of this info (MtM and model value) when evaluating regulatory capital with respect to bank solvency and receivership. However, investors need to be able to evaluate the value of assets as well, and as the other commenter suggested, letting the inmates run the prison for asset valuation means that balance sheets will cease to be a meaningful evaluation of the company's financial position.

Mar 24 06:41 PM

[logicalthought:]

Milton Recht,

You write: "Mark to market and historical price valuation of a balance sheet provide little, if any, information about the continued viability of the company's operations."

Your statement is completely wrong when we're talking about a company (i.e., a bank) whose primary business is lending money. After all, if I repeatedly lend you $100 and the market has now determined that for each of those loans I'm only likely to get back $50, how do my operations have "continued viability"? And yet, if we don't mark that balance sheet to "reality", how would we ever know about this?

Mar 24 08:03 PM

[Milton Recht:]

"After all, if I repeatedly lend you $100 and the market has now determined that for each of those loans I'm only likely to get back $50, how do my operations have "continued viability"?"

I agree with your statement if the bank had no other future sources of income or loans, but banks with viable businesses do. All banks, even very good ones, write off some of their loans. All banks have made $100 loans that they only get $50 back or even less. However, most banks have other loans and sources of income to make up for the loss and to provide a reasonable return to their investors. Most banks today hold US Treasury bonds with very low interest rates that could be lent out as loans at a higher interest rate.

Every company has flops, but hopefully, it makes enough from other places or future business to be profitable in the long term. A balance sheet is a snapshot of a point in time. It does not include future business. In your example, suppose the bank made some $100 loans and got back only $50 on each of those loans. Suppose the bank learns its lesson, stops making those loans, and finds a different lending or bank service opportunity that is profitable over the next several years. The bank can get back to its starting place and recoup its losses by relending the $50 and redeploying cash and low yielding securities as loans. Sure it might be a bad past investment, but should the bank be closed?

Suppose you open a restaurant and sell hamburgers, hot dogs and steaks in an area that is predominately vegetarian. While there are some meat eaters, there are not enough customers for you to pay your rent, staff, interest and other expenses. You lose a lot of money. One day, you decide to change the restaurant's menu to vegetarian. Customers love your new food. You make lots of money and are successful. If the restaurant were a regulated bank, it would be shut down before the menu could be changed.

Loans are NOT now marked to market on a bank's balance sheet. Loan loss reserves are taken against loans based on historical and current loss experiences and are used to reduce the loans' balance sheet value. There is no market pricing or cash flow discounting of originated and kept loans. The bank determines the amount to set aside for loan loss subject to regulatory disapproval. Usually a bank reserves enough for the next couple of years expected loan losses and replenishes it as it is used. The expected losses over the next 10 -15 years are not taken all at once.

If the banks had not bought mortgage securities from other entities and instead had originated and kept their own mortgage loans, we would not be in the current mess. There would be no marked to market of the mortgages.

Changes in market prices are not just due to losses. For example, if a bank issues a 30-year, $100,000 mortgage at a fixed 5 percent and the rate for new mortgages shoots up to 10 percent after the mortgage is on the books, the old mortgage market price would be around 60 percent of its original value, $60,000. The borrower could be a great credit risk with zero chance of default and payoff the entire balance $100,000 over the life of the mortgage but because the market rate for mortgages increased, the old, low interest rate mortgage is worth less. It is worth less than the book value because it is paying less than the current market rate. However, it will payback the full $100,000. It is like buying older US Treasury bonds at discounted or premium prices because of the difference between the coupon rate on the old bonds and newly issued bonds. Discounted Treasury bonds still pay back the full principal.




On Mar 24 08:03 PM logicalthought wrote:

> Milton Recht,
>
> You write: "Mark to market and historical price valuation of a balance
> sheet provide little, if any, information about the continued viability
> of the company's operations."
>
> Your statement is completely wrong when we're talking about a company
> (i.e., a bank) whose primary business is lending money. After all,
> if I repeatedly lend you $100 and the market has now determined that
> for each of those loans I'm only likely to get back $50, how do my
> operations have "continued viability"? And yet, if we don't mark
> that balance sheet to "reality", how would we ever know about this?

Mar 25 07:28 AM

[logicalthought:]

Okay, I will agree that the balance sheet for a bank certainly provides "incomplete information". However, in my opinion, the way someone ran a business in the past (i.e., lending recklessly or buying stupidly-constructed mortgage securities... or not) is an excellent indicator of future performance (assuming the same management team is in place).


On Mar 25 07:28 AM Milton Recht wrote:

> "After all, if I repeatedly lend you $100 and the market has now
> determined that for each of those loans I'm only likely to get back
> $50, how do my operations have "continued viability"?"
>
> I agree with your statement if the bank had no other future sources
> of income or loans, but banks with viable businesses do. All banks,
> even very good ones, write off some of their loans. All banks have
> made $100 loans that they only get $50 back or even less. However,
> most banks have other loans and sources of income to make up for
> the loss and to provide a reasonable return to their investors. Most
> banks today hold US Treasury bonds with very low interest rates that
> could be lent out as loans at a higher interest rate.
>
> Every company has flops, but hopefully, it makes enough from other
> places or future business to be profitable in the long term. A balance
> sheet is a snapshot of a point in time. It does not include future
> business. In your example, suppose the bank made some $100 loans
> and got back only $50 on each of those loans. Suppose the bank learns
> its lesson, stops making those loans, and finds a different lending
> or bank service opportunity that is profitable over the next several
> years. The bank can get back to its starting place and recoup its
> losses by relending the $50 and redeploying cash and low yielding
> securities as loans. Sure it might be a bad past investment, but
> should the bank be closed?
>
> Suppose you open a restaurant and sell hamburgers, hot dogs and steaks
> in an area that is predominately vegetarian. While there are some
> meat eaters, there are not enough customers for you to pay your rent,
> staff, interest and other expenses. You lose a lot of money. One
> day, you decide to change the restaurant's menu to vegetarian. Customers
> love your new food. You make lots of money and are successful. If
> the restaurant were a regulated bank, it would be shut down before
> the menu could be changed.
>
> Loans are NOT now marked to market on a bank's balance sheet. Loan
> loss reserves are taken against loans based on historical and current
> loss experiences and are used to reduce the loans' balance sheet
> value. There is no market pricing or cash flow discounting of originated
> and kept loans. The bank determines the amount to set aside for loan
> loss subject to regulatory disapproval. Usually a bank reserves enough
> for the next couple of years expected loan losses and replenishes
> it as it is used. The expected losses over the next 10 -15 years
> are not taken all at once.
>
> If the banks had not bought mortgage securities from other entities
> and instead had originated and kept their own mortgage loans, we
> would not be in the current mess. There would be no marked to market
> of the mortgages.
>
> Changes in market prices are not just due to losses. For example,
> if a bank issues a 30-year, $100,000 mortgage at a fixed 5 percent
> and the rate for new mortgages shoots up to 10 percent after the
> mortgage is on the books, the old mortgage market price would be
> around 60 percent of its original value, $60,000. The borrower could
> be a great credit risk with zero chance of default and payoff the
> entire balance $100,000 over the life of the mortgage but because
> the market rate for mortgages increased, the old, low interest rate
> mortgage is worth less. It is worth less than the book value because
> it is paying less than the current market rate. However, it will
> payback the full $100,000. It is like buying older US Treasury bonds
> at discounted or premium prices because of the difference between
> the coupon rate on the old bonds and newly issued bonds. Discounted
> Treasury bonds still pay back the full principal.
>
>

Mar 25 07:54 AM

[logicalthought:]

P.S. What about the moral hazard issue? If you give banks a "free pass" on (fakely) juicing up their earnings by loading up their balance sheets with crap, they'll just keep doing it. I think the insolvent banks should be put into bankruptcy, with the equity holders getting wiped out, and the senior debt holders taking major haircuts.


On Mar 25 07:28 AM Milton Recht wrote:

Mar 25 09:02 AM

[Duncan:]

Good thread on this issue. The example of the hamburger stand is good in theory, but today's problem is really one of scale. It's as if the hamburger guy borrowed 30x his net worth and put it all in hamburger inventory. He can't go back and get another loan to convert to veggies. He's broke many times over. Of course letting a burger stand go under is nothing compared to seeing the entire US banking system fail.

What does it mean to owe trillions to the Chinese? Did you see their proposal for a global currency? We are going to see a lot of interesting ideas from them about making the world more Sino-centric and they will have leverage. Calling foreign debt is one of the main reasons the world is US centric today, and now we find ourselves being forced over to the other side of the fence. It's not a pleasant place to be.

The banking system needs everything we can do to keep it viable. Mtm is neither causal nor a silver bullet, it's a small but symbolic issue that can bolster confidence in the gov'ts commitment to get the banks back on their feet. But dropping MTM is not on the table. It works just fine in functioning markets both up and down. FASB needs to develop guidelines to help define when a market is frozen or an asset class is distressed. Judgment is obviously not in great supply among the current inmates of our banking asylum, er industry.

Mar 25 11:05 AM

[CalTexan:]

I, and millions of other Americans are still paying our mortgages. The banks/insurers that own these as Mortgage Backed Securities are still receiving some sort of an income stream from them. Now if I remember my Finance 101, the cash flow from a performing asset discounted by some interest rate gives that asset a Net Present Value, and although it may be pretty low, I don't think it's zero. I believe we should Mark Troubled Assets to Current Cash Flows on an annual basis up to the face value of the loans. This would solve a whole host of problems:

1) Simplicity-It's not hard to figure out the CURRENT value of the asset. Cashflow is this. Interest rate is this (30 yr bond? Fed Funds? Prime +2%? 30 yr fixed mortgage? I don't know what interest rate to use, that's what Tim and Ben should decide). Voila!!! Value is this. Easy. Simple. No models. No complex formulas. Here is what its value is TODAY. (Actually this IS a little like Mark to Market when you think about it...)

2)Transparency-If a loan is nonperforming the cash flow from it decreases and its value goes down. It should be written down and a charge taken. No chicanery, no manipulation, just facts. If it's performing, it has SOME value. The current arrangement was put in place (from ENRON and WORLDCOMM experiences) to prevent assets worth nothing being valued at something. The unintended consequence now is that assets worth something are being valued at nothing.

3) Policy-If the Fed needs to slow down the economy, it can raise interest rates, the value of the asset producing cash flow goes down, the business writes it down, it has less regulatory capital and reduces lending. If the economy needs stimulus the Fed decreases the rates, the value of the asset producing cash flow goes up, banks have greater regulatory capital available and can lend more to aid economic activity. (If the economy needs some extra juice, you even have the option to temporarily lift the "Face Value Max" restriction)

4) Cost-With this solution, you don't need programs, TARP, TALF, Bank Nationalization or $2 Trillion in extra Federal Spending to make up for the PRIMARILY PAPER LOSSES on the Balance Sheets of banks. All you need is someone with knowledge of Finance, GAAP and a little common sense to revise the rules, figure out what discount rate to use, then let the banks revise their balance sheets, income statements and begin to lend again so the current economic "crisis" can finally be over....

Bottom Line? We're talking about PAPER and how you RECORD things on PAPER. The problem right now is we have a rule that forces us to exxagerate our PAPER losses (and oh by the way it allowed us to also exxagerate our PAPER gains when there was a market, isn't that short term speculation?!?!?!) and it's having an effect on the REAL economy. It's a RULE. Change it. It will take 15 minutes. Pro forma Bank Balance sheets and earnings statements for the past 3 years with both methods and see how their regulatory capital situation looks. It can't hurt to at least give it a TRY....

Mar 26 12:30 PM

[CalTexan:]

Obviously, I "exxagerated" when spelling exaggerate in this comment....


On Mar 26 12:30 PM CalTexan wrote:

> I, and millions of other Americans are still paying our mortgages.
> The banks/insurers that own these as Mortgage Backed Securities are
> still receiving some sort of an income stream from them. Now if I
> remember my Finance 101, the cash flow from a performing asset discounted
> by some interest rate gives that asset a Net Present Value, and although
> it may be pretty low, I don't think it's zero. I believe we should
> Mark Troubled Assets to Current Cash Flows on an annual basis up
> to the face value of the loans. This would solve a whole host of
> problems:
>
> 1) Simplicity-It's not hard to figure out the CURRENT value of the
> asset. Cashflow is this. Interest rate is this (30 yr bond? Fed Funds?
> Prime +2%? 30 yr fixed mortgage? I don't know what interest rate
> to use, that's what Tim and Ben should decide). Voila!!! Value is
> this. Easy. Simple. No models. No complex formulas. Here is what
> its value is TODAY. (Actually this IS a little like Mark to Market
> when you think about it...)
>
> 2)Transparency-If a loan is nonperforming the cash flow from it decreases
> and its value goes down. It should be written down and a charge taken.
> No chicanery, no manipulation, just facts. If it's performing, it
> has SOME value. The current arrangement was put in place (from ENRON
> and WORLDCOMM experiences) to prevent assets worth nothing being
> valued at something. The unintended consequence now is that assets
> worth something are being valued at nothing.
>
> 3) Policy-If the Fed needs to slow down the economy, it can raise
> interest rates, the value of the asset producing cash flow goes down,
> the business writes it down, it has less regulatory capital and reduces
> lending. If the economy needs stimulus the Fed decreases the rates,
> the value of the asset producing cash flow goes up, banks have greater
> regulatory capital available and can lend more to aid economic activity.
> (If the economy needs some extra juice, you even have the option
> to temporarily lift the "Face Value Max" restriction)
>
> 4) Cost-With this solution, you don't need programs, TARP, TALF,
> Bank Nationalization or $2 Trillion in extra Federal Spending to
> make up for the PRIMARILY PAPER LOSSES on the Balance Sheets of banks.
> All you need is someone with knowledge of Finance, GAAP and a little
> common sense to revise the rules, figure out what discount rate to
> use, then let the banks revise their balance sheets, income statements
> and begin to lend again so the current economic "crisis" can finally
> be over....
>
> Bottom Line? We're talking about PAPER and how you RECORD things
> on PAPER. The problem right now is we have a rule that forces us
> to exxagerate our PAPER losses (and oh by the way it allowed us to
> also exxagerate our PAPER gains when there was a market, isn't that
> short term speculation?!?!?!) and it's having an effect on the REAL
> economy. It's a RULE. Change it. It will take 15 minutes. Pro forma
> Bank Balance sheets and earnings statements for the past 3 years
> with both methods and see how their regulatory capital situation
> looks. It can't hurt to at least give it a TRY....

Mar 26 12:33 PM

[MHN:]

Not exactly. Imagine you have a company selling widgits. Typically you buy the widgits for x and sell them for 2x. Every once in a while you have sales and sell them for 1.5x or even x. Sometimes you have dead inventory and you sell it for less than x.

If, however, you're going out of business and have to vacate the premises you might get only .02x (2 cents on a dollar you paid). I personally have seen this in action more than once.

So, what is the value of your widgits? As they get closer to being dead inventory (clothing is prime example of this) the value of the widgits approach zero.

Mark to market is excellent except in a market that's crashing. I had a piece of property that lost half its value in the 1990s before coming back. If I was FORCED to sell I would have lost money. I waited -- had to live somewhere right? -- and made money.






On Mar 24 06:04 PM Buy and Hold Plus wrote:

> Here's what I don't understand. If we get rid of mark to market,
> won't that make balance sheets less, not more transparent? After
> all, we won't know what went into valuing an asset that's on the
> balance sheet. All we'll know is that the company that owns it is
> going to set the value for it.
>
> And in the case of the banks, that's like my broker letting me determine
> what the price is of the assets I use for margin purposes. My broker
> will only allow me to lever up so much, and the FDIC only allows
> banks to lever up so much.
>
> I don't get to tell them, well, the GE stock that's in my account
> is a long term holding of mine, and I'm not selling it at $10 a share,
> so I'm assigning a value of $20 to it because that's the price I'm
> willing to sell it for.
>
> So why should we let a bank do the same?

Aug 19 02:28 PM