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Mark to Market Watch
Make Fair Value Fair
This is the sixth installment of "Providing Relief from the Crisis." Read editor-in-chief R. Emmett Tyrrell, Jr.'s introduction here.
The last time I looked I couldn't find mark-to-market accounting in the Constitution of the United States. It must be the eleventh commandment because it's obviously sacred. I understand the President has the authority under the Emergency Powers Act, or some such legislation, to suspend the Bill of Rights in case of a national emergency. Well, we have a national emergency, so mark to market must be more important than the Bill of Rights.
If a foreign power destroyed a fraction of the wealth that mark-to-market accounting has in the past year, we'd go to war. I'm no accountant, but, as I understand it, mark to market is part of what they call "fair-value" accounting; so it must be fair.
If so, I have a couple of questions. What's fair about a financial institution being put out of business because a small portion of its bundled assets become impaired and the whole bundle must be treated as a loss? How is it fair that an expected loss of a few thousand dollars a few years from now, in some cases, must be treated as a loss of millions in the here and now? If a small number of mortgages behind a mortgage-backed security become impaired, or potentially impaired, why must the whole bundle be written off? If I have a sack of apples with a couple of bad ones, I throw the bad ones away -- not the whole sack.
More questions: If the "impairment" results from lack of liquidity because markets aren't working, why can't banks simply hold on to their securities -- until maturity if necessary? Why must they assume a fire sale at fire-sale prices for something they don't have to sell? If some of the impairment results from actual losses on the underlying mortgages, why can't they write off only that portion of the impairment? Does it really make sense to force write-offs of the whole bundle of mortgages when only a few would have to be written off if the mortgages were held individually?
What makes the answers so crucial is that these write-offs we're talking about reduce the banks' regulatory capital dollar for dollar. That used to mean failure or a forced marriage when capital reaches zero. These days it only has to approach zero, to preserve insurance funds and stretch bail-out money.
The answers to my questions apparently have to do with transparency -- investors and creditors need to see exactly what you've got in your portfolio. Well, show them. Surely, you can show them what's in the sack without having to throw the sack away. Surely, transparency can be achieved without throwing common sense out the door.
In a recent blog posting, I described a variant, the PWC proposal, which would count only the markdowns attributable to credit impairment against regulatory capital and would treat those attributable to illiquidity in another manner. Show it all; let it all hang out; just don't crucify our financial system and economy on the cross of mark-to-market accounting.
Now is the time for all good accountants to come to the aid of their country, and put some fairness in fair value.
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Bob| 12.15.08 @ 4:13PM
McTeer -- What we are talking about here are derivatives and leverage. Have you ever bought on margin from a broker? You don't pay the full value of the security, you pay a portion -- perhaps 50% -- and the investment house loans you the rest. If that security loses 25% of its value, the investment house loses 50% of its loan to you. To back this up, they went to companies like AIG to get swaps, i.e., insurance if they took a loss. Well, this is a ponzi scheme and a house of cards. An investor can't really value derivatives because they are just slices of groups of loans. If you don't use MtM, the securities are significantly overvalued and the company -- like Lehman -- is overvalued significantly. If you are a technical market expert, you can read about the risks in the financial notes, but most investors just rely on ratings services like Moody's. At some juncture, the investment house will become illiquid and cannot operate even though the financial reports look good. Is that really what you want? You can prevent this by having capital requirement and regulating these entities more -- which most conservatives don't like.
If you do use MtM, then you are seeing the real value of the assets of the companies. However, the problem here is that real value is difficult to calculate for derivatives. Therefore, there is an overreaction to their strength. If they rise, people value them way too high and if they fall, they are valued way too low.
As an investor, I like MtM and that's where Cox went. It is the height of transparency. Cox was philosophically opposed to more regulation which would have been required without MtM. There is no good solution to this. However, having been in the business, I am more favorably inclined to have greater regulation and less volatility using historical costs and increased financial reporting to show the amount of leverage.
I don't buy your argument regarding future value being inappropriate. The markets are always forward looking and we always value securities in relation to their future value. If we find out that Company A has no new products in their pipeline, we devalue that company even though that might not effect its earnings capacity for a couple of years.
When we allow institutions to leverage themselves without appropriate capital requirement, you will always have losses in one place covering profits in another. It's like a company with several divisions. If a company has 4 divisions and three are making a profit but the 4th loses more than the other 3 make, you still have a company loss. This situation is not different.
The answer is to increase regulation and capital requirements and reduce leverage. But I think you know that.
Alex| 12.15.08 @ 10:01PM
Time to bust some trusts again. Fiancial institutions have gotten too big and too diversified. Remember when banks could only operate in one state and couldn't sell insurance? there was a good reason behind such restrictions. We can't go back to that, but we have to limit the size of banks so that no single entity is "too big to fail." MtM is not the real problem. THere is no other reasonable way to price assets because there is no reasonable way to predict the future.
richard M| 12.17.08 @ 6:57AM
The protagonists in the pros and cons of the mark-to-market debate seem to have missed the core of the problem: finding a transparent and conceptually rational algorithm that has withstood test by falsification to value an asset (having regard to its previous price history) from this moment onward, under market conditions which may or may not replicate the past. This algorithm must of necessity start with a yardstick defining what the asset value is expected to be under these parameters, absent unforeseen “extraordinary (current price) movement”.
PMC_0 in Fig. SMP_2.3aa_1120 in http://stockmarketpredictor.spaces.live.com/ provides such a yardstick. Deviation (measured in MSL steps) of the actual/projected price of the asset (PMC) from the norm (PMC_0) now becomes quantifiable, and open to transparent evaluation or amendment against the actual/projected change in income-generating capacity of the asset which defines its true worth, to arrive at a truly “fair value”.
Consider the alternative to mark-to-market quoted by Dr. McTeer in his “Mark to Market Frustration” blog: Pricewaterhouse & Cooper’s proposal of principles in valuation can amount to no more than a proposal, until a universally applicable algorithm that can establish incontestable asset value is tabled.
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