Mark to Market Watch
Rules Have Consequences
And those consequences can be very dire for our economy. The third part of “Providing Relief from the Crisis.”
This is the third installment of “Providing Relief from the Crisis.” Read editor-in-chief R. Emmett Tyrrell, Jr.’s introduction here.
The government has pulled out all the stops, and is injecting trillions of dollars into the economy through just about every avenue that anyone can dream up. What’s so frustrating is that no one in control will seriously consider a change to the inflexible rules of mark-to-market accounting.
Mark-to-market (or fair value) accounting forces financial institutions to use market prices (gathered by soliciting bids from buyers) to value assets in its portfolio. Then, those values are used to mark an institution to market.
Any loss gets pushed though the income statement, which in turn subtracts from capital. If capital-asset ratio falls below legal levels imposed by regulators, the institution can fall into insolvency. While this is typically an end-of-quarter calculation, the government can step into an institution at any time and apply mark-to-market accounting.
As a real life example, imagine that a forest fire is one mile from your $1 million home, the winds are blowing it your way and you have a $600,000 mortgage. Then, imagine that your banker knocks on your door, and demands that you mark the value of your home to the price that you could sell it for, right now. Then, the bank forces you to come up with more money or be foreclosed on. If the wind shifts and your home is saved, it’s too late. You’ve already been “marked-to-market.”
Forcing firms to mark assets in the midst of a fire storm needlessly destroys capital. Everyone knows it. So the question is why won’t the powers that be change it? There are a number of reasons used to defend inaction.
First, they say that suspending fair value accounting would create less transparency and allow companies to make up whatever values they want. This is a curious argument because activity in this past year has been anything but transparent. In addition, there are many ways to value assets and footnoting with detail about how values were calculated in a financial report would be very transparent.
Second, some say that it is too late — suspending accounting rules at this point would not help. This is almost ridiculous. Because the financial system has priced in a very deep and damaging recession, and many markets have become illiquid, assets values have been pushed well below their fundamental value. This creates a vicious cycle of asset write-downs, capital impairment, a tightening of credit, which then hurts the economy. In turn, this causes credit agencies to lower ratings on more bonds, which in turn causes more asset write-downs. Stopping this is important and suspending mark-to-market accounting is still very important.
Third, those against suspending mark-to-market ask: what will replace it? There are many answers to this question, but as long as liquidation-type, fire sale prices are not used, and reasonable cash flow values are allowed, it will be better for the economy.
In the end, the real reason accountants, auditors, and regulators won’t push for a change in the law is that they are the ones who put it in place, saying that it would keep things like this from happening. Changing it would be an admission that they were wrong.
Also, the rule exists to protect auditors and regulators. It keeps them from making any judgment calls. As long as they have rules, and they follow them, they can’t get in trouble. The problem is that managing a business takes judgment. Judgment is stifled when fire sale prices are applied to the management of financial risk.
Finally, there are many who think that enforcing the right rules will take the risk out of economic and financial market activity. This is impossible. An economy without risk is an economy that does not grow. Rules have consequences and one of the most consequential rules of our lifetime is mark-to-market accounting. Unfortunately, its consequences have created a real crisis for the economy.
Rogelio| 12.12.08 @ 10:32AM
So Brian, how would you change the rules? You don't bother to propose a better formula than the market.....which is, after all, what "mark to market" is all about, right?
RelC
Terrence O'Donnell| 12.12.08 @ 10:36AM
Not only has mark to market accounting rules devastated the books of banks, going forward beyond the current turmoil it will affect the risk taking by banks, creating an even bigger brake on the economy.
Sean| 12.12.08 @ 12:02PM
Mark to market accounting is brain dead. As a CFA charterholder, I understand the issues why people want it. They want it so they don't have to use fundemental judgements. They need numbers to plug into a calculator, not judgements as to the value of of a debt instrument. One loan is not the same as another, even if a credit rating agency rates them the same. If we really want to put our financial system in the hands of the bond traders? Aren't we dooming the capital markets to rapid boom and bust sequences?
Bill Wimberly| 12.12.08 @ 1:45PM
Brian Wesbury has been calling for this "rule" to be changed for several months now. He's right that the auditors/regulators don't want to admit that they are wrong. Is the U.S. becoming Japan ? Can we not admit it when we make a mistake and then look for a better solution? Instead, our "leaders" seem to be too busy trying to keep anyone/everyone from feeling any pain. That is not reality. Brian is right, an economy with no risk "of pain" is an economy with no growth. Keep it up Brian !!
Craig Elderkin| 12.12.08 @ 5:01PM
To Rogelio: Brian uses the short hand "cash flows" to describe his preferred alternative. In other words, an asset is the present value of expected cash flows over time. Since ~94% of mortgages, to pick a debt class, are current, you can assume that 94% of the mortgages, either stand alone or part of a securitized package, can be valued this way. For the remainer, you can apply historical averages of defaults over time to reduce the expected cash flows from the remaining 6%. You could also increase the discount rate to reflect greater risk, although this is really double counting. At the end of the exercise, you would end up with an asset that's probably worth 90% +/- of face value, reflecting the current economic problems. Mark to market forces you to value this debt at 40% of fact value, or worse, which has no basis in economic reality. Hope this helps.
Bill Nonte | 12.12.08 @ 6:20PM
Brian is exactly right and has been on the forefront of this movement since the credit markets started to freeze. I now understand why FASB and other regulators do not want to change it. But really, can someone say "tort reform"!! If by making a judgement of an asset's value, CEO's and auditors knew they would not be thrown in the slammer for life and fined out the wazzu if they were slightly mistaken, maybe we could go back to historical cost plus footnotes. I despise our sue happy society and many people's lack of personal responsibility. I so loved Bill Isaac's statement (paraphrasing) that assets can be valued historically and relfected at "judgement value" in footnotes and this is the key "UNLESS THEIR VALUE IS PERMANENTLY IMPAIRED!!!!" Stop this craziness of forcing banks to write down assets to fire-sale prices that are in no way permanently impaired!!! Thanks again Brian! Let's get this change done!!!! Bill
TaxDoc| 12.12.08 @ 9:24PM
I guess some people are not capable of learning - let's try this again. Please read the summary of SFAS 157 and note that it specifically allows for management to designate assets as Level 3 assets and use their own assumptions to value the assets - Further, if someone believes that the CDOs and MBS securities owned by banks are worth 90% of face value - then I'm sure the Fed would be glad to enter into a contract to sell them about quite a few. Please read 157 for a change.
Fair value hierarchy
SFAS 157 prioritizes the valuation inputs according to whether they are observable (reflecting market assumptions based on independent data) or unobservable (reflecting reporting entity assumptions from its own data). This hierarchy allows the user of financial statements to assess the relative reliability of fair value measurements, ranked as follows:
Level 1 inputs are quoted prices (unadjusted) in active markets for identical assets or liabilities, which the reporting entity can access at the measurement date.
Level 2 inputs are those other than Level 1 quoted prices, directly or indirectly observable, such as:
Quoted prices for similar assets or liabilities in active markets;
Quoted prices for identical or similar assets or liabilities in inactive markets; or in which there are few participants; or in which prices are not current or vary substantially among market makers (brokered markets); or in which little information is released publicly (principal-to-principal market);
Observable inputs, other than quoted prices, such as interest rates, yield curves, volatilities, prepayment speeds, loss severities, credit risks, and default rates; and
Inputs that are derived principally from or can be corroborated by market data.
Level 3 inputs are unobservable inputs; i.e., inputs that reflect the reporting entity’s own assumptions about what market participants would use to price the asset or liability (including risk), developed using the best information available without undue cost and effort. There is no verification requirement if the assumptions are in line with those of market participants.
Michael L. Hauschild| 12.13.08 @ 8:25AM
The last economic downturn (aka the depression) was overcome, not by a domestic production turnaround, but by a World War. Most of the economists offering hair-brained “recovery schemes” can only be evaluated in the light of the fact that virtually none of them saw this coming and the reasons for it. Here is the terrifying thing to me; one of the principle reasons for saving the big three auto industry is that we will need them “in case of war” to build all of the Victory Ships, Sherman tanks, and Jeeps. The reality is unless Rosie the Riveter is building Cruise Missiles and nuclear warheads (and able to manufacture them in thirty minutes) Detroit won’t contribute much to the conflagration.
Peter Forbes| 12.13.08 @ 12:34PM
Mr. Wesbury,
Your certainty about mark-to-market appears to be an echo of your certain adulation of Alan Greenspan. Have you considered a retraction of your 7.22.04 post?
Greenspan, the high priest of higher thinking, may be gone, but the legacy of his philosophy about markets and risk still permeates the minds and models of Wall St. and those now tasked with governmental oversight.
The key issue is not accounting but intelligence and morality. Institutions led by idiots should be destroyed; that is the only way to mitigate moral hazard and rebuild a healthier, more stable financial system. This is the pain that faux-conservatives refuse to face. No serious critiques from the right about accountability. Talk about "pay-to-play".
The epistemology of Greenspan is the religion of our time. But Greenspan is not alone in the Pantheon of false idols. Rubin, Friedman, Krugman; the “roll the dice on housing” liberal regulators like Frank, and the theocrats of deregulation like Gramm and Paulson. The names and politics don’t matter.
But to be clear, our financial experts just destroyed the equivalent of all profits ever made in the history of banking. Worth repeating: the experts who managed the assets and risk of our banking and financial system just destroyed the equivalent of all profits ever made in the history of banking. And they and their followers are still in charge of the money that we and our great grandchildren, at gunpoint, just lent them.
The same “experts” who we listened to before the crash are the same ones we are listening to now.
Greenspan’s recent testimony was especially revealing, but no one has caught or reported on the true absurdity of his statements:
“We are in the midst of a once in a century credit tsunami…The whole intellectual edifice [of modern risk management], however, collapsed in the summer of last year because the data inputted into the risk management models generally covered only the past two decades, a period of euphoria. Had instead the models been fitted more appropriately to historic periods of stress, capital requirements would have been much higher and the financial world would be in far better shape today, in my judgment.”
Neither Greenspan nor reporters seem to understand that these statements cannot co-exist if one is serious, let alone understands, risk and risk management. Greenspan demonstrates the casualness if not arrogance of modern experts about the (over)importance of data and what data actually tells us about the past, let alone the future.
Only a fool could think that turbulent markets can be explained with elementary bell curve statistics; only a fool could make a statement that 100 year probabilities (let alone cascading consequences) could be “calculated” from 40 let alone 20 years of data.
As Taleb says: "We human beings do not experience probabilities, we experience events! "
And even though Greenspan et al. had statistical evidence that unpredictably horrible events regularly befall us, they still could not and cannot accept that the biggest risks always exist outside our own narrow experience and history.
As Peter Bernstein once told me early in my career: “You must remember, a century is just one data point.”
These experts are like the doctors who for centuries fought the empirical evidence from lowly midwives, that merely washing one’s hands greatly decreased the likelihood of death from surgical procedures.
They are not financial experts; they and their followers are quacks.
Elvis Oswald| 12.13.08 @ 8:17PM
Using your example... "imagine that a forest fire is one mile from your $1 million home, the winds are blowing it your way and you have a $600,000 mortgage."
Would you give this man a $400,000 loan backed by his equity in the house that is at great risk of being burned to the ground?
I don't believe you would - therefore I officially declare you full of sh*t.
Todd Edwards| 12.14.08 @ 11:40AM
Does anyone ever mention that Mark to Market accounting was a hallmark of Enron?
scott| 12.15.08 @ 1:10PM
Mr Wesbury- Please provide a specific example of an impaired company that could be helped by suspending the MTM rules. Enough abstract discussion, provide an example of how government rules, not privately negotiated credit and covenant terms with counterparties affect the companies cash position .