It’s March, which for college basketball fans means March Madness.In the financial markets, investors are experiencing their own version of madness – Mark-to-Market madness. The idea that nearly every asset that could be priced should be priced and that price represents its fair value is absurd. Let me illustrate with the following example:
Say a homeowner has a fixed rate mortgage. Now let’s say in the mark-to-market world the bank holding that mortgage is able (required?) to continuously determine the asset value of that home based on comparable sales in the area. Suddenly, due to weakness in the housing market, the comparable homes in our homeowner’s area decline in value. What if the bank were then able to go to the homeowner and demand more money as the loan to asset ratio declined below the bank’s requirement? Demand more equity capital for an asset that the market says has declined in value. Mark-to-market in action.
Apparently, the mark-to-market madness has infected the mind of Fed Chairman Bernanke. Consider the following two segments from a recent Bloomberg article, which includes an exchange between Senator Chuck Schumer and Bernanke:
Federal Reserve Chairman Ben S. Bernanke said in congressional testimony on Feb. 28 that accounting rules may be forcing banks to put artificially low values on little-traded assets when they mark them to market. The inability to value such assets on the basis of actual trades, Bernanke said, is "one of the major problems that we have in the current environment. I don't know how to fix it. I don't know what to do about it.''
Later in the article, this:
Bernanke was responding to a question from Senator Charles Schumer, a New York Democrat, who said he had heard "from many people'' that the valuations have been "artificially low.'' That leads to a vicious cycle, he said, in which the writedowns sap bank capital and "they can't do any more lending and everything's frozen up.'' Schumer suggested one response might be to have a six-month grace period on mark-to-market. "You really don't know the value of the asset, and if you undervalue it, you may be hurting things as much as if you overvalue it.''
Bernanke didn't buy that idea.
"The risk on the other side is that if you do too much forbearance or delay mark-to-market, the suspicion will arise among investors that you're hiding something,'' he said, adding, "This is really an accounting board responsibility.''
Frankly, I am speechless. I don’t know which is worse – to admit that you have no idea how to fix a serious credit problem or to pass off responsibility of asset valuation methods to FASB. No wonder equity values tanked after the Fed Chairman spoke. Investment Strategy Implications.
If you are unfamiliar with George Soros’ reflexivity principle, I strongly suggest you get acquainted with it. The self-fulfilling nature of reflexivity is the feedback loop between the financial markets and the real economy. The real economy is set to experience a moderate recession at worst. However, due to reflexivity, should conditions in the financial economy continue to deteriorate driven in large part by mark-to-market madness (thereby generating a graveyard spiral in asset values) the real economy may be in for a deep recession, possibly global in nature, thereby turning the currently extremely undervalued equity markets into a fair value reading.