Mark to Market: Why Not Bend the Rules on a Temporary Basis?

First, I don't claim to be a world-class expert on the intricacies of bank balance sheets, collateralized mortgage obligations (CMOs), and the like. But the debate regarding the "mark-to-market" (MTM) of bank and investment company assets is a fairly familiar subject to me, as I am experienced with derivatives, leverage and risk. As a former CBOE Market Maker, I had open options positions with a stock hedge (that were at times gigantic and involved hundreds of strikes on a single equity) that had to be priced every single trading night. The pricing of these options is called mark-to-market -- basically the clearing firm would price every option, usually using a bid/ask average or a theoretical price, depending on its liquidity. This would then be compiled into a risk profile/risk matrix on that particular equity's options.

Currently as a Portfolio Manager at BigTrends, we "mark-to-market" our client trade recommendations every trading night, using auto-broker fill prices and bid/ask averages. A Bid/Ask average is often better to use for options than Last Trade, because some options may not trade very often if at all during a given day. For stock positions, the Last Trade is an easy logical way to mark-to-market, which is what brokerage houses use to value your positions.

So in general, I am in favor of "fairly" valuing an asset on a systematic, timely basis. However, in the current situation, what has happened is that certain financial companies have acquired large baskets of assets which apparently have very little liquidity and are difficult to price -- in addition to the fact that they have lost huge amounts of value. Apparently a realistic MTM of these assets in the current market would cause balance sheets to basically turn insolvent for some companies. In the mean time, some of these assets may actually turn out to be drastically undervalued over the long term, if the mortgage/housing market stabilizes. But in the short-term, the pricing of them is causing problems for many companies that basically took on far too much risk/leverage.

So what makes sense to me is to allow some sort of temporary lifting of MTM regulations on certain assets held by banks and investment companies. I don't think this should be permanent -- in fact, we need to be adding more transparency, risk control, and regulatory rules in general because apparently many large firms virtually ignored their risk management departments (or more likely, the VPs of Risk Management were inclined to "play ostrich" and to look the other way due to the massive profits being brought in by certain departments). But if allowing these assets to priced on some sort of "positive curve" long-term theoretical valuation will help large financial institutions remain solvent, then a temporary changing of accounting rules would seem to be justified.

It's not as if gigantic corporations don't use financial shenanigans of all sorts anyway, running the gamut from extremely legal and ethical to basically shady and corrupt (see Enron for the latter). And by shenanigans I don't necessarily mean it as a negative connotation, more a colloquial expression -- could also be called "financial engineering". For example, remember when the venerable General Electric (GE) would exceed its quarterly earnings estimates by a penny or two, every single quarter like clockwork? In my view, that was basically due to complex massaging of financial engineering (probably contributed to by the GE Finance side) ... they could basically make the quarter come in at whatever number the company needed to hit. GE is just an example, I certainly am not making any assertions about its credibility -- the company is honest and forthright as far as I know ... it's just that when things were going great for most companies and the stock market, it had tactics and pools of money to utilize in order to meet (exceed) its numbers each quarter.

So, bottom line to me, if letting some "loose" or "creative" MTM occur will allow some giant financial institutions to stabilize (thus helping stabilize the entire world economy) ... then bend the rules on a temporary basis.

Disclosure: None.

Comments

[Mad Hedge F...:]

How about this? There is an easier, cheaper, and faster way to solve the banking crisis which no one is talking about on Capitol Hill. If collateralized debt obligations (CDO’s) are the problem, just get rid of them! Desecuritize them! Just convert them back into the underlying loans. There are $1.4 trillion in CDO’s outstanding backed by Alt-A and subprime loans in the form of 3,700 individual securitizations of perhaps 3.7 million loans. Over 68% of the loans backing these bonds are current. Mark to market rules are forcing the banks to carry this paper on their balance sheets at 50%-80% discounts. The problem is that mark to market is a meaningless accounting fiction when there is no market. If you break up these securities and place the underlying loans back on the banks’ balance sheets, the good mortgages can be valued at 100% of face, and those behind in their payments or in default can be discounted to maybe 70% because they are still secured by the value of the homes. This would boost the value of the entire asset class from the current 20-50 cents up to 90 cents on the dollar. Restored balance sheets would enable banks to resume lending. Of course it would be a massive admin job unwinding the rats’ nests behind some of these securities, but Heaven knows there is abundant subprime and Alt-A expertise available for hire these days. Just sift through the ashes of Lehman Brothers and Bear Stearns. It is a workable plan, and therefore is unlikely to ever see the light of day.

Mar 27 11:23 AM

[henarl:]

The combination of securitization and mark to market is far more toxic than the underlying assets of these mortgages. Unwinding the securitization would be advantageous, if possible, and suspending the current mark to market rules would be too.

Mar 27 01:12 PM

[Milton Recht:]

You are assuming the government wants a simple solution. This is the administration that does not want to waste a crisis. Until stronger Federal regulation of financial services is achieved, until GM is resolved and until the budget is passed, the banking crisis will linger.

Mar 27 01:40 PM

[Jay LITT:]

just remember the asset still has to make operational sense. I operate hotels and many of the properties that are not valued at their underlying debt is due to greed not market; shame on those that just "took" too much in the front end. Operators, like our group, now have to go into these businesses and restructure management, change operating guidelines, re-insure etc. That's what is needed: businessmen and women that can operate businesses that have real estate shells.

Apr 01 05:43 AM