New Mark-to-Market Rules: Playing Pretend 46 comments
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When elementary school kids want to escape the confines of their circumstances they pretend to be pirates, princesses, and Jedi knights. Now, with the relaxation of "mark to market" valuation rules announced last week by the accounting trade's self-regulatory body, our bankrupt financial institutions can escape their own reality by pretending to be solvent. The unraveling of our fairytale economy over the last few months has not yet convinced us that the time has come to put away childish things. The applause that greeted the news Thursday on Wall Street is a clear sign that we still have some growing up to do.
The imaginative conceit that lies behind the accounting change is that the toxic assets polluting bank balance sheets are not really toxic at all. They are in fact highly valuable assets that for some irrational reason no one wants to buy.
Using the "mark to market" accounting method, mortgage-backed securities were valued relative to the latest prices fetched by the sale of similar assets on the open market. Currently, those bonds are being sold at deep discounts to their original value. By "marking" their unsold bonds down to those prices, the insolvency of our financial institutions had been laid bare. The new accounting changes will allow the nervous owners to assign more "appropriate" (i.e. higher) values. Problem solved.
It is important to note that the Financial Accounting Standards Board made their rule modifications only after intense pressure had been applied by Washington and Wall Street. In their heart of hearts, I can't imagine that there are too many bean counters happy with the outcome.
The banks and the government have argued that the assets should be valued based solely on current cash flow. Most mortgages, after all, are not delinquent. Therefore, a few bad apples should not spoil the whole cart, and those that are not yet delinquent should be valued at par. This method assumes we have no ability to look into the future and make assumptions about what is likely to happen, which is presumably what the market is already doing by valuing the assets lower than the banks wish.
All kinds of bonds (corporate, government and municipal, etc.) that are not in default frequently trade at discounts. In fact, the reason that agencies such as Moody's and Standard and Poor's rate bonds is to assess the probability of default. The higher that probability, the lower the value placed on the bonds, regardless of their current cash flow.
For example, GM bonds that mature 10 years from now currently trade for only 8 to 10 cents on the dollar, despite the fact that GM is current on all interest payments. The 90% discount reflects investor awareness that GM will likely default long before the bonds mature. By the new logic, financial institutions with GM bonds on their balance sheets should be able to ignore the market and value these bonds at par.
Some argue that the comparison is invalid because GM's bonds are liquid while mortgage-backed securities are not. However, if sellers of GM bonds were holding out for 70 or 80 cents on the dollar, those bonds would be illiquid too. The reason GM bonds are trading is that sellers are realistic.
The same should apply to bonds backed by mortgages. To assume that a 30-year, $500,000 mortgage on a house that has declined in value to $300,000 has a high probability of remaining current to maturity is ridiculous. The borrower could lose his job, his ARM might reset higher, or he may simply tire of paying an expensive mortgage for a house that is unlikely to be sold at a profit. Any bond investor with half a brain will factor in these probabilities and look for deep discounts. The only way to accurately assess a real present value is to let the market discover the price.
Despite the pleas from bankers and politicians, mortgages are not plagued by a lack of liquidity but a lack of value. If sellers would be more negotiable, there would be plenty of liquidity. Who knows, at the right price I might even buy a few. The problem is that putting a market price on these assets would render most financial institutions insolvent, which is precisely why they do not want to let that happen.
Simply pretending that all these mortgages will be repaid does not solve the underlying problems. It may keep some banks alive longer, but when they ultimately do fail, the losses will be that much greater. In the meantime, solvent institutions are deprived of capital as more funds are funneled into insolvent "too big to fail" institutions - hiding their toxic assets behind rosy assumptions and phony marks.
Going from the sublime to the completely ridiculous, in a speech at the just-concluded G20 summit in London, President Obama urged Americans not to let their fears crimp their spending. It would be unwise, he argued, for Americans to let the fear of job loss, lack of savings, unpaid bills, credit card debt or student loans deter them from making major purchases. According to the president, "we must spend now as an investment for the future." So in this land of imagination (where subprime mortgages are valued at par), instead of saving for the future, we must spend for the future.
I guess Ben Franklin had it wrong too - apparently a penny spent is a penny earned.
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Obama has not changed one molecule. He is already a cornered animal, showing a teflon exterior (with tremendous media backing). What did the article you just read clearly indicate...washington is now institutionalizing and enforcing blatant fraud!! Holy crap logical...snap out of it. Where else do you think this could possibly lead?? You can never talk your way out of something you behave your way into!
With that said, I would love another shot at SKF and hopefully they can't hold down TBT much longer either.
On Apr 05 09:29 AM logicalthought wrote:
> This is an excellent summary. However, I'm a bit more optimistic
> about how this will all work out than is Peter and most of the comment
> posters here.
>
> I think that while most Americans are somewhat macroeconomically
> naive (after all, they've got their own problems to worry about!),
> once they do get a good approximation of what's going on, they can
> force Congress to think quite sensibly (and Obama already strikes
> me as an extremely smart and adaptable guy who has recently learned
> to rein in his leftist tendencies). In that light, I think that if
> the mortgage-backed paper continues to erode in value (as, as Peter
> writes, the cash flows dry up), the American people will simply say
> "Enough! We poured enough into this already, and now it's time for
> the banks' equity and debt holders to pay for the rest of this (via
> major-league haircuts)."
>
> I really think that in the end (and yes, it often takes a while),
> common sense usually wins out in this great country of ours.
>
> P.S. The other thing I'm saying is that if bank stocks keep going
> up, eventually we'll be handed the rare gift of an instant replay
> on one of the great shorting opportunities of all time (via the beautiful,
> high-beta insanity of the SKF).
Here's why: by marking to market, investors that aren't close to the insiders can get a pretty good picture of the financial condition of an entity, assuming the CFO / CEO aren't cheating.
Now, retail investors will have to guess for themselves and include their own price estimation when putting a price on the entity as a whole. Pricing multiple entities with different maturities can only lead to more volatility.
Volatility is how investors calculate risk. More volatility is more risk. More risk leads to a lower P/E.
In my opinion, the new rules are erasing potentially a trillion dollars worth of stock market equity by cutting the P/E multiples. That's sad, because it's like a hidden tax.
I understand where the banks are coming from. I still would rather have seen more balance sheet transparency than a mark-to-whatever move. Let ME, the retail investor, decide if the fire sale prices on bonds held to maturity are extreme.
A relatively small percentage of defaults in a CMO can render the security worthless (as we have seen with subprime paper), so unfortunately, the value of MBS paper is likely not as substantial as you suggest.
On Apr 05 01:11 PM retired aviator wrote:
> It's completely unfair to compare mortgage-backed's with GM's bonds.
> Everybody knows GM is insolvent and likely to default. More importantly,
> it is a single entity, so it's an all or nothing proposition (nothing,
> except whatever Chapter 11 might award).
>
> MBS on the other hand are diversified with millions of borrowers
> and only some percentage of them will ultimately default. It's anybody's
> guess what that percentage will be, when the economy bottoms. As
> MBS are diversified baskets of mortgages, they will undoubtedly have
> substantial value in any scenario.
>
> More importantly is the "MB" of "MBS". In default, creditors then
> own the homes, and homes are a type of collateral that can't walk
> away. GM's unsecured bonds bear no resemblance whatsoever to mortgages
> where the creditor in worst case scenario owns a valuable piece of
> real estate.
You have what, 189 trillion $ worth of derivatives in top 25 US banks (OCC’s Quarterly Report on Bank Trading and Derivatives Activities for the 3rd quarter), let alone the infamous quadrillion melting iceberg of the whole world’s financial instruments.
Yes, Fed is printing money and it’s being funneled to banks en masse. So what? How all those printed dollars getting sucked into this financial hole will be inflationary?
To all you gold lovers and adorers of "I am right and all my critics are wrong!" genius who has already managed to loose a bunch of money on his decoupling/etc strategies - if this is really it, call it Great Depression 2 or something, and the layoffs and demand will continue to go down in a spiral – you’re so gonna get burned it won’t be in the least damn fun.
I just fail to see why there throughout this crisis there has developed a pure herd mentality gold that will shine IF the world economy and financial system collapse sometime in future.
“They will throw their silver into the streets, And their gold will be like refuse; Their silver and their gold will not be able to deliver them In the day of the wrath of the LORD” (Ezekiel 7:19).
"I don't make jokes anymore, I just watch what the government does and report it."
Only half joking, I think all our financial problems would be solved if the government gave everyone a million dollars. Then we would all be millionaires.
Don't laugh. It's worth a try. Besides, I could use the money.
On Apr 05 07:39 AM sticktoitiveness wrote:
> If the bears are right, and so far thy have been, the accounting
> change only kicks the can down the road. As the cash flow drops on
> the CDOs they will have to write them down again. Just wait 4 or
> 5 months.
>
> "Who knows, at the right price I might even buy a few."
>
> I can hear the sarcasm in your written words. Now, where did I put
> my meds.
On Apr 05 09:29 AM logicalthought wrote:
> This is an excellent summary. However, I'm a bit more optimistic
> about how this will all work out than is Peter and most of the comment
> posters here.
>
> I think that while most Americans are somewhat macroeconomically
> naive (after all, they've got their own problems to worry about!),
> once they do get a good approximation of what's going on, they can
> force Congress to think quite sensibly (and Obama already strikes
> me as an extremely smart and adaptable guy who has recently learned
> to rein in his leftist tendencies). In that light, I think that if
> the mortgage-backed paper continues to erode in value (as, as Peter
> writes, the cash flows dry up), the American people will simply say
> "Enough! We poured enough into this already, and now it's time for
> the banks' equity and debt holders to pay for the rest of this (via
> major-league haircuts)."
>
> I really think that in the end (and yes, it often takes a while),
> common sense usually wins out in this great country of ours.
>
> P.S. The other thing I'm saying is that if bank stocks keep going
> up, eventually we'll be handed the rare gift of an instant replay
> on one of the great shorting opportunities of all time (via the beautiful,
> high-beta insanity of the SKF).
Americans have been programed to believe the government will always save us. Post Hoc Ergo Proctor Hoc fallacy. what worked in the past will always work in the future. A surprise is coming !!!
The great government salvation game is finally coming to an abrupt end.
On Apr 13 07:11 PM bpgreen20 wrote:
> I may misunderstand this rule and it's application to loans secured
> by real estate but if I don't misunderstand it this seems like a
> positive change. My understanding is that in a case where a bank
> makes a $500,000 loan against $600,000 in real estate and the borrower
> ceases to make payments against the loan the bank is forced to record
> the value of the loan as zero on their balance sheet since the payments
> are not being made and it is not likely that they can sell the note
> on a secondary market. Where the rule falls short is that it ignores
> the value of the collateral in the case of a loan secured by real
> property. While the value of the asset (right to foreclose) held
> by the bank will not be the full future value of the $500,000 loan
> payments it is certainly not zero and the change in the rule to allow
> the bank to assign a value other than zero is clearly logical. Do
> I understand this rule correctly?
Was was that rule allowed (by someone who worked for Enron no less) to let other people insure against your debt?
so if my neighbors buy home insurance on my home I am suppose to feel safe?
the market is too rigged for any fundamentals these days.
remember how people used to say that currency markets aren't that safe since governments can cause too much change in a matter of days??? how did ALL of our markets get to this phase?
no wonder so many people are just buying guns and ammo. It is something they can understand.
No. Money is not a zero sum game. It is created and destroyed as easy as a character gathering gold coins in a video game.
That said, inflation happens when expectations of the value of goods and services outstrips the value of money and its obligations.
It is a double edged sword. Because they government can print all the money it wants as long as it isn't used for anything that goes into circulation of the main economic sphere.
It is a double edged sword.
Like the bank of Japan... They print money out the wazoo but because Japanese bank refuse to loan it and Japanese people refuse to spend their savings, then Yen tends to be more valuable than most other currencies right now in the broad sense.
Currency value has really nothing to do with being backed by anything in particular or government debt. The Swiss franc is one of the few currencies back by fractional gold but Switzerland has a higher debt to GDP ratio than the USA (strangley enough).
Then again... I always joke that the USD is backed by the IRS and nuclear weapons. Perhaps Government power is what truly make a currency valuable.
I mean even if we had the gold standard, the government is still dictating that to be so they still hold the power and have the ability to use the IRS to take it away from you.
The point of mark-to-market being leading to an unreasonable result during 'the great unwinding' is that buying volume could not possibly hope to match the colossal selling volume of unilateral institutional unloading en masse. "Market value" is meaningless in such a scenario. When 'mark to market' was instituted to stop accounting shenanigans, it was not foreseen by the FASB that the market could actually 'cease to function' with such volume imbalances. It was unprecedented on this scale.
My own feeling is that either Congress or the President should have the authority to temporarily suspend 'mark to market' accounting during times of national financial panic when markets are deemed to not be functioning normally.
On Apr 05 07:33 PM Trillion with a T wrote:
> The point of these securities is to NOT collect the collateral.
> In the past the collection of this collateral allowed the holder
> to get some sort of return for their investment. What happens though
> when suddenly you own 100 'valuable pieces of property' that no one
> wants to buy them at the price that is valuable to you (keeps you
> from taking a bath on the transaction).
>
> This is the actual worst case scenario, that we are currently in,
> and much worse then the scenario you have lined out.
>
> So you see in reality MBS and GM bonds are much more comparable then
> they should be...