Mark To Market (A Brief Post)
I don't know how much tolerance my friends here have for financial reporting arcana so this will be a very brief post on mark to market accounting. Mark to Market is an accounting term that requires banks, financial companies and public companies that invest their cash to give frequent, market based disclosures of the value of the securities on their books. It's necessary because sometimes one public company owns shares in another and investors should probably know that, "hey, those Microsoft shares on Google's balance sheet are worth half of what they were six months ago!" (I made up that scenario). It works very well for stocks and bonds because those are liquid markets.
But it can also be applied to other types of securities like the mortgage backed securities and other asset backed securities on bank balance sheets. The banks were very happy, when a heated market for these securities meant that they could mark the values up. Now that the market has dried up, they have to mark the items down. They don't want to.
Now, they do have a reasonable argument -- the market is now so dried up and prices so depressed, they say, they'd rather hold the securities until better prices emerge or until maturity then sell. So, they argue that they should be able to, with their auditors, come up with other valuations for these assets. Higher valuations, natch.
Problem is, the banks are leveraged. Leveraged entities don't always get to decide when they have to sell assets. So, mark to market is important, even if it's inconvenient for bank managers. Shareholders do need to know what the fire-sale value of a company's assets are. They deserve to know.
But here's the other twist -- these assets are considered bank capital. So when the value drops, regulators might require the banks to recapitalize to meet debt loads. The banks can only do that by selling stock (tough in this market) or business units (even tougher in some cases). So one proposed solution is to give shareholders mark to market information but to have the regulators take models, intentions and auditor's opinions into account.
I think I like that idea but am not sure. One thing I am sure of is that the bank lobby will push congress to just abolish mark to market and that congress or regulators will assume the public doesn't care about accounting terms and will just let it happen. Even Jonathan Taplin, who posts here, has called for a mark to market suspension.
Bad idea. just remember, when mark to market worked in their favor, when it allowed the banks to raise more and more debt as they wrote up their balance sheets, nobody complained.
Mark to market has a purpose. It keeps them honest. We can compromise on it at the margins but in the end, we need it.
But it can also be applied to other types of securities like the mortgage backed securities and other asset backed securities on bank balance sheets. The banks were very happy, when a heated market for these securities meant that they could mark the values up. Now that the market has dried up, they have to mark the items down. They don't want to.
Now, they do have a reasonable argument -- the market is now so dried up and prices so depressed, they say, they'd rather hold the securities until better prices emerge or until maturity then sell. So, they argue that they should be able to, with their auditors, come up with other valuations for these assets. Higher valuations, natch.
Problem is, the banks are leveraged. Leveraged entities don't always get to decide when they have to sell assets. So, mark to market is important, even if it's inconvenient for bank managers. Shareholders do need to know what the fire-sale value of a company's assets are. They deserve to know.
But here's the other twist -- these assets are considered bank capital. So when the value drops, regulators might require the banks to recapitalize to meet debt loads. The banks can only do that by selling stock (tough in this market) or business units (even tougher in some cases). So one proposed solution is to give shareholders mark to market information but to have the regulators take models, intentions and auditor's opinions into account.
I think I like that idea but am not sure. One thing I am sure of is that the bank lobby will push congress to just abolish mark to market and that congress or regulators will assume the public doesn't care about accounting terms and will just let it happen. Even Jonathan Taplin, who posts here, has called for a mark to market suspension.
Bad idea. just remember, when mark to market worked in their favor, when it allowed the banks to raise more and more debt as they wrote up their balance sheets, nobody complained.
Mark to market has a purpose. It keeps them honest. We can compromise on it at the margins but in the end, we need it.
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Good Post Destor. Check on Obey too, interesting information.
March 11, 2009 11:19 PM | Reply | Permalink
I agree in spirit, but it seems to me that a limited time suspension could be enacted with minimal damage. You know kinda how they suspend the market when it falls too quickly, or in times of emergency. It could be structured over a few months and then if things don't improve then you have to face the music.
Thoughts?
March 12, 2009 1:13 AM | Reply | Permalink
My thought is that I as a shareholder have the right to regular pricing information. I also don't really believe in the concept of a market that isn't functioning. When people say that the market isn't functioning they usually mean that it isn't going up.
Markets are always functioning. I wrote a novel in college. No publisher wanted to buy it. I don't get to argue now that it's worth a $100K advance but that the market isn't functioning so give me a mortgage loan based on my $100K asset.
Clothing manufacturers have tons of inventory that nobody wants to buy. They have to mark it down to zero and that's that!
Why are these mortgage and asset backed securities on bank balance sheets given preferential treatment over the badly conceived clothing designs in warehouses at Liz Claiborne?
March 12, 2009 9:48 PM | Reply | Permalink
Willem Buiter, in an otherwise hard-hitting article calling for regulation now, recommends regulatory forbearance when prices are depressed due to illiquidity.
I wonder how much it matters for the value of the fire-sale assets, though. When the asset consists of tranches that have fluctuating variables for sometime in the future under god-knows-what conditions and the models have already shown that they are incapable of handling the problem, where does the value amount come from? Isn't this problem part of the larger problem today?
March 12, 2009 1:16 AM | Reply | Permalink
Even Jonathan Taplin, who posts here, has called for a mark to market suspension.
This is probably the worst idea imaginable. It is also offered by people who have little idea what mtm involves.
The reason it is a terrible idea is this - confidence in the industry (as measured by stock prices, interbank rates etc) has cratered because the market no longer trusts any estimates of the true value of banks. Suspending mtm requirements would only reinforce - in fact it would greatly legitimize - this lack of confidence.
Existing accounting rules already offer enough forebearance when liquidity dries up and reliable mtm, quite simply, is too difficult. In accounting speak, there is a lack of observable market data.
The mtm rules are fine.
What's not fine are the loopholes through which firms are sometimes able to arbitrage mark-to-market and accrual accounting. Insurance companies, in my experience, are the most egregious abusers, but they aren't alone.
Also a problem are the pro-cyclical - and therefore destabilizing - bank capital requirements. Another day, another debate for this, however.
March 12, 2009 8:35 AM | Reply | Permalink
I just saw this now, Destor. Really good discussion!
- what percentage of assets are mtm? I've seen some figures for the big banks at below 30% of assets. The rest are level 2 or 3.
- Is mtm accounting pro-cyclical? yes. Because when asset prices get inflated balance sheets look great and capital buffers look adequate. when asset prices slide, those buffers disappear.
- what to do about the pr-cyclicality? Well, obviously, increase reserve requirements in good times. Reserves were pretty much nil going into 2007. The Chinese were much better on this.
- should we suspend mtm? Well the pro- argument is that it will stop the desparate cutting of credit lines happening now as banks try to meet Basel II capital requirements. The anti- argument is that it just worsens the uncertainty in the market.
- My short answer (which will probably change in 10 minutes) is keep mtm - and resolve the uncertainty quickly by (i) nationalization, or (ii) explicit guarantees for bank-creditors and suspension of capital requirements.
Anyway, good stuff!!
March 12, 2009 9:18 AM | Reply | Permalink
Destor, this is such a great post… I created a TPM account just to let you know how much I enjoyed reading it. So clear, economical, and well crafted. Well done.
I landed here via google, while trying to improve upon my vague understanding about what MTM actually is, and to confirm my intuitive understanding about how short-sighted it will be to make reforms, which in effect, amounts to nothing more than “looking the other way” while our shady asset problem continues to get swept under the rug. Thanks for helping me check these items off my list.
The scary thing is this: the problem hasn’t even started yet. The overwhelming majority of loans issued during the refi boom are adjustable, and they have not re-set yet. The TARP money reflects but a small percentage of the aggregate portfolio, just like FDIC reserves reflect only a small percentage of consumer deposits. Not good.
Plain and simply we have a de-leveraging problem. And all the good intentions and ass-covering and agenda-pushing that we can muster are just not going to help.
Eddie-George... very, very well said. Amen bruddah. If we’re going to try to rebuild, then we need to build on a sound foundation. This is a short-cut, band-aid, not-going-to-work-around.
For anyone interested, I just posted a Seeking Alpha article that runs parallel to this “bad call” genre as it relates to TARP-backed loan modifications. Here is a link:
http://seekingalpha.com/article/125279-56-car-economic-pile-up
March 12, 2009 4:51 PM | Reply | Permalink
I'm flattered. And glad to be of some help.
March 12, 2009 5:39 PM | Reply | Permalink
Hey, one note on Re-Sets that might make them seem not as bad as they could be:
There's a chance that people have now had time to plan for the fact that the easy re-fi the broker who sold it to them promised isn't coming and so they've already taken steps to mitigate the disaster (ie the uptick in savings rates recently).
Also a chance that because interest rates are so low and because the government now controls Fannie and Freddie that more re-fis might happen than we think. But, still not as many as people thought were going to happen during the never-ending boom that ended.
You have a great point. Resets are an atom bomb with a timer. Those are the only two things I can think of that offer some hope. They're not wholly convincing, to say the least, but they are possible.
March 12, 2009 9:39 PM | Reply | Permalink
I'm not convinced, incidentally, that suspending mark-to-market would help much right now.
It might help in that some institutions which are currently undercapitalized, or will be if particular assets are marked to a market that drops tomorrow, would be able to ignore the market fluctuations for a while. But it might also hurt just as much, in that investors, now shy of financial institutions in the first place, would view their reported positions with even more suspicion: "why should I trust Bank X's reports, when I know they don't even have to bother checking their loan portfolio against the market?"
So rather than a suspension per se, perhaps the appropriate thing to do is relax the banks' leverage ratios. However, this also has its pitfalls. It's not really clear what to do, in the absence of some sudden miraculous stabilization/reflation of the real estate market.
March 12, 2009 11:06 PM | Reply | Permalink
I sure wish that increased savings and super low rates will mitigate the impending problem, but I fear a truly objective analysis suggests a really ugly outlook.
I'm not attached to being right, and I hope I'm wrong… in fact let’s pray I'm wrong. But every rosy view we can muster includes at least some amount of wishful thinking, whereas the more pessimistic view is based on a simple harsh blueprint that we all just witnessed roll out in Rate Re-Set Part I. Here’s how Part II looks to be shaping up:
It is true that the $700k to $2m homeowner crowd, as a group, does enjoy greater insulation (i.e. savings, education, other resources, discipline, opportunity, etc)… but they are also a sort of a giant, in that the bigger they come, the harder they fall.
For sure, some folks are watching this unfold and saving more like crazy. But here's the deal: even if 90% of the crowd can bunker down, it just takes some marginal folks, say a hard working couple with two jobs, two cars, credit cards and a new baby, and escalating healthcare expenses. One loses a big account, the other gets their hours cut.
It is not the rate re-sets that pose a problem... but rather the loan re-sets from i/o to p&i… and not over 30yrs... but 25yrs. On and $800k loan, this equates to $1,245/mo higher payment... and that’s with rates being super low.
Imagine if the loan was $1.2m. Imagine if rates tick up.
We don't have a socio-demographic problem. We have a math problem. And a disciplined savings plan is not going to protect anyone from watching their home value get erased.
Because once a few marginal folks are forced to sell an asset, for which there is virtually no market… in a market where low rates do not exist, where no financing is available, where there is no demand… whose effect will, in turn, decrease discretionary spending further… which will put more pressure on the next level of marginal people to sell… while the neighbor who could afford making payments on their $900k loan but watch their value go down to $700k… Part II sucks.
The scariest thing about this whole mess is not that people don't see this coming... its that they don’t see it coming because they don't want to. And way more than the “sub-primers” and way more than the “richest 1%'ers”... the upper middle class are the true stimulators of the economy. When their cash flow freezes... look out below. That's what I'm waiting for in the way of capitulation.
March 13, 2009 12:35 PM | Reply | Permalink