Mark to market is sexy again; on Thursday there was another hearing on the subject. Although nothing was decided of any consequence, the stock markets will no doubt read the tea-leaves for signs, as if a simple decision can radically change the fundamental value of the financial system.
Actually it can:
1: The argument for mark-to -market is that it quickly tells investors the true health of financial institutions. Indeed it does, and it provide a quick, cheap, transparent and convenient way to value assets, WHEN THE MARKET IS WORKING PROPERLY.
When the market is NOT working properly, all that can be said is just that "the market is not working properly". And so investors (and regulators) who are interested in long-term value (i.e. what the value would be if the market was working properly, and eventually it will) are provided with zero useful information, that sort of information is only of interest to day-traders and short sellers.
2: The argument against is (a) that what solved the Great Depression was when in 1938 President Roosevelt suspended mark to market and (b) it is clear that slavish reliance on mark to market when markets are in what International Valuation Standards calls "disequilibrium", is "pro-cyclical"; it over-values as a bubble is developing (when the market is not working properly on the upside), and under values when a slump is developing (when the market is not working properly on the downside - like now).
"Technically" what Chairman Bernanke said on Tuesday was "I do NOT support the suspension of mark to market".
But remember, this is Washington; you have to read between the lips.
Insofar as it affected capital adequacy calculations, "mark to market" was effectively suspended the moment the US government decided not to let another large financial institution fail. That's another word for "regulatory forbearance" that allowed banks to hold-on after the S&L debacle, this time thy just threw cash at any bank that was technically in breach of (government) mandated capital adequacy requirements.
Once that happened, any discussion of adequacy was a one sided debate about how many assets that were once liquid but are now not, could be allowed to be held to maturity or marked to model (like any normal loan, with appropriate provisions), and how many had to be marked-to-market in case there was a requirement to liquidate them at short notice (i.e. if there was a run).
And who decided that?
The government, and the government decided how much banks had to pay in terms of ceding capital to be allowed "bend" the rules that the government imposed.
So Chairman Bernanke might just as easily have said "I don't support the sun coming up every morning". So what? The sun came up yesterday and most likely it will tomorrow. The Chairman may not "support" suspending mark to market, but the reality is that is exactly what happened starting six moths ago.
But investors are not same as creditors, and particularly not depositors
The Chairman also said (I paraphrase), that mark to market was a "good thing" for investors, because it gives them "real-time" information and is the most transparent mechanism, therefore he did not support suspending it.
That's a commendable sentiment; but it has nothing to do with capital adequacy.
And although one must applaud The Chairman's broad range of interest in all things financial, deciding if a bank is solvent or not, and what investors are told about this, is nothing to do with the Fed.
So who was he speaking for? Middle America, Pension Funds, Sovereign Wealth Funds, Day-Traders, World Peace...who exactly?
He also said "valuing those assets is very difficult". Read between the lips, that means what...he doesn't know how to do it? That's interesting, if someone in such an elevated position can't value a toxic asset, then how is a simple investor with one tenth of the information, supposed to do it?
There is this illusion that if you don't know how to value something, well you can just ask the market. As if at lest one person in the market can magically do what you can't do.
So there we have it, in his day job (as a critical part of government) Chairman Bernanke does not support mark to market, but off duty (as an investor?), he supports it...in principle.
So are the banks insolvent?
Well the market hath spoken; bank shares are apparently worthless. Could it be that someone in that cosmic life force which is "the market" knows something Chairman Bernanke doesn't?
Or could it be that the market is confused? One thing that is certain, is that there is a lot of confusion and "surprises" floating around these days.
Yet mark to market was supposed to reduce confusion and do away with surprises? But in reality it manifestly did not.
Nouriel Roubini has gone on record that "mark to market all the big banks in USA are insolvent".
With all due respect, that is a meaningless statement.
A bank is insolvent if its assets are worth less than it's liabilities. But if 50% of those liabilities are not due for three years, then the information that is required is what 50% of the assets will be worth in three years. That's nothing to do with mark to market.
What's relevant is whether the bank will be able to honor it's debts when they come due and/or pay back depositors, or whether an insurance company will be able to pay claims when they come due. And just because you are feeling like "death warmed up", does not mean you can claim on your life insurance, you have to actually die first.
Yes, there are accounting standards, SEC rules, and other regulations, that determine whether a bank is solvent or not. But there again, just as the issue of how many assets must be marked to market and how many can be held to maturity or marked to model, in the end it is simply a negotiation, the "rules" are just that "rules".
Recently, UBS changed the definition of some assets from "liquid" to "illiquid" and, at a stroke, radically increased their "value".
Whether the information from all these shenanigans deliver a true picture to investors, is increasingly debatable. Earnings is not just the P&L; it is the increase in assets compared to liabilities. That's why there is a balance sheet.
That's a good one. "Earnings are down"; ever heard that stale old accountant's joke?... "Profit 'Gov. What would you like it to be?" (The old joke that an accountant's answer to the question "How much is two plus two?" is "How much do you want it to be?")
The root of the "problem" that the world financial system is facing right now, and the ultimate cause of this problem, is that neither US GAAP (nor indeed IFRS) can conceive of a valuation of an asset that has two or more radically different "values" at the same time, depending on the purpose of the valuation.
That is a denial of reality.
It fueled the bubble and is exacerbating the slump, and in this respect the Chairman is absolutely correct: such a system of valuation is pro-cyclical (that's what economists call the "bad thing" that causes booms and busts).
Mark to market valuations are too high going into a bubble, which pumps up "liquid" capital and makes capital adequacy look better, this in turn allows banks to lend more, which further raises valuations, in a feedback loop.
What just happened was that assets which were once liquid are no longer, this radically downgrades capital adequacy, stalling lending, which makes the assets even less liquid.
Ever wondered why mortgaged backed securities were so sexy? The reason is that a loan counts for much less in terms of capital adequacy than an ABS because the loan is "illiquid" the ABS is (or was) liquid, so if you re-package loans then you can lend more on a lower capital base, which is great for bonus season.
Chairman Bernanke acknowledged two things which are important on Tuesday. First, the "problem" and the solution is all about "Valuations". Second, he does not have a solution.
It appears less and less likely that there will ever be a solution until there is a radical change in mind-set about "valuations" that brings this critical pillar of the financial system, closer to reality. "Tweaking" by committee can never deliver fundamental change.
Example (from the real world):
A few years ago the firm I was working for (Moore Stephens) was appointed by a court to value a bottling business, no one wanted the job and I got lumbered with it.
By the way, the law in the place I was working was "Napoleonic" so the "expert" got appointed by the court to give an impartial opinion - in USA and UK "independent" experts and are appointed by both parties to fight it out in front of the judge (and independent or not they invariably disagree).
Under Napoleonic Law, the "expert" has as much or more power than the judge; typically judges just look at the law, the expert comes up with the number, and unless one party can convince the judge that the expert acted fraudulently, judges typically go along with the expert's recommendations.
The main asset of this business was a twenty-year old bottling machine and the owner of this machine (the plaintiff) was suing an international soft drinks company (the defendant), who had canceled a franchise to bottle their soft drink It was a classic case of poor little local boy made good against a large and insensitive (and rich) out-of-towner, the plaintiff was looking for $100 million, which was big news in a small town (he didn't get it).
Depending on the "purpose" of the valuation, the bottling machine had no less than six "values":
1: It was fully depreciated according to the local tax code, so its value in front of the tax-man was zero, there was no way that the owner could reduce his tax burden by depreciation (amortization in USA) of his asset.
2: In order to "rectify" this, the owner had "appointed" two lay-about cousins as "technical managers" of the machine, add those guys in and from a tax perspective the operation was making a healthy loss every year. So do an income capitalization of what the accounts showed and the value was negative, according to the defendant he was doing the plaintiff a favor by canceling the franchise.
3: In "mark to market" the value was also negative, because as scrap it would cost more to cart it away than what it could be sold for.
4: But the owner had been producing fizzy drinks, and the machine was still running fine (more or less - I asked to inspect it and the line got jammed; what ensued was a shower of exploding fizzy drink bottles over a thirty foot radius; it was explained to me that that was a "normal" Black Swan" event combined with "Murphy's Law").
But the accounts showed that the net profit operating the machine after maintenance (and exploding fizzy drinks); was very profitable, particularly if you slipped the costs of the two lay-about cousins from the departmental operational costs to the holding company. Do an income capitalization of that and it was worth a lot.
5: Then we had an argument about the "normal life" of one of these machines. The plaintiff said that with tender loving care (which only he could provide), the machine could operate 100 years or more - and in "fact" that was a "conservative" number which he was putting forwards in "good faith", the defendant said 20 years max!
Then we argued violently about how much would new one cost, the plaintiff got a quote for the latest German computer controlled model, the defendant said that the original machine was rubbish anyway (something to do with exploding fizzy drinks) and you could get something made better in China for a quarter of the price.
Many a happy afternoon were spent in lawyers' offices arguing this point with great eloquence on both sides, plus a great deal of acrimony, and with me in the middle. Eventually we reached a sort of consensus from where the depreciated replacement cost could be worked out.
In the end we persuaded the judge that the issue was how much the plaintiff had lost from the cancellation of the franchise, and eventually both parties went along with this and did not appeal the judgment, and settled. And I am pleased to say, that both parties cursed me, my children and my grandchildren in this life and the next, when that happens you know that your valuation was bang on target.
The "hard" part was not doing the valuations; it was deciding which one to use.
So what are banks worth?
Nouriel Roubini has a reputation for getting it right, so if he says they are insolvent, I'm not going to stick my head up out of my hole to say they are not.
But then there is the proviso...."if toxic assets are marked-to-market".
That's the kicker, if the assets are market to market when the market is evidently, obviously and manifestly not working properly. That's a great piece of information!
My son is a "rocket scientist" (he is reading Physics at university). I would like to remark that although I am someone of rather limited intelligence, I was smart enough to combine my tired old in-bred gene pool with some really good stuff, so sadly none of the credit for my son's brilliance cannot be claimed by me.
Anyway, last year his dream was to "get into Private Equity" (they go for physicists for some reason (or used to)). I was amazed by the tests that he had to endure over about three days by every firm he applied for, only to be told that he didn't have the "right stuff" (presumably due to the residual genes that I had lumbered him with).
I suppose I can break it to him now that all this advertising about how Private Equity companies come in, re-structure (sack the cousins), streamline the business processes and turn untreated sewage effluent into gold, is just baloney.
It's nothing more than arbitrage between different valuation methodologies.
In the early days of Slater Walker (remember him), it was simple. You bought a company with assets written down to zero, for nothing, then sold those same assets for a fortune. It's more complicated now, but nothing really changed.
Of course you couldn't "tell" anyone it was that simple. That's why Private Equity firms employ teams of rocket scientists, to make it look complicated. It's not; just that business model works a lot better in a rising market than a falling one.
Prospects for the banks:
1: Forget about capital adequacy; the government is looking after that, none will fail catastrophically. In reality there is now absolutely no reason for banks to either hoard cash or write-down ruthlessly, outside of fear that the government will renege on it's commitments; rather the opposite.
2: You can be pretty sure that the "Stress Tests" will reveal that a lot of assets that were previously marked-to-market, can be re-labeled. What the whole "stress test" business is about is a convoluted procedure to "suspend mark to market" insofar as this is used to assess capital adequacy, without actually saying "we have suspended capital adequacy regulations". That's what they called "regulatory forbearance" in the old days.
All that the existing capital adequacy regulations are, is a rule of thumb that was supposed to provide a cheap and easy way to make sure that banks did not get into so much trouble that that either went belly-up or went crawling to the central bank for help. Well here is some news, they didn't do the job, now they are being re-invented on the run, it's not pretty, but there is no option.
The day that the government and the Fed can go back to sleep is the day the crisis is over, until then it's WAR, and like any war the only rule is that plan of action NEVER lasts longer than the sound of the first cannon.
3: The main reason that bank shares are so low is that all the investors can see looking through the window is a bunch of suits having an acrimonious punch-up about laws, regulations, standards etc. Fun as they are, punch-ups in full sight of customers are not good for business, sometimes you can take "transparency" too far.
4: The issue for an investor is what will those toxic assets be worth whenever the markets start to work properly again. That's the sixty-four-thousand dollar question, and it's hard to work that out without the full information (and even then it's a little complicated, but not impossible which is what Chairman Bernanke implies).
What wrong with the system now is that investors that matter (buyers of toxic assets and investors in banks) are not provided with this information, all they get is "well IF the market was working (which it's not) we could tell you, now all we can tell you is that the market is not working)".
So right now all the investors can do is bet blind, using the cosmic intuition of the market, the one that magically works out the value of things whenever the Chairman of the Federal Reserve and/or the Secretary of the Treasury can't figure it out (and no that's not the price - price is something else completely).
So Chairman Bernanke is right again; "transparency" is important. If you want investors to pay the price you like for your bank, give them the information they need. And right now, since the markets are not working, giving investors "mark to market" is simply an insult to their intelligence, which is why they voted with their feet.
To get them back, what is needed is real transparency, which is something else completely.