Schrodinger's Mark-to-Market Law of Dead Cats

In 1935 Schrodinger came up with an explanation about how some elementary particles appeared to be able to exist in two "states" at the same time. This involved the idea of a cat in a box that was fed poison and monitored by a Geiger Counter which showed that the cat was dead and alive at the same time, but you couldn't know if it was dead or alive unless you looked in the box. Sound nuts, but if Schrodinger (or someone else) hadn’t figured that out you would be still using pen and paper and communicating by Telex.

That's exactly the problem with mark-to-market of asset-backed-securities (ABS).

There are two values that matter.

1. What you can sell it for today (mark to market). This value affects how you calculate your capital adequacy which is about having enough "liquid" assets on hand to be able to deal with a run. How this is calculated is mandated by banking regulations.The whole point of ABS was that unlike the loans that they were packaged out of, you could buy and sell them, so they were "liquid", and therefore their value in terms of achieving the required capital adequacy targets was much more than the underlying loans.
2. What it will be worth when you decide to sell it, or if you hold it until you know how much of the loan(s) and interest will be paid back. That's the same question that you ask when valuing assets (loans) every day of the week. This valuation affects solvency and so long as a loan pays back when you expect it to, you will be able to meet your obligations on that day. The job of the auditor is to report if that is a reasonable notion. If it is, he will sign-off the audit (a) to say you are solvent and (b) that you are a "going concern", i.e. you can expect to be in business this time next year.

What the auditors had (have) a problem with, was (is) the notion that the same asset could be recorded in one place in the accounts as having a value of say 80 cents on the dollar (hold to maturity) and at the same time being valued at 30 cents on the dollar (mark-to-market) somewhere else in the accounts.

The current "solution" that is being put forward does not solve that problem, all it does is give a lot more latitude for management to decide whether to count the cat as "dead" i.e. 30 cents on the dollar, or not (i.e. 80 cents on the dollar). Previously it was basically the auditor who decided, and in the current climate auditors are not in a mood to do anyone any favors or to have their arms twisted, so more often than not they insisted on the 30.

It is likely that the banks will elect to record to 80 cents, which the new rules will let them do, even if this means that their capital adequacy is shot, simply because they know that the government has explicitly or implicitly guaranteed that there will be no runs on banks, so long as they meet their “Stress Tests”, which is in reality just a way of re-formulating the capital adequacy regulations that failed in the past (evidently otherwise the banks would not have needed re-capitalizing).

So most banks will be (technically) solvent, but will be at risk of runs and may still have a problem rolling over debt. But who cares, the government is standing by, and in the old days that was called “forebearance”.

How about "transparency"

The old rules stipulated that a cat could either be dead or alive, AND they stipulated when the cat should be considered dead, and when it should be considered alive. Now management has a choice, but there is no reason that this should reduce transparency, so long as this is understood and reported properly. The fact that management can chose how they get to comply with the various regulations they are obliged to comply with, gives them more latitude.

But there is nothing "sleight-of-hand" - all management is doing is valuing loans just like they always valued loans.

But that's not the end of the story. The reality is that the cat CAN be dead and alive at the same time, and until the financial reporting standards properly reflect and report on this reality to shareholders and investors, they will be at risk. Transparency is not about rules; it is about communicating the reality to the people who need to know what the reality is.

What's ironic is that International Valuation Standards deal with this reality ten years ago, there is nothing "new" here.

Example: How mark-to-market caused the credit crunch:

Mark-to-market isn't just used to value toxic assets, houses are typically valued mark-to-market. That makes sense, a buyer wants to know the right price on the day, so does the seller, and the bank financing that transaction wants to know that the buyer and the seller are not colluding.

But that value is not necessarily a good value to use when calculating the cover on a loan collateralized by the house, because, as just happened, the price that a house bought in June 2006 could sell for now is a lot less.

So a prudent "Mortgage Value" (an EU concept) or "Other-than-Market-Value (International Valuation Standards), would have been the correct value to use. In 2006 that might have been 40% lower than mark-to-market if properly assessed. And there was no reason why that value should not have been reported - just no one asked the question.

So in June 2006 the mark-to-market value might have been 100 and the other-than-market value might have been 60; two purposes, two values, at the same moment in time.

But that didn't happen; the rest is history.

Let's hope that piece of history will not repeat, and that the reality that a cat can be dead and alive at the same time will be incorporated into accountancy standards.

Time to move on from the constraints of the past (that failed), to a system that can deal with the future.

Stock position: None.

Comments

[mplaut:]

I think you got the idea and the title for this article from the comments on the last one. It is unfortunate since there is a lot of clarity in your remarks and it is obscured by the screwy title.

Thanks for a good article.

Apr 03 04:45 AM

[Andrew E Bu...:]

You are right, I liked the idea of the dead cat in a box which is alive and dead at the same time

Yeah..I suppose you are right the title IS pretentious if you didn't read the joke on the last one.

Thanks for the comment

Apr 03 07:06 AM

[User 386086:]

I think Butter has it exactly right. I also like the analogy. There are two different realities here. Mark to market reflects a point in time. The asset also has a life of its own independent of market conditions. Although we''ll need to check with Soros on our physics.

Apr 03 07:18 AM

[dtrader:]

Is a glass half empty or half full? If your heart stops and then you are revived 5 minutes later were you dead, alive or both? Schrodinger was a renowned scientist but he really shouldn't be given credit for a new scientific discovery which is probably more an issue on how we define things.

Changing mark to the mark is probably like going back to the future but in reverse forward to the past.

Sorry I don't have the time to discuss my perspective on mark to the mark right now but some of us actually still have a job thank God and I better not be late. Maybe I'll be able to find some time later to make some comments.

Apr 03 07:27 AM

[SW Richmond:]

One of the reasons that we are where we are today is that everyone likes "mark to market" when the market is up and it makes them feel wealthy.

"So a prudent "Mortgage Value" (an EU concept) or "Other-than-Market-Value (International Valuation Standards), would have been the correct value to use. In 2006 that might have been 40% lower than mark-to-market if properly assessed. And there was no reason why that value should not have been reported - just no one asked the question."

By suggesting we might have used 'correct' values for houses in 2006 the author suggests that we might have broadly recognized we were in a bubble. Well, some of us did, but the high 'mark to market' valuations kept the game going and there was absolutely no interest in marking MBS securities to anything but inflated market values based on the inflated values of the homes contained therein. Now that the bubble has burst and the securities are beginning to fail to perform AND the underlying assets (homes) are losing their market value, we are to correct our earlier error and mark those securities to values which are still based on the inflated home values? This is mark-to-fantasy, defeats transparency and is exactly the wrong approach.

Are the auditors who are to buy into this idea not supposed to take into account future outlook for these securities? Have we forgotten about the now-famous Credit Suisse mortgage reset chart? Are we ignoring the unemployment numbers?

Hmmmmm, tell me again why this makes sense? And finally, as an engineer I object to your ridiculous misuse of Shroedinger's good name. MBS do not exist in some quantum state, as much as banks would like them to. There is nothing scientific about any need to imagine that an MBS is more valuable than it really is. It is quackery. I'm afraid your article merely exhorts everyone to get on board with this latest fantasy.

Apr 03 08:33 AM

[Allan Frain:]

Excellent.

Key points. 1) Mark-to-Market is subjective, hence 2) the rule does not provide transparency, but flexibility.

The last thing we need is to allow these banks more flexibility.

Apr 03 09:08 AM

[Andrew E Bu...:]

Sorry to misuse Schrodinger’s name but I thought he was a Physicist, if I’d known he was an engineer I would have been more careful.

Let me explain my point in engineering terms.

Say you are designing a pipeline, you work out the maximum flow and you size the pipe and the pump by optimization. So in your calculation sheet you have one “value” for pressure, the purpose of that value is to decide the head of the pump.

Then you work out the surge pressure that might occur either in a normal course of events (opening and closing valves too fast, electrical failure on the pump - etc), or because once in a blue moon someone might do something stupid (that's called Murphy's law (I hope you don't have any special affection to people called "Murphy", if you do I apologize but I'm afraid that is a well known engineering expression).

Anyway then you get another "value" for pressure, and you decide do you put in surge protection devices, relief valves etc to prevent column separation, or do you just specify a pipe of a higher pressure rating and up-size your thrust blocks? Either way you have two values for pressure, depending on the purpose of your "valuation".

In this analogy in 2003/4/5/6 the "engineers" decided not to work out the "surge pressure". Someone did something stupid, the pipe burst causing a huge amount of damage.

Questions:

(1):Who's fault was that?

(2): Is it smart the next time you design a pipeline to deny that you need to work out TWO pressures, or is it reckless?



On Apr 03 08:33 AM SW Richmond wrote:

> One of the reasons that we are where we are today is that everyone
> likes "mark to market" when the market is up and it makes them feel
> wealthy.
>
> "So a prudent "Mortgage Value" (an EU concept) or "Other-than-Market-Value
> (International Valuation Standards), would have been the correct
> value to use. In 2006 that might have been 40% lower than mark-to-market
> if properly assessed. And there was no reason why that value should
> not have been reported - just no one asked the question."
>
> By suggesting we might have used 'correct' values for houses in 2006
> the author suggests that we might have broadly recognized we were
> in a bubble. Well, some of us did, but the high 'mark to market'
> valuations kept the game going and there was absolutely no interest
> in marking MBS securities to anything but inflated market values
> based on the inflated values of the homes contained therein. Now
> that the bubble has burst and the securities are beginning to fail
> to perform AND the underlying assets (homes) are losing their market
> value, we are to correct our earlier error and mark those securities
> to values which are still based on the inflated home values? This
> is mark-to-fantasy, defeats transparency and is exactly the wrong
> approach.
>
> Are the auditors who are to buy into this idea not supposed to take
> into account future outlook for these securities? Have we forgotten
> about the now-famous Credit Suisse mortgage reset chart? Are we
> ignoring the unemployment numbers?
>
> Hmmmmm, tell me again why this makes sense? And finally, as an engineer
> I object to your ridiculous misuse of Shroedinger's good name. MBS
> do not exist in some quantum state, as much as banks would like them
> to. There is nothing scientific about any need to imagine that an
> MBS is more valuable than it really is. It is quackery. I'm afraid
> your article merely exhorts everyone to get on board with this latest
> fantasy.

Apr 03 10:06 AM

[SW Richmond:]

Mr Butter,

I will engage your attempt at misdirecting my criticism in this manner:

If you were an engineer you would know that the engineers would not have used two values, they would have used a worst case value and designed the system to withstand that, something the bankers obviously did not do. And while they would certainly have used a range of operating values for sizing the pump, the piping would have been rated for worst case. Period.

Bankers, on the other hand, want to change the rules to suit them as the case might warrant. Each time I drive over a bridge my engineering background makes me exceedingly glad that bridges are not designed by bankers. The banking system designed by bankers and run by bankers has directed traffic straight into the chasm precisely because their bridge failed. Now that the bridge has failed the stress test they want to change the design requirements for the bridge. This is not a rigorous approach to anything, let alone engineering. It is obfuscation, something that would land an engineer in jail and earn him the contempt of his peers, as in the case of the recent famous bridge collapse, the response to which included a search for the guilty. Bankers, on the other hand, seem to praise each other for constantly indulging in obfuscation, and believe they are due bonuses for getting away with it. Nor has there been any such search for the guilty, since everyone knows that bankers are not guilty of anything even though they have destroyed millions of lives.

Of course, I am well aware that Shroedinger was a scientist and not an engineer.

Apr 03 10:38 AM

[sr9web:]

Ah but Wall Street is full of "engineers" - "financial engineers" that is. Of course, they live in an elastic reality which is buffered by their personally owned levels of extreme wealth. And for that reason, it matter not one whit to them if the crap they feed us is nothing more than a house of cards held together with spit and bubble gum. As to what they engineered this time, well it's just more of the same: They get richer, the average joe gets poorer. And how do they manage this? Because they never do publish the full specs to the projects they're working on. Even Rube Goldberg could tell you that Wall Street plans are insane, but we never get to see the full plans. So alas, the hard discipline of honest design work is never applied. What we get instead is hype, spoofery and scams.


On Apr 03 10:38 AM SW Richmond wrote:

> Mr Butter,
>
> I will engage your attempt at misdirecting my criticism in this manner:
>
>
> If you were an engineer you would know that the engineers would not
> have used two values, they would have used a worst case value and
> designed the system to withstand that, something the bankers obviously
> did not do. And while they would certainly have used a range of operating
> values for sizing the pump, the piping would have been rated for
> worst case. Period.
>
> Bankers, on the other hand, want to change the rules to suit them
> as the case might warrant. Each time I drive over a bridge my engineering
> background makes me exceedingly glad that bridges are not designed
> by bankers. The banking system designed by bankers and run by bankers
> has directed traffic straight into the chasm precisely because their
> bridge failed. Now that the bridge has failed the stress test they
> want to change the design requirements for the bridge. This is not
> a rigorous approach to anything, let alone engineering. It is obfuscation,
> something that would land an engineer in jail and earn him the contempt
> of his peers, as in the case of the recent famous bridge collapse,
> the response to which included a search for the guilty. Bankers,
> on the other hand, seem to praise each other for constantly indulging
> in obfuscation, and believe they are due bonuses for getting away
> with it. Nor has there been any such search for the guilty, since
> everyone knows that bankers are not guilty of anything even though
> they have destroyed millions of lives.
>
> Of course, I am well aware that Shroedinger was a scientist and not
> an engineer.

Apr 03 12:07 PM

[Andrew E Bu...:]

I agree with you - someone designed a bridge that fell down, it is a disgrace.

We disagree about where the original mistake was, and how to fix it.

The original mistake was valuing houses in a market that was obviously in disequilibrium using market-to-market to decide a prudent Loan to Value. The system that allowed that was ultimately at fault, bankers, accountants, regulators, does it matter?

The mistake was pretending the market was not in disequilibrium.

Now the market is in disequilibrium, on the other size. All I'm saying is quit pretending, and use IVS which was explicitly designed to handle this situation.

By the way I am an engineer - Cambridge University Class of 75, designed hundreds of pipelines and pump-stations; never had a complaint yet.


On Apr 03 10:38 AM SW Richmond wrote:

> Mr Butter,
>
> I will engage your attempt at misdirecting my criticism in this manner:
>
>
> If you were an engineer you would know that the engineers would not
> have used two values, they would have used a worst case value and
> designed the system to withstand that, something the bankers obviously
> did not do. And while they would certainly have used a range of
> operating values for sizing the pump, the piping would have been
> rated for worst case. Period.
>
> Bankers, on the other hand, want to change the rules to suit them
> as the case might warrant. Each time I drive over a bridge my engineering
> background makes me exceedingly glad that bridges are not designed
> by bankers. The banking system designed by bankers and run by bankers
> has directed traffic straight into the chasm precisely because their
> bridge failed. Now that the bridge has failed the stress test they
> want to change the design requirements for the bridge. This is not
> a rigorous approach to anything, let alone engineering. It is obfuscation,
> something that would land an engineer in jail and earn him the contempt
> of his peers, as in the case of the recent famous bridge collapse,
> the response to which included a search for the guilty. Bankers,
> on the other hand, seem to praise each other for constantly indulging
> in obfuscation, and believe they are due bonuses for getting away
> with it. Nor has there been any such search for the guilty, since
> everyone knows that bankers are not guilty of anything even though
> they have destroyed millions of lives.
>
> Of course, I am well aware that Shroedinger was a scientist and not
> an engineer.

Apr 03 01:33 PM

[fireball:]

no cat has 8 tails.
every cat has one more tail thaan no cat.
therefore every cat has nine tails.

loan me $100
only give me $50 now.
then you will owe me $50.
i will owe you $50. so we will be even.

can i get a job keeping the books yet?

Apr 03 03:30 PM