Mark to Market

[aiki14]

As much as I hate to agree with Larry Kudlow, I think he's a blowhard, I am becoming convinced that mark to market is an unmitigated disaster. Steve Forbes has been railing against it for months and the more I consider it the more I agree with him. The intrinsic value of the "toxic" assets is far greater than the market value. Performing loans have little or no market, and must be taken as valueless under the mark to market accounting practices, but if the loan is performing by definition it has value. I think assigning a value to these assets, have the gov't backstop against default of these loans at that or a fair percentage of that value and you free up trillions of dollars without having to use taxpayer money to recapitalize the banks.

[concrete]

Well, it can be a really useful tool, but in Mortgage Backed Securities, it has been an unmitigated disaster, that's for sure. Sale value sucks, while cash flow value is something entirely different. From what I've seen, the real reason for a lot of the losses reported that are driving the market in the toilet are a result of companies being forced to mark down asset prices to market value instead of cash flow value. Somebody is making a shitload of money somewhere

[aiki14]

Well, it can be a really useful tool, but in Mortgage Backed Securities, it has been an unmitigated disaster, that's for sure. Sale value sucks, while cash flow value is something entirely different. From what I've seen, the real reason for a lot of the losses reported that are driving the market in the toilet are a result of companies being forced to mark down asset prices to market value instead of cash flow value. Somebody is making a shitload of money somewhere

The problem is the banks are required by statute to hold a certain amount of assets as a percentage of their total outstanding loans (One of the things the Fed sets as part of it's open market operations is this percentage). If these loans have no market value then the banks have to hold other assets to meet the FOMC requirements, usually including any cash they have lying around. This cash is then not available for loans, thereby freezing up the credit markets.
If the government backstops these assets (by assigning them a value) then the banks can use the equal value in available cash to make loans. estimates are that this could free up more than 1 trillion dollars, some even say 3 trillion, making the bailout unnecessary.

[concrete]

The problem is the banks are required by statute to hold a certain amount of assets as a percentage of their total outstanding loans (One of the things the Fed sets as part of it's open market operations is this percentage). If these loans have no market value then the banks have to hold other assets to meet the FOMC requirements, usually including any cash they have lying around. This cash is then not available for loans, thereby freezing up the credit markets.
If the government backstops these assets (by assigning them a value) then the banks can use the equal value in available cash to make loans. estimates are that this could free up more than 1 trillion dollars, some even say 3 trillion, making the bailout unnecessary.
I'm not sure the motive was or is to solve the problem. It could be that the Fall 08 bailout was motivated by a gun to the head and our response was to hand money to the gun holders. Maybe the motive behind this one is to keep our inner cities and ghettos from boiling over so were going to hand over some money to the less fortunate and down right pissed off?
There is just too much interwoven investment to just say "let them eat the loss". The cascade of dominoes includes pension funds, institutions, private investors, other banks, etc. On a normal scale the "let them eat the loss and fail" works fine. Concrete's business goes tits up due to stupidity on my part, my loss. If I convinced a few folks to invest in my biz, their loss. But on a multi-Trillion Dollar scale the scythe cuts very sharp and very wide and is not very discerning about what is lopped off. That is the ONLY reason I have any support at all for the Fall 08 Bailout. We, as a country just can't afford that kind of hit.
Our initial error was allowing ANY company to get large enough that, through its mismanagement or misfortune to have the capacity to savagely impact the largest economy in the world. We need to learn a lesson from that error.

[XOM]

I think we did receive a warning in the way of Enron, but hey that was just an isolated incident.

[aiki14]

I am hearing rumors of a suspension of mark to market, and that's why the market is rallying. Now CNBC is reporting the rumors

[Galt]

Yep, it may trun out that there was never any crisis, just a huge FUBAR due to the mark to market regs. The old guys will never admit it (Bush, Paulson, et al), and many congressmen will still deny it, but the whole collapse can be laid at the foot of the FASB theory of shoving every possible accuonting footnote thru the financial statements.

Try to figure out how much money a long-term hedged oil producer is actually making each quarter, when their P&L is twisted by M2M (CHK is one example). Or a bank.

Of course, unravelling it now will be tricky, since house prices have in fact collapsed and unemployment is on the march.

[Survivor]

Another Rotting Cesspool

Did Mark-to-Market Accounting Create the Credit Bubble?

Paul Davies, in "True impact of mark-to-market accounting in the credit crisis," discusses a paper by Tobias Adrian of the New York Fed and Hyun Song Shin of Princeton University that claim that mark-to-market accounting play a direct, perhaps central role in the credit bubble, and that it works just as dramatically in reverse.

Once they explain the thesis, it's so blinding obvious that one wonders why that sort of thinking hasn't gotten top billing sooner. When asset prices rise (say because interest rates fall), the balance sheet gains lead directly to increases in a firm's equity. Financial institutions tend to maintain the same level of gearing, so when equity goes up, they want to increase their balance sheet size. Similarly, when asset prices fall, the losses are hits to equity, and balance sheets contract.

These expansions and contractions happen system-wide, and lead to what is perceived as increases and falls in liquidity. The authors argue that liquidity tantamount to the rate of growth in aggregate balance sheets.

I've only skimmed the paper, but it looks suitably rigorous and has lots of analyses and charts.
It's puzzling that it hasn't gotten more attention.

The writeup by Davies presents the findings faithfully and makes some observation of his own.

From the Financial Times:
Back in April 1993 the eyes of the world were on the beseiged Balkan town of Srebrenica, which the UN declared a safe haven for Bosnian muslims, and on Northern Ireland, where secret talks between leaders from rival factions kick-started a tentative peace process.

In the same month, a less-noticed development saw US accountancy regulators approve a rule that paved the way for today's widespread use of mark-to-market accounting standards. This rule, which forced US banks to carry more securities at market value, emerged from the wreckage of the US savings and loan crisis when losses on loans had been hidden by the use of "historic cost" accounting.

Only now, in the middle of a global credit crisis, is the impact of the broad introduction of mark-to-market accounting becoming clear. The critical concerns are around how much these changes helped to inflate the credit bubble and whether they will increase the speed and destructive power of its collapse.

To be fair, the US banks protested at the outset that the move would change their role in the economy. So did the French banking federation before similar changes came to Europe in 2005. It warned that fair-value accounting "could even further increase the euphoria in a financial bubble or the panic in the markets in a time of crisis". Tobias Adrian, an economist at the New York Fed, and Hyun Song Shin of Princeton University, have produced a string of work about this kind of "pro-cyclicality" in finance and the economy, culminating in a paper last September entitled Liquidity and Leverage .

This paper examines the links between asset prices and the value of banks' capital bases when mark-to-market accounting is used. It postulates that banks are driven to lend more and grow their balance sheets as the value of their capital rises. This is because they target a more or less constant leverage multiple on their balance sheets.

The paper concludes it was inevitable that an industry buoyed by rising asset prices would pursue increasingly aggressive lending growth. This pushed credit upon ever more risky clients and loan structures, which then fed into asset price growth. This of course added more fuel to the fire - or created "positive feedback loops".

The most disturbing conclusion is that this system should behave in exactly the same way in reverse, creating "negative feedback loops" with a destructive impact on all kinds of asset values - from structured finance to house prices and equities.

In a way this is nothing new - the old adage about a banker is that he gives you an umbrella when it is sunny and asks for it back when it starts to rain.

But there are two important differences. First, fair-value accounting will speed up the process. One of Adrian and Hyun's conclusions is that it was the speed of balance sheet expansion that caused the most blatant excesses of US mortgage lending.

Second - this isn't mentioned in the paper - there is the impact of securitisation, the practice of converting illiquid individual loans into saleable securities.

This accelerated the speed at which banks could increase lending because it reduced the amount of capital needed for each new loan. It was so widely adopted because of the way it turbo-charged returns on capital.

Banks' use of pseudo off-balance-sheet vehicles to house securitised bonds further boosted this process, particularly from 2005 onwards, as can be seen in the asset-backed commercial paper market.

What we will see over the remainder of this year is an ongoing painful reduction of capital values and leverage levels throughout the economy, centred around banking.

Investors need to believe this re-adjustment has at least stabilised before they will return. Each new wave of price falls in leveraged loan markets or asset-backed securities markets -- and each post-earnings restatement of losses from the likes of AIG, Credit Suisse or whoever is next - illustrates that the prognosis is not good either for the financial world or the wider economy.

The lesson for regulators is that the solution to one problem almost always contains the seeds of another.

[Roger]

I also read a lot about the mar2market phenomenon. A few days ago Ive read an interesting article about this topic with an additional problem: the large amount of accumulated intangibles on the balance sheet of the banks.

The article states that banks accumulated too much goodwill on their balance sheets. This is caused by asset-price bubbles which lead to goodwill inflation. The question is whether this goodwill value has realy this value. If this is not the case, banks have less capital left to absorb toxic assets. According to the article, markets seem to recognize this, because many banks trade below their book value. This could be a reason why banks are hesitant to resume lending. Another implication is that banks have a higher leverage in reality.
A realistic valuation could cause accounting losses up to 800 billion globally. However, it seems that neither banks nor regulators have interest in revealing the extent of this goodwill impairment.