Schrodinger's Mark-to-Market Law of Dead Cats

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Includes: DIA, SPY, XLF
by: Andrew Butter

In 1935 Schrodinger came up with an explanation about how some elementary particles appeared to be able to exist in two "states" at the same time. This involved the idea of a cat in a box that was fed poison and monitored by a Geiger Counter which showed that the cat was dead and alive at the same time, but you couldn't know if it was dead or alive unless you looked in the box. Sound nuts, but if Schrodinger (or someone else) hadn’t figured that out you would be still using pen and paper and communicating by Telex.

That's exactly the problem with mark-to-market of asset-backed-securities (ABS).

There are two values that matter.

  1. What you can sell it for today (mark to market). This value affects how you calculate your capital adequacy which is about having enough "liquid" assets on hand to be able to deal with a run. How this is calculated is mandated by banking regulations.The whole point of ABS was that unlike the loans that they were packaged out of, you could buy and sell them, so they were "liquid", and therefore their value in terms of achieving the required capital adequacy targets was much more than the underlying loans.
  2. What it will be worth when you decide to sell it, or if you hold it until you know how much of the loan(s) and interest will be paid back. That's the same question that you ask when valuing assets (loans) every day of the week. This valuation affects solvency and so long as a loan pays back when you expect it to, you will be able to meet your obligations on that day. The job of the auditor is to report if that is a reasonable notion. If it is, he will sign-off the audit (a) to say you are solvent and (b) that you are a "going concern", i.e. you can expect to be in business this time next year.

What the auditors had (have) a problem with, was (is) the notion that the same asset could be recorded in one place in the accounts as having a value of say 80 cents on the dollar (hold to maturity) and at the same time being valued at 30 cents on the dollar (mark-to-market) somewhere else in the accounts.

The current "solution" that is being put forward does not solve that problem, all it does is give a lot more latitude for management to decide whether to count the cat as "dead" i.e. 30 cents on the dollar, or not (i.e. 80 cents on the dollar). Previously it was basically the auditor who decided, and in the current climate auditors are not in a mood to do anyone any favors or to have their arms twisted, so more often than not they insisted on the 30.

It is likely that the banks will elect to record to 80 cents, which the new rules will let them do, even if this means that their capital adequacy is shot, simply because they know that the government has explicitly or implicitly guaranteed that there will be no runs on banks, so long as they meet their “Stress Tests”, which is in reality just a way of re-formulating the capital adequacy regulations that failed in the past (evidently otherwise the banks would not have needed re-capitalizing).

So most banks will be (technically) solvent, but will be at risk of runs and may still have a problem rolling over debt. But who cares, the government is standing by, and in the old days that was called “forebearance”.

How about "transparency"

The old rules stipulated that a cat could either be dead or alive, AND they stipulated when the cat should be considered dead, and when it should be considered alive. Now management has a choice, but there is no reason that this should reduce transparency, so long as this is understood and reported properly. The fact that management can chose how they get to comply with the various regulations they are obliged to comply with, gives them more latitude.

But there is nothing "sleight-of-hand" - all management is doing is valuing loans just like they always valued loans.

But that's not the end of the story. The reality is that the cat CAN be dead and alive at the same time, and until the financial reporting standards properly reflect and report on this reality to shareholders and investors, they will be at risk. Transparency is not about rules; it is about communicating the reality to the people who need to know what the reality is.

What's ironic is that International Valuation Standards deal with this reality ten years ago, there is nothing "new" here.

Example: How mark-to-market caused the credit crunch:

Mark-to-market isn't just used to value toxic assets, houses are typically valued mark-to-market. That makes sense, a buyer wants to know the right price on the day, so does the seller, and the bank financing that transaction wants to know that the buyer and the seller are not colluding.

But that value is not necessarily a good value to use when calculating the cover on a loan collateralized by the house, because, as just happened, the price that a house bought in June 2006 could sell for now is a lot less.

So a prudent "Mortgage Value" (an EU concept) or "Other-than-Market-Value (International Valuation Standards), would have been the correct value to use. In 2006 that might have been 40% lower than mark-to-market if properly assessed. And there was no reason why that value should not have been reported - just no one asked the question.

So in June 2006 the mark-to-market value might have been 100 and the other-than-market value might have been 60; two purposes, two values, at the same moment in time.

But that didn't happen; the rest is history.

Let's hope that piece of history will not repeat, and that the reality that a cat can be dead and alive at the same time will be incorporated into accountancy standards.

Time to move on from the constraints of the past (that failed), to a system that can deal with the future.

Stock position: None.