Mark to No Market

We have all heard of "mark to market" accounting. In short, you value an asset based on its market value. But, what if there is no market? This is what is happening with the current situation. Banks and lenders are basing values of assets, not on the performance of them, but on the "perceived value". This is causing huge write-downs of the assets, that then forces the institutions to raise capital.

How? A forced selling of these performing assets. Since everyone else is on the same boat, no one wants to buy them. If there are no buyers, there is no market. When I took Economics 100, a market was defined as a "place where buyer and sellers of goodד or services meet". Unless that definition changed in the last 21 years, we should not force holders or these instruments to "mark to no market".

When the market knows a seller has to dump an asset, the last thing it will get for that asset is a fair price. Now, the question is, are the assets really performing? Since this all centers around mortgages, let's look. According to the FDIC, 98% of all real estate loans are current as of 12/31. Admittedly there has been some deterioration of this metric since then, but it is nowhere near the level that would cause the pricing of mortgage backed assets today.

It is not a question of performance but one of complexity. How can you value a CDO that you cannot understand the revenue stream from? When in doubt, in times like this, investors flee. Thus we have the current environment. So, what happens? Intense pain followed by a surge in the opposite direction. Think of it this way.

You live in a home and have a job. The value of your home has fallen and thus your "net worth" along with it. Has this "net worth" decline had any real effect on your day to day life? Is your EPS (income) affected by it? No. But, if you are a bank, you have to account for the decline in your home as a "loss" in your EPS. Now, assuming you are the bank, because the value of your home has fallen, and perhaps you have a home equity loan on it, you have a problem. The holder of your home equity loan tells you that you have to liquidate assets in order to keep a "ratio" of assets to liabilities that they want.

Now you are in trouble. You have to sell something and fast to raise money or reduce debt. It is a fire sale. Since you cannot sell more "shares" of yourself (like the bank can) to raise cash, you have to sell the home to the first bidder to reduce debt and raise cash. The problem is, everyone looking at the home knows you have to do this. How low are those offers going to be below the fair value of the home? Way below....

As you start getting offers in for the home the banks sees them. Now we have a problem because the money you will raise from the sale is much less than what everyone previously thought you would get. Your "net worth", or EPS if you were a bank, would fall further because your new net worth would be based on this artificially low new estimate. Now you may have to sell the car also to meet their "asset levels".

Suddenly, out of the blue Grandpa comes in and gives you the money you need to restore your "asset levels" with the bank. Now, all of a sudden the home sale is not necessary and you can value your house at a fair market value and your net worth rises.

But, did anything actually happen? No. It was a mystical market driven event that turned into a very real problem for you. Were you late on a payment? No. Did you lose your job or revenue stream? No. Did you actually have to sell them home? No. Was the "quality" of the loans you had out less based on your payment results? No. But your "net worth" fell and rose and thus the above actions took place.

Had the value of you, the loan payer, been based on your performance on the loan, none of the above would have happened. When the forced dumping by irresponsible holders of these mortgage assets stops, the value of what is left will rise, rapidly. When it does, the holders of what is left will then do the reverse of what they are doing now. They will announce "write-ups" of the assets and EPS will surge for many of the institutions. Thus is the current financial institutions situation.

Comments

[GaryD:]

It's great that you have a rich grandfather that bails you out whenever you act like a retard. What if you don't have a rich grandfather? Or, what if he has already bailed out all his other financially-retarded grandkids and has no more money? Or, what if he himself is borrowing the money to bail you out?

2008 Mar 18 12:14 PM

[Reclined:]

Everyone is now bashing mark to market. I question whether it would be better if we had 'mark to performance'. It makes the valuation even more opaque for the investor in financial institutions. A loan will be at risk a long time before the first default and mark to market uses the best instrument known to mankind in measuring the value of something: the market. And for evaluating a banks options of raising cash mark to market obviously is quite well suited.

Since loan performance figures are routinely provided as well everyone can make up their own mind of what these assets' values are when held to maturity.

Would you buy a bundle of subprime mortgages today that have not defaulted so far (= perfect performance)?

2008 Mar 18 04:53 PM

[Wisdom-Seeker:]

Let's straighten out that analogy in a couple of ways:

1) Rational Economic Actor: "Hmm, my home is declining in value. There's a recession on, and my job (and/or my spouse's job) is at risk. How am I gonna keep my house and provide for my kids if something bad happens? I better save more money and spend less."
Net Result: Amplification of Recession (short term) as there is less borrow-and-spend and more save-and-invest. But, if the "invest" part is done wisely, the economy grows again later.

2) Joe Six-Pack (no rich Grandpa): "Everything is more expensive! But I can't borrow any more against my house, and they won't give me any more credit cards, and I'm drowning in bills! Oh, no, I just lost my job too!" Result: either (a) default, foreclosure, and possibly homelessness, or (b) scrimp like mad and hope things get better before the Repo Men find you.

3) Grandpa Baby-Boomer: "This new home in Florida (Arizona, Las Vegas...) is great, but that mortgage is sure costing me, and damn, those life-sustaining medicines are expensive! Social security won't cover all this! And I sure don't get much out of my pension that got frozen in the 1990s. Ack, now my 401k fund is going down! I shouldn't have retired in (1997, 1998, 1999, 2000, 2001, 2002, 2003, 2004, 2005, 2006, 2007, 2008) with the market like this.... Crap, I can't even sell this damn House and get any money back! I gotta get a job! What do you mean, there aren't any jobs out there right now? I NEED A JOB!"

Bottom Line: "Mark-to-Market" on that declining home price is damn real (on the margins, where it matters), not "something no one's gonna notice". It means NO MORE SPARE CASH TO BURN. It means Credit Crunched Consumer Spending is Contracting...

This, by the way, is a vicious circle with a high risk of "lollapalooza" (Charlie Munger's term for nonlinear amplification) effects. The real question that the bulls should be asking is, what emerging fundamentals will break the vicious circle? (Unfortunately, the price of oil has to be pretty damn high before a home is worth more as firewood than as a home, so that's NOT gonna be the price floor on all that surplus housing...)

2008 Mar 18 09:58 PM

[Rational:]

I agree that mark to market accounting changes have caused untold havoc on our financial market. In fact it's pretty much the reason a company like Thornburg almost went bankrupt. Mark-to-market forced sales on their repo agreements, yet their overall portfolio had a delinquency rate of only .47% and almost no realized credit losses. Isn't it something like $750K in realized credit losses the past 10 years? Insanity.

I agree with the idea of a "mark to performance" measure when you are holding the loans to maturity. Perhaps take the present value of future cash flows factoring in the prepayment speeds, and cut it by the delinquency rate. Or even twice the delinquency rate.

This means AAA stuff like Thornburg had would remain valued at nearly full value on their books (all of their loans originated were intended to hold for investment until the forced selling of August 2007). Lenders with "toxic" sub-prime loans with 30% delinquency rates would still be able to value them at something better than 10 cents on the dollar. Who really thinks 10 cents on the dollar is a fair value for mortgage security where 70% of the people are paying on time? You'd make back the purchase price of that security in less than 2 years of P&I receipts... Even if you docked the mark to performance value by twice the delinquency rate, a 30% delinquent CMO is still 30 cents on the dollar instead of 10. But a .5% delinquent TMA CMO is at 99 cents on the dollar, instead of 70 cents.

2008 Apr 08 04:49 PM

[MM be damned:]

The market value of a stock is determined every day, so no problem; likewise with other frequently traded assets.
Homes are being bought and sold every day, so because we don't have a "daily" price, we don't know their value? Hog-wash. Knowlegable realtors and lenders make daily appraisals of "value" Are they wrong NO! The appraisal is made based on "recent sales of similar homes". And sice we don't have a "daily record" smart people can't determine value (or potential price)? We never know a market price for any goods or assets until the assets are sold.
The whole thing here is an attempt by dishonest banks, lenders, and our government etc. to cover their stupid mistakes and fool the publ;ic
RGD

Mar 16 05:35 PM