March Market-to-Market Madness

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.

Comments

[fabian]

Well, when the market was going up and banks were marking up to market, lending more money based on unrealized equity gains and paying bigger dividends everything was great.
Finally it is very simple, mark to market when things go up and switch to rule of thumb value when the boom is over.
When there is no buyer there is no value, but you still have to discount all the expenses like you discount future profits.

[User 42150]

Fed’s actions have done no favor to us by helping the banks and Wall Street. Lower the interest rate has been affecting to our life tremendously, especially to the fix income families (Middle class, lower income and retired seniors). Our life is always directly related to energy and commodities. Higher the energy will reduce our purchasing power. I know my income will be affected this year. My interest income will be lower, and my expenses will go much higher. I know some retirees will have to change their steak dinners to dog food, from comfortable heated and cooled home to the mercy of weather.

Japan has shown zero percent interest rate will not help their mistakes from estate market. I wonder why Fed would think lowering interest rate will cure the problems caused by the banks and Wall Street scams. Fed’s responsibility should be in a mutual position as Europe, not reacting to the pressure from politicians and Wall Street. Keeping the inflation in check should be the number one priority.

[jjason]

I was listening to Rep. Waxman asking Mozillo from CFC "How could this happen?" Lend money badly, don't follow up on what happens with the loans and make millions for yourself in the process and retire with your buddies in some nice, warm place. In other words, tough shit.

But , of course, Moziillo didn't say that. Enough of us know who screwed up. The mess that CFC, CITI, WB,TMA the hedge funds and others created will be worse than Enron and Worldcom.

I hope Rep Waxman can put some of these guys in jail and fine them hundreds of millions of dollars.

[warrenmosler]

Couldn't agree more. The US banking system was not meant to be a mark to market business model for public purpose, and trying to force it into that mold does not serve public purpose.

The banking model is individual underwriting of loans, internal credit analysis, and then lending based on a myriad of variables that go into determining 'credit worthiness' and ability to make the required loan payments.

Additionally, bank regulators regularly examine all the bank's loans for compliance, reveiw credit statements from borrowers to make sure their credit worthiness hasn't deteriorated, etc. If there are any problem loans found, they are classified as such and the bank takes a capital hit, which will increase as the loan quality deteriorates.

All this is to 'protect' the govt who insures bank liabilities. The liability side is not the place for market discipline. The asset side and capital requirements (shareholder risk), legal lending requirements, etc. provide the market disicpline.

This sytem is far from perfect, of course. Regulators make errors, incentives are sometimes put in the wrong places, etc. But it does work reasonably well over time, and the regulators constantly adjust to changing times, however late and slowly.

To try to suddenly apply market to market requirements on this system is at best inapplicable, and at worst a major contributor to the current financial crisis.

Nor is there any good reason, regarding public purpose, to impose mark to market on a system based on individual credit analysis. it comes from a lack of fundamental understanding of the US banking model.

That said, it also makes no sense to let banks get into businesses that are based on mark to market models. That was the regulatory mistake, and that's what should be reversed.

Let the banks fund their own sivs by taking them back on their balance sheets with capital charges based on risk determined by underwriting, but then take sivs and related vehicles off the list of approved bank activities. That way they all get funded at the ff rate and eventually mature their way away.

[MarkWisniewski]

It seems Fed Chairman Bernanke’s (Ben) “I don't know how to fix it. I don't know what to do about it” statement is applicability across more of his actions rather than directly related to the topic of accounting rules forcing banks to put artificially low values on little-traded assets when they mark them to market. “I don’t know how to fix it” is also apropos to his behavior as Fed Chairman. Raise rates! Cut rates! Also please take into consideration his paraphrased statements that the sub-prime problem will not seriously impact the US economy. Mmmmmmm? Sounds like Bernake’s “I do not know how to fix it” also is evident in his erratic behavior as Fed Chairman too!

So Ben, Baby! Here is some simple and sweet advice for you: Stabilization, meaning to make stable, steadfast, or firm. Stabilize the dollar by holding interest rates in check for a year or two! Let the banks stand on their own two feet or lack thereof; you are not a messiah, a savior, or whatever higher order divination you align yourself too. A far as the economy goes Ben, have you taken a peak at Safeway’s (SWY) shelf food prices of late? They are falling big time because their costs were too high and people are now shopping for bargains or shopping less. Seems like the fundamentals of capitalism, supply and demand, is working at the grocery story as well as other parts of the economy at this time to include our housing market.

What goes up must come down! Ben, did you forget about gravity too? Inflation is a lagging economic indicator not a leading economic indicator. It is too high and it will come down when people have less money and therefore consume less; remember supply and demand from Economics 101? Ben, have you noticed the stock market of late? Mmmmm? It seems like many of the exorbitantly high P/E ratios for a large percentage of stock are coming down big time too.

Ben, the last time I check the United States was and is Capitalistic! Capitalism made this nation from the beginning and it is what will eventually make it strong financially again; along with deep cuts to the federal budget and a withdrawal from a war that is costing us in more than just whopping sum of money – Our money, “We the people…!” Our lives, “We the people …!”

Ben, are you aware that as you try to fight inflation while other parts of our US Government maintains routine escalation factors in a significantly high majority of their government contractors? How about stopping this nonsense by being an advocate for US Government procurement reform? Mmmmmmm? You are worried about raising inflation when most of our government contracts contain annual escalations of between 1.5% and 2.5%. You cannot stop inflation until you and others within our federal government stop this nutty practice too.

And lastly Ben, are you aware that housing is an end commodity! If building houses is our salvation as a country and to our economy we are in big trouble! How about new energy sources, increases in the use of solar power, wind, or a new type of engine for our cars and truck? How about something revolutionary rather than focusing on housing which offers no revolutionary or beneficial end value; a house produces nothing but it sure subsidies many. House should be built where capitalism thrives, and not the other way around in life. Watch, Ben, please watch over the next few years! All those $300,000 to $600,000 plus so called fantastic buy homes in the middle of no where in cities that maintain no other production capabilities are dead or dying … sub-prime mess? No, just a former Federal Reserve Chairman that made the availability of money too easy and many US citizens that made the choice to use this easy money to build houses rather than to innovate or revolutionize a market-segment or market place that provides a real and true benefit to themselves and this country of ours.

“I don’t know how to fix it”. I guess you are going to have to learn lessons the hard way too. It just seems too easy for you to consider stabilization. It just seems too easy for you to implement! If the earth is moving under my feet, it sure makes it hard for me to get from one place to another easily. The same goes for your changes in the interest rates! This country and “We the people …” will get there eventually, but you are making it a lot harder and longer by limiting the pain of those people and institutions that had the right to and made the choice of entering into risky ventures. Actually, a form of capitalism that either provides gains or losses for those associated with the venture.

So the bottom-line, Ben! Stop trying to protect us from what made our nation great – Capitalism! Stop trying to bail-out the people and institutions that took the risk and failed or are paying a high price for their lack of rational investment strategies.

I do not maintain a position in Safeway (SWY).