"Suspending mark-to-market accounting, in essence, suspends reality."

-Beth Brooke, global vice chair, at Ernst & Young

>

Misinformation, bad dope, and spin seem to be dominating the current discussion on Mark-to-Market accounting. Let’s see if we cannot simplify the arcane complexity of the accounting rules regarding FASB 157.

Understand why this is even an issue: Many banks, brokers, and funds chose to invest in certain "financial products" that were difficult to value and were at times thinly traded. If you are looking for the underlying cause of why some arcane accounting rule is an issue, this is it.

In my office, we don’t buy our clients beanie babies or Star Wars collectibles or 1964 Ferrari 275GTBs. We purchase stocks and ETFs and bonds and preferreds for them (some clients also own options and commodities). Why? Because we believe — and our clients have insisted upon — the need for instant liquidity. Nothing we have purchased cannot be liquidated on a moments notice. We know what the fair value of these holdings are second by second.

While we may have been tempted by potential greater returns that
some of these other products offered, we simply could not justify the
risk of owning hard to value, thinly traded, hard to sell items. And, we never had to rely on the models of the individuals who created and sold us these products in the first place, to determine an actual price. If ever a product was rife with self-interested conflicts of interest, this one is it.

That is one of the key elements of the current situation. A decision was made to bypass the broad, deeply traded traditional markets (Equities, Fixed Income, Commodities and Currency) and instead create new markets for new products. No one should be surprised that the net result was a flawed system of garbage paper, with too little room at the exits in case of emergency.

Let’s puts this into some context:

"Accounting is a way of portioning economic results by time periods. It
doesn’t affect the cash flows, but tries to allocate economic profits
proportional to release from risk. If we were back in an era where the
financial instruments were simple, then the old rules would work. But
once you introduce derivatives, and securities that are called bonds,
but are more akin to equity interests, you need to mark them to market."

-David Merkel

Exactly. Otherwise, you are left with public companies, who have made capital allocation and investment decisions that are hidden from their owners (shareholders) and the investing public.

Now that the garbage is on the books, no one wants to admit the original error of purchasing this class of assets. Its not just that the trade has gone bad, its the original buying decision was so flawed even if the trades were not such giant losers.

Recent actions of corporate titans in the financial sector are essentially an admission that their business model was deeply flawed. No one would invest any capital for a ROI of 50 bps per year. They of course knew this — so they leveraged up that 50 bps 35X or so, creating the false appearance of more attractive returns. This higher risk, potentially higher return paper was part of that misleading process.

Suspending FASB 157 amounts to little more than an attempt to hide this broken business model from investors, regulators and the public. Its not just getting through the next few quarters that matters; Rather, its allowing the market place to appropriately reallocate this capital to where it will serve its investors best. That is what free market capitalism is, including Schumpeter’s creative destruction. (A WSJ OpEd today get this issue precisely wrong).

I have been steadfast over the past 2 years about why I did not want to own any of the financials that held this paper on its books. The key was that we could not figure out what the liabilities were relative to the assets. That is investing 101.

If FASB 157 is suspended, I would advise our clients and the investing public that owning any financials that failed to disclose their holdings accurately were no longer investments — they were pure speculations, with more in common to spinning a roulette wheel than owning Berkshire Hathaway (BRK) or Apple (AAPL) or Google (GOOG). Indeed, I know of no faster way to end up on the DO NOT OWN list than to hide from your shareholders what is on your books.

If investors cannot trust the valuations of what is on a firms books, they simply cannot invest in these firms PERIOD.

There are other alternatives for the institutions that now must deal with this discounted, thinly traded hard to value junk paper. They can sell it for whatever price a the market will bear, they can spin it off into a separate holding company, they can write it down to zero and reap the rewards of mark ups in future quarters.

But suspending the proper accounting of this paper is the refuge of cowards. It reflects a refusal to admit the original error, it hides the mistake, and it misleads shareholders. I find it to be totally unacceptable solution to the current crisis.

As Japan learned, not taking the write downs only delays the day of reckoning. They propped up insolvent banks, and suffered a decade long recession for it. That way disaster lay . . .

>




Previously:
S&P500 ex-Risk ? (November 06, 2007)
http://bigpicture.typepad.com/comments/2007/11/sp500-ex-risk.html

Sources:
Summary of Statement No. 157
Fair Value Measurements
http://www.fasb.org/st/summary/stsum157.shtml

Auditors Resist Effort To Change Mark-to-Market
JUDITH BURNS
WSJ, SEPTEMBER 30, 2008, 4:29 P.M. ET
http://online.wsj.com/article/SB122280147924091325.html

SEC, FASB Resist Calls to Suspend Fair-Value Rules
Jesse Westbrook
Bloomberg, Sept. 30  2008
http://www.bloomberg.com/apps/news?pid=20601087&sid=agj5r6nhOtpM&

How to Start the Healing Now
Fix accounting rules and private money will come.
BRIAN WESBURY
WSJ, OCTOBER 1, 2008
http://online.wsj.com/article/SB122282734447293049.html

Category: Corporate Management, Credit, Derivatives, Earnings, Legal

Please use the comments to demonstrate your own ignorance, unfamiliarity with empirical data and lack of respect for scientific knowledge. Be sure to create straw men and argue against things I have neither said nor implied. If you could repeat previously discredited memes or steer the conversation into irrelevant, off topic discussions, it would be appreciated. Lastly, kindly forgo all civility in your discourse . . . you are, after all, anonymous.

101 Responses to “Understanding the Significance of Mark-to-Market Accounting”

  1. It appears that if we are to avoid this mess, we’ll all have to wage a public PR campaign against Wall Street, the banks and anybody else in support of suspending mark-to-market accounting.

    I would urge everyone to spread this message via blog posts, blog comments, e-mail to friends, e-mail to your government representatives.

    Regards,
    George

  2. Greg0658 says:

    consider:
    “banks must pay county property taxes on all held property on a quarterly basis”
    versus:
    current system of the next buyer pays all property taxes
    will:
    put some jump in their step to price assets to sell

  3. GRUMPYOLDVET says:

    Gotta agree with ya Barry….all this weeping and gnashing of teeth over mar-to-market is nothing more than pure bullshit.Most of the Congress decrying the system have absolutely no idea what it is they are talking about. Rep Tom Price of Texas said on Bloomberg yesterday he didn’t understand mark-to-market but it was a free market principle if it was abandoned,
    Corporate titans know better but hey why speak out for it when if it’s abandoned/suspended they win.

    Oh when is Gasbag going to join the list of unemployed.

  4. Marek says:

    No one argues that the companies need to mark-to-market liquid assets. The real issue comes as to what to do with illiquid assets. The rule should never ever be applied to illiquid assets because this rule over inflates (overprices) the assets of the way up and over deflates (under prices) the assets on the way down. (somewhat similar to illiquid AH trading in stocks)

  5. Indeed, I know of no faster way to end up on the DO NOT OWN list than to hide from your shareholders what is on your books.

    Dunno if it’s faster, but being on the ‘do not short’ list is a pretty quick way to get on the ‘do not own’ list… When you need the gummint to change the rules just for you, that’s a pretty big red flag..

  6. John(2) says:

    I couldn’t believe this one but then I learned it was being pressed by those folks in the house who think tax cuts were the solution. The guys Tom Friedman says probably couldn’t balance their own checkbooks and I suspect he’s not far wrong. If this gets by I’m going to value my house at about 2 million above local comps and get a home equity loan on the new valuation. Seriously this has to be beaten back. Hopefully someone like Uncle Warren will deliver a reality check.

  7. John(2) says:

    And just an addendum: Wesbury’s promoting it. ARRRRRGGGGGGHHHHHHHH

  8. Aunt Deb says:

    I just want to thank you for this excellent explanation. Your blog is extremely helpful even for those of us who are just watchers of the play.

  9. Clint Golden says:

    I’m really not a financial guy so I’d appreciate it if somebody could help me out with this.

    The way I understand it is, if I’m in the business of trading say, Oranges, and I buy a bunch of Oranges that have been contaminated with something that makes them so radioactive nobody wants to buy them this FASB157 rule dictates that I must markdown the value of my Orange inventory to zero?

    And if the FASB157 rule is eliminated I can value my radioactive Orange inventory to any value I like and not reflect anywhere in my financial statements that I have so arbitrarily valued my inventory?

    As I understand it, I agree with everything the author of this article says, especially the point about bullshit investments and the creators of such that implemented an unregulated thinly traded so called market to trade the ponzishares they created.

    Lastly, intuitively, this whole mark-to-market debate Washington is giving us seem to me like a rope-a-dope.

  10. Clint,

    other than the Fact that FAS 157 has, mostly, to do w/ Financial Instruments, you’re on the right track.

    see: Summary of Statement No. 157
    Fair Value Measurements
    Summary

    This Statement defines fair value, establishes a framework for measuring fair value in generally accepted accounting principles (GAAP), and expands disclosures about fair value measurements. This Statement applies under other accounting pronouncements that require or permit fair value measurements, the Board having previously concluded in those accounting pronouncements that fair value is the relevant measurement attribute. Accordingly, this Statement does not require any new fair value measurements. However, for some entities, the application of this Statement will change current practice.

    Reason for Issuing This Statement

    Prior to this Statement, there were different definitions of fair value and limited guidance for applying those definitions in GAAP. Moreover, that guidance was dispersed among the many accounting pronouncements that require fair value measurements. Differences in that guidance created inconsistencies that added to the complexity in applying GAAP. In developing this Statement, the Board considered the need for increased consistency and comparability in fair value measurements and for expanded disclosures about fair value measurements.

    Differences between This Statement and Current Practice

    The changes to current practice resulting from the application of this Statement relate to the definition of fair value, the methods used to measure fair value, and the expanded disclosures about fair value measurements.

    The definition of fair value retains the exchange price notion in earlier definitions of fair value. This Statement clarifies that the exchange price is the price in an orderly transaction between market participants to sell the asset or transfer the liability in the market in which the reporting entity would transact for the asset or liability, that is, the principal or most advantageous market for the asset or liability. The transaction to sell the asset or transfer the liability is a hypothetical transaction at the measurement date, considered from the perspective of a market participant that holds the asset or owes the liability. Therefore, the definition focuses on the price that would be received to sell the asset or paid to transfer the liability (an exit price), not the price that would be paid to acquire the asset or received to assume the liability (an entry price)…
    http://www.fasb.org/st/summary/stsum157.shtml

    past that, nice work BR, a succinct unpacking of this issue, at hand.

    Further, just a rhetorical Q: “Given the share price of GOOG, Am I Really the only one that has a web-browser that’ll field results for http://www.google.com?

  11. Michel Caldwell says:

    A thought from an ignorant fan of yours.
    I think I understand your point. However, it seems to me that marking to a market where there are no trades is as illusionary as marking to some theoretical model. How about having an adjustable average between marking to model (or yield to maturity) and marking to market? The average should be 100% mark to market when the market is liquid (e.g. stocks) and closer to 100% model when there are no trades going on. Or maybe we should require firms to report both methods.

  12. Posted by: Michel Caldwell | Oct 1, 2008 9:43:49 AM

    Michel,

    simply, illiquid G**bage that doesn’t trade (noone wants), isn’t an ‘Asset’, it’s a Liability.

  13. PrahaPartizan says:

    Does eliminating the “mark to market” rule mean that any firm can “adjust” their assets to some murkily derived value just as the financials will be allowed to do? I remember back in the early 1980s when firms and banks in Texas were going belly up right and left as the petroleum price fell from $40 per barrel to $10 per barrel and these enterprises had to adjust the loans which had been made with these oil reserves pledged against the loan. Should those firms have been allowed to keep the asset values at $40 per barrel – maybe even adjust them higher – since everybody knew that in the long run the price of petroleum would go even higher? How much special coddling does the financial services industry need in order to remain viable? Maybe we should nationalize the whole mess.

  14. VoiceFromTheWilderness says:

    Yes Ai! Way to go Barry. The truth is out folks.

    In (semi-)related news:

    Isn’t it funny how all the former free marketers have started yammering about ‘actual value’ as opposed to market price of an asset? What were these guys too busy doing beer bongs to attend class the day their econ101 teacher explained that in free markets supply and demand set the price and ‘inherent value’ is a completely non-economic notion — one for those wooly librul do gooders that believe in things like inherent worth. The gold bugs are also pretty funny about this — free markets uber ales, but Gold has ‘inherent value’. It’s just not inherent to its demand (use) or supply (there’s lots more where that came from).

  15. larster says:

    Good post, Barry. I also think that to suspend mark to market at the time of a crisis in confidence is pouring gas on the fire. Kind of like proposing a capital gains tax cut, when you are approving a $750 billion expenditure.

  16. Donkei says:

    The flip side of mark-to-market rules is that liabilities are marked to market as well.

    Since a failing firm’s liabilities decline in value as it fails, you can have the conundrum that a firm starts looking profitable just before it goes under.

    Maybe those “profits” before implosion can be the source of capital needed to save the firm.

  17. lutton says:

    A Republican Congressman (voted against bailout Monday) on the Rachel Maddow show was rallying for abandoning the mark-to-market requirement. I turned to my wife and said, “sure, let them just make up values, that’s bound to work”

  18. wunsacon says:

    Michel, these assets HAVE traded but at a much lower price than the banks want to recognize/admit. They don’t want to mark down their entire “warehouse” of inventory to the observed prices for the few trades that have been forced (via banks either desparate or in bankruptcy).

    And bank assets “in foreclosure” *are* the market, just like a house still has value in foreclosure. All the sellers (homeowners and banks alike) holding out for “2005 bubble prices” are simply avoiding reality.

  19. cloudy says:

    FNMA/FHLMC, lenders, banks were sold on FICO credit scoring as a way to assess risk. The assumption was a certain credit score determined the likelihood of default. Higher FICO score meant lower risk.
    You could get a no verification mortgage in seconds with a sufficiently high FICO score. Banks and consumers loved it.

    Packaging of loans was based, in part, on FICO scores.
    Well, that whole model has been blown to shreds.
    The FICO model must never have been stress-tested.
    If you have a pool of mortgages you bought based on FICO, and now FICO is a meaningless number, then you are left with essentially nothing on which to base a value.

  20. p.a. says:

    I can understand the s–tpile owners pushing this, but who in the US gvt is? Who is responsible to oversee (cough, hack) this? SEC? Some other regulatory (cough, hack) agency?

    Please excuse me for now getting partisan, but for any nation to elect GW Bush TWICE given his long previous history of ineptitude and crudeness, maybe we should file this collapse under ‘Karma’.

  21. M.Z. Forrest says:

    This is far afield for me. It sticks in my head for whatever reason that mark-to-market was originally created when the market was rising so that companies could raise their balance sheet based on the inflated values. Many of these financial instuments as far as my understanding goes used to sit on the balance sheet at a significant discount to market value because companies didn’t want to have to take large losses come bad times. I think Warren Buffet said something about having to mark his stocks higher than he thought they were worth due to the accounting rule change. Does any accountant and finance guy know more on this? I could just be wrong.

  22. Jay says:

    Great post. Thanks for the info on this topic. I’m disappointed supposed ‘free market capitalists’ would want this rule suspended.

  23. bdg123 says:

    Mark to market suspends reality? Are you kidding? Does anyone truly believe Wall Street and politicians haven’t already suspended reality? They did so loooooong ago.

    They can do anything they want to do with their accounting rules. This has nothing to do with real estate or its associated debt. They can shake it, bake it, fry it or anything else they want to do with it. In fact, they can shove it where the sun doesn’t shine. None of it will stop the environment we see unfolding.

    Correlation is not causation and they will find this out soon enough.

  24. scorpio says:

    there is no such thing as an “illiquid” asset. there’s always liquidity, and a price, where something will trade. the rule that shd come out of this is that financial companies should never own things that some describe as illiquid. does not fit their business model. a pension fund can own timber, not a bank. financials and those who love them should accept reality.

  25. clipc says:

    as i understand it, fasb 157 divides “investments” into 3 categories: lv1 mtm on actively traded stuff. lv2 “fair value” as defined by what a willing buyer would pay to a willing seller. lv3 mtmyth, as warren said. changing or eliminating the marks would look better, i guess, on valuation of abs of one sort or another, but the coming problems are direct loans: mortgages, cc receivables, junk loans, c&d loans, etc. none of these are subject to fasb 157, as i understand it, and get reserved against as the loans go delinquent (or worse) something that will continue at an increasing rate going forward.

  26. mashedpo says:

    Mark to market is as much a much a fiction as mark to model when a market has vaporized or seized up for reasons now beyond the underlying asset issues – understating an assets value is as material a mistake as overvaluing it. Sound judgement is required in illiquid markets. That’s what we lost sometime ago and now, any measure of trust. Suspension of mark to market is a reasonable short term proposition until there is a market- that would be an important element in any “price discovery” process needed to get a good deal for taxpayers in a bank re-cap – much less buying their “toxic assets” via reverse auction or whatever. I might also add that the economic and financial literacy of the American public and indeed many commentators on this board is appalling.

  27. Philipat says:

    And we would all be expected to trust the arbitrary valuations because we all know how intelligent and honest bankers are?

    Fool us twice, shame on us?

  28. AlexPagoda says:

    I’ve seen it posted here recently, but this is a perfect explanation:

    EXECS & GVT OFFICIALS ARE DOING NOTHING MORE THAN KICKING THE CAN DOWN THE ROAD.

    Yes, it will delay the day of reckoning; yes it will put us into a Japan-or-worse-funk; but that water-torture will take place after execs have been given the chance to cash out, and after the current administration is gone.

    Is there any other explanation?

  29. Mr. Obvious says:

    Bowyer is back on the radio here in P-burgh. Looks like one hour a week during the afternoon drive on 1360.

    Last week he spent his hour ranting about the evils of mark-to-market, and how this entire crisis was caused by the rule and therefore McCain should be elected because he will deregulate Wall Street and the crisis will go poof.

    I’d love to see BR and Bowyer go at it mano-a-mano.

  30. Clint Golden says:

    @MEH, TYVM

  31. Comrade Darkness says:

    Please excuse me for now getting partisan, but for any nation to elect GW Bush TWICE given his long previous history of ineptitude and crudeness, maybe we should file this collapse under ‘Karma’.

    Way ahead of ya. But, it would feel more cleansing though if those that have backed Bush and cheered him on all these years despite all rational evidence didn’t file it all under “rapture”.

  32. Blue Steel says:

    I’ll resubmit my comment from the earlier thread:
    I admit to being a little confused; a financial neophyte who is learning along the way.
    Yesterday I watched the movice “Enron: the Smartest Guys in the Room”, and they talked about one of the factors in Enron’s house of cards was their employment of the mark to market rule – basically booking profits before they existed. Now many of you (and BR) are talking about how we need the ‘transparency’ of mark to market, rather than this suspension of the rules to make banks feel better about their balance sheets. What’s the deal?

    To add a further question, this bailout is supposedly about purchasing some of the toxic assets from banks, etc. – but at what price? If we change the accounting rules, and the big shitpile of dreck is now worth 77 cents on the dollar instead of 23 cents – won’t the taxpayer be overpaying that much more?

  33. Philipat says:

    Comrade Darkness, yes I also wonder what America has been collectively smoking for the last 8 years.
    I never thought i would ever have to say this but the French were actually right! So much for freedom fries and it perhaps also explains why we now march down the road to French socialism?

  34. RW says:

    I don’t know about bennie babies but the one fellow I know who invests in vintage cars has done a lot better over the last few years than most of the stock pickers I know.

    You might reconsider that “no Ferrari’s” rule.

  35. Steve in Fly-over Land says:

    Barry,

    Sorry, but I am not pursuaded by your logic. It is well and good to say that these thinly traded and illiquid securities should never have been purchased; but that’s like saying you shouldn’t have purchased a stock after it went down.

    The markets judgement on these securities was very different three years ago. At that time they were easily traded and thought to be very valuable. Was the market wrong then, is it wrong now or is the truth somewhere in between?

    If I purchase a fixed income asset that pays me interest over it’s entire term and is then redeemed at maturity at face value, why should I have to be constantly booking profits and losses as the market changes its mind about the value? The effect of mark to market seems to be positive feedback to the market swings, overstating profits for the upswings and overstating losses for the downswings.

    It is true that if an asset suffers impairment then I should be required to mark down its value on the books and I suppose that if the market was always reasonably close in setting the value of assets that mark to market would be a better way of establishing impairment of assets than most others, since it would be immune to the accounting gimmicks that we all fear would be used to hide the truth about losses.

    Unfortunately, the market isn’t always reasonable in its valuations. If it were we wouldn’t be in this mess.

    I’m afraid I’m going to have to go against the crowd on this one.

  36. Jasper says:

    As an accountant, I’m puzzled how the information required by FAS 157 affects actual solvency. If a company is sitting on a pile of affected assets, isn’t the goal of FAS 157 to tell investors how to value what those assets would bring IF they needed to be sold to raise capital?

    What an asset MIGHT be worth in 10 years (at “maturity”) is not relevant to people making decisions today on whether a bank can meet its obligations, THIS YEAR.

    And even if some totally invisible mathematical model proves that an investment will have a positive discounted cash flow over a sufficiently long period of time, what is the market demand for such an investment. What kind of discount does the market place on uncertainty, lack of liquidity. I would think that with comparable expected net cash flows, FAS 157 affected assets would trade at a giant discount, 20-40% or more, just to account for the investments’ total unsuitability to the vast majority of potential investors.

    It’s lunacy to believe that FAS 157 asset would EVER trade at a price equal to more liquid investments with similar EXPECTED cash flows.

  37. leftback says:

    I am standing on the subway platform, having recently stepped off the D-train™. I am waiting for the R-train™. Driver Paulson has been delayed by signal problems on Capitol Hill, but the train is on the move again and ready to pull into the station…

    We can (and surely will) debate this issue repeatedly, as a series of bailouts will likely be proposed as this process continues.

    For now, I think we have to accept that this is going to be passed, and that we are looking for reflation trades for a while. Mine are GDX and DXKSX (inverse 2.5 x the 10-year). There is an awful lot of safe haven money in Treasuries and they are going to get destroyed when this is passed. We can also expect a stock rally of uncertain duration -

    Et après ça? Le déluge…

    [Any rally might be surprisingly brief as the market will face pressure of selling from hedgies needing to raise cash for redemptions.]

    Off to DC to sit in a committee room…

  38. Bruce in Tennessee says:

    If we ban shorting the ISM index,(today’s numbers were terrible), will this restore manufacturing in the US?

    ….just wondering….

    (John 2, it is supposed to be a humorous, nonsensical question…)

  39. leftback says:

    @Bruce in TN:

    There are no problems in the US ! It’s a Goldilocks economy. Didn’t you see the ADP report this morning (only -8000 jobs). Wonder what those guys are smoking?

    Please keep me amused tomorrow while I am in DC, and let me know if there are any more burgers to be had this week.

  40. grumpyoldvet says:

    Ron Suskind wrote a book last year about the Bush administration. In a particular passage, one of the Bush administration persons said and I paraphrase….you live in reality, we make our own reality. So it is with those who don’t understand the reason for mar to market.

    Jasper @ 10:42 explains it well.

  41. ECONOMISTA NON GRATA says:

    “Religion, is the scoundrel’s last refuge…..”

    Or as my father used to say… “Faith is for skeptics…”

    The suspension of the FASB 157 shall be the equivalent of the Jones Town Massacre. These A-Holes are going to get exactly what they deserve.

    Best regards,

    Econolicious

  42. VG says:

    The idea that mark-to-market somehow provides a “perfect price” every time is pure nonsense.

    Eighteen months ago, the “fair value” of these same securities by mark-to-market was about a trillion dollars more than it would be today. A TRILLION FREAKING DOLLARS.

    So which is it? Was mark-to-market completely useless back then? Or is it completely useless now?

  43. OhNoNotAgain says:

    “FICO model must never have been stress-tested.”

    I knew FICO scores were shit the day I tried to get mine and realized that I would have to pay money to see it. I *know* what my credit-worthiness is. I was trying to see if *they* knew what it was.

    We’ll do a lot better in the future to have information like this available through public means instead of through private companies. The profit incentive completely distorts the entire process of determining credit-worthiness and proper rating of risk. The credit reporting agencies had a vested interest in keeping the party going, because they were making a killing from all of the consumer credit applications. This was the same issue with the ratings agencies and MBS’s.

    I like to think of it like the NFL or any other major sports league (and no, I do not gamble). Both historical and current information that is used to determine risk when betting on games is publicly available and does not cost any money to the consumer. IOW, the transparency is in place to assure everyone that every person betting on a particular game has the *exact* same information available to them. More importantly, no one is making money off of this information, guaranteeing the consumer of this information that there has not been any distortions introduced into the information due to profit motivations.

    I guess what I’m saying is that the government should be in the information clearinghouse and ratings games, and that this may be an efficient and cost-effective way of eliminating the systemic risk from the system that has ended up costing us all dearly.

  44. E says:

    Steve-in-flyover-land,

    If you look at FASB 115, it distinctly lays out which assets need to mark-to-market – and it is not the ones that are intended to be held to maturity. If these troubled institutions wished to hold them to maturity, they could mark them to maturity and avoid these huge writedowns. They do not intend to do so, so they take the huge writedowns.

  45. john bougearel says:

    Barry,

    I agree 100% that ‘if ever a product was rife with self-interested conflicts of interests,’ this is it.

    But let us not forget that the treasury and fed reserve’s bailout plan is an active way for them to make the FASB 157 problem disappear.

    So, I am alarmed that Bernanke would say “removing the rule would erode confidence that firms are owning up to losses.”

    Firms won’t have to own up to losses if the treasury pulls a magic act and makes those losses disappear. Creating the illusion that those assets have disappeared from their books does not restore any confidence in these firms. It just lets them off the hook for their egregious actions. And that is inexcusable of the Fed and Treasury.

  46. dead hobo says:

    Carried to an extreme, using mark to market accounting, the Mona Lisa could be devalued if it were considered an asset available for sale and the market for art was in a tumble. If Mona were purchased for $1 billion, does that make it now worth $1 billion, or only worth $1 billion to the highest bidder? If nobody offered $1 billion to purchase it from time to time, would it be considered distressed and a target for frightened auditors? (Maybe short sellers would try to crash the art market just to get Mona cheap?)

    If the value of the underlying in a junk real estate oriented security falls by 40% and it is reasonable to assume that the real estate will not increase in value soon and the loan secured by the property is at risk, then a markdown of the junk bond is prudent.

    If cash is still flowing then an alternative valuation model must be considered separate from the those used by extremely timid auditors and stubborn regulators.

    Perhaps a class of assets between ‘available for sale’ and hold until mature’ is required?

    Perhaps this liquidity panic is just the law of unintended consequences rising up, and not simply the result of ‘absolute truth revealing itself’.

  47. Serf's Up says:

    I’m new here, so please be patient with this question:

    If the ‘assets’ of the financials can be marked to fantasy, the balance sheets are instantly repaired, these firms can lever up to 12x fantasy asset value, and nobody had to spend a dime to make it happen.

    Got a bad loan on the books? Mark it up and make 12 more. Odds are that two or more will actually pay.

  48. Serf's Up says:

    I’m new here, so please be patient with this question:

    If the ‘assets’ of the financials can be marked to fantasy, the balance sheets are instantly repaired, these firms can lever up to 12x fantasy asset value, and nobody had to spend a dime to make it happen.

    Got a bad loan on the books? Mark it up and make 12 more. Odds are that two or more will actually pay.

  49. Serf's Up says:

    I’m new here, so please be patient with this question:

    If the ‘assets’ of the financials can be marked to fantasy, the balance sheets are instantly repaired, these firms can lever up to 12x fantasy asset value, and nobody had to spend a dime to make it happen.

    Got a bad loan on the books? Mark it up and make 12 more. Odds are that two or more will actually pay.

  50. Posted by: Blue Steel | Oct 1, 2008 10:30:28 AM

    They, ENE, and their cohorts, were the market. It, the ‘Market’, they were ‘marking’ to, was a total scam–to say nothing of it being a ‘test-run’ for what we’re witnessing today–that exercise of ‘check kiting’ would have made the Sharps, that inhabited the Vancouver Stock Exchange, of yore, blanch.

  51. OhNoNotAgain says:

    Jasper,

    Great post. Along these same lines, why don’t they simply suspend any accounting of assets that are being held to maturity for the purposes of the *current accounting period* ?

    Stay with me on this…I’m not an accountant and so this may be a completely crap idea.

    What I’m saying is this:

    - If an asset is being held to maturity, then only the cash flow from that asset can be included as income for current accounting purposes.

    - If the entity that owns the asset is being valued for the purposes of purchase by another entity, then these assets would then be marked to market for a valuation that is pertinent to the sale *today*.

    This would accomplish two things:

    1) Any valuation of such assets would not be included for any current accounting purposes, thus making the accounting *more* conservative than it should be. This is a positive, in my view. These entities would have to make up any difference needed for capital reserve requirements with actual liquid assets. This is also where the government could step in with infusions of capital.

    2) One could still look at these assets in terms of deciding whether to purchase stock in the entity holding these assets, but the subsequent valuation would be completely based upon what the *market* decides it should be, not what the accountants decide it should be. So, you have the effectiveness of the market’s power of averaging to get the intended result, i.e. a fairly accurate view of what everyone thinks these assets are worth *today*, based upon the stock price *today*.

  52. John(2) says:

    Unfortunately, the market isn’t always reasonable in its valuations. If it were we wouldn’t be in this mess.

    I’m afraid I’m going to have to go against the crowd on this one.

    Posted by: Steve in Fly-over Land | Oct 1, 2008 10:41:34 AM

    What can one say. As I understand it FASB 157 says the assets they have to mark to market are the ones they are NOT going to hold to maturity. Have I got this right? There’s a hell of a lot of pushback against this loony idea developing from the accounting companies etc and I’m inclined to think Paulson will call it for the balls it is.

  53. Posted by: dead hobo | Oct 1, 2008 11:18:49 AM

    THE Central Tenet, of Accounting, is Reflexivity.

    “They” took the Gains, of MTM, on the way Up, “They” take the Loss, on the way Down.

    Other than that, BR is correct: ~”Take it to Vegas”

    @CG, YW.

  54. donna says:

    I illustrated the financial crisis to my son the other day by giving him a promisory note for $100 million and telling him to have fun spending it!

  55. gene says:

    Great explanation and rationale for mark to market!

  56. JoJo says:

    “Eighteen months ago, the “fair value” of these same securities by mark-to-market was about a trillion dollars more than it would be today. A TRILLION FREAKING DOLLARS.

    So which is it? Was mark-to-market completely useless back then? Or is it completely useless now?

    Posted by: VG | Oct 1, 2008 11:02:12 AM”

    VG,

    It is much like over-valued houses. Much like in the (at the time) “hot” real-estate markets in such as Cali, Florida, etc there was a froth (whipped up by the availability of cheap money, plain greed from buyers and sellers and a lack of regulations) that drove up prices of houses to a level above and beyond what it was ever really worth (based on all the fundamentals of housing, i.e. location, house size & quality, supply, etc). The same thing for the papers BR discussed. Demand has plummeted.

    The market always catches up. Suspending mark-to-market for derivatives is the equivalent to have house buyers be forced to buy at whatever price the seller sets. That would be absurd.

  57. zgveritas says:

    AMEN!!! to that.

  58. jj says:

    Great posts today!

    Just one query on the latest bailout proposal, specifically wrt increasing deposit insurance to $250k …

    It is widely reported that Americans have little savings so I am wondering how many people this specific plan element will affect?

    How many people have an account less than than $100k?

    How many people have an account greater than $100k? … greater than than $200k?

    I would make the statement that there are many more “rich” people in the second and/or third group.

    And I am guesing (inviting correction) that the second and third groups are much much smaller than the first.

    So if the proposal passes all but the first group will be well looked after by this plan, whereas the first group gets no added benefit.

    IE what is the gov’t really doing for the average American? Is this plan is another wolf in sheep’s clothing?

    I have no hard numbers illuminate these questions, so if anyone has better insight please share.

  59. Fred S. says:

    These products did not have the correct risk ratings on the way up therefore over inflating them. Now the real risk is known. I consider all these discussions academic at best since the assets under discussion are so insidious. The priority now should be to contain the destruction as it is systemic.

  60. Estragon says:

    Jasper,

    Your description fits with the way I learned (principles based) accounting (a very long time ago). As I recall, one such principle was that of conservatism, which required assets to be valued at “the lower of cost or net realizable value”.

    Fitting in with “E”‘s comment, net realizable value may not suffer a permanent impairment IF the asset was acquired with the intent of holding to maturity AND there have been no adverse material changes in the expected cashflows or terminal value of the asset. From an accounting point of view, marking an asset meeting the above criteria to fire sale prices violates another accounting principle, the going concern principle.

    The accounting treatment necessarily differs from an investment analysis point of view. Among other things, investors and lenders have to be able to assess the level of risk involved in various potential distress situations, whereas accounting seeks only to present financial statements which fairly reflect the condition of the company at the time of preparation.

    It seems to me that the answer is to distinguish between assets intended (or required) for short term liquidity, and those intended (and funded) for holding to maturity. Financial statement notes should provide necessary transparency for illiquid asset pricing methods to allow investors and lenders to analyse risk.

  61. grumpyoldvet says:

    this from AP:
    Majority Leader Harry Reid and GOP Leader Mitch McConnell say, however, that they’re going to add a tax cut package already rejected by the House on Monday.

    The bipartisan move caps a day of behind-the-scenes maneuvering on Capitol Hill over what sweeteners to add to the bill to attract votes from House Republicans.

    Reid and McConnell’s move may prove popular with Republicans, but it risks a showdown with House leaders insisting that a popular measure extending certain business tax breaks be financed by tax increases elsewhere in the code

    Now I really want this thing to drown in the bathtub. Another Tax Cut….exactly how does that help the liquidity crisis. It’s been all BS from the start

  62. grumpyoldvet says:

    Now I understand how they are going to get this thing passed. They are calling it an Omnibus Bill, combining pending stuff with the bailout so it becomes palatable tp everyone. Magical

  63. Estragon says:

    I’d also like to point out that while it’s interesting talking about mark to market accounting, it’s a red herring in terms of the current situation.

    Holders of illiquid mortgage securities aren’t having trouble so much because of accounting valuations. They’re having trouble because the risks involved in holding these securities has risen exponentially, and their solvency is in question. However these securities are valued on balance sheets, investors and counterparties are going to look to solvency using their own judgement.

    It isn’t an accounting question at all. It’s the underlying uncertainty surrounding the assets themselves that is causing the problems and changing the accounting won’t change that.

  64. cb says:

    Great article Barry,

    But I think you are missing a tremendous opportunity for financial innovation.

    Imagine acquiring and pooling piles of collectables:
    Cabbage patch kids, political buttons, star wars collectables, antique furniture, Damian Hirsh cows, baseball cards, stamps, etc.

    This basket of assets could valued by experienced appraisers, divided into risk based tranches then sold to investors.
    Since collectables rarely lose value the most senior tranches would certainly be rated AAA.

  65. Big E says:

    I’ve seen it mention here before, but I want to re-iterate this point: what are we really talking about valuing here? Strictly mortgages? I don’t think so.

    If it was strictly mortgages (let’s say a block of 1000 mortgages with 700+ FICOs and extremely low missed payments/defaults), and it was selling at $.75 on the dollar, it would be snapped up in a heartbeat, even with housing prices dropping like a stone.

    But if you’ve got a big group of prime, alt-a, subprime, HELOC crap, you just don’t know what you have – how the hell can you value it? And dare I say, most people would value it at or near ZERO because they can clearly see where everything is going. So what if you hold this crap for 30 years? In 30 years, you’ll have damn near nothing anyway.

  66. Bob A says:

    As if anyone gave a crap about reality up till now?

  67. larster says:

    jj, they are proposing raising the FDIC insurance limit not to protect the “rich”. Most companies of any size need large accounts for tax pyments, wages, vendor payments, etc. Buffett’s companies used to provide additional insurance for these accountsw privately but have stopped writing it.

    This created a situation whereby companies could shoot hundreds of thousands of dollars from bank to bank with a simple keystroke due to latest rumor. IMO this is a smart move that will lens some stabilization to bank deposits, i.e bank capital.

  68. blue bellied yankee says:

    Amazing simply amazing. Mark to myth has got to be the greatest way in the world to screw confidence.

    Not an accounting type here, but I sure am going to buy into a company that fudges their assets/books. Right.

  69. Francois says:

    “And bank assets “in foreclosure” *are* the market, just like a house still has value in foreclosure. All the sellers (homeowners and banks alike) holding out for “2005 bubble prices” are simply avoiding reality.”

    Except that, as a lender of last resort, the go-vermin is basically enabling the banks to avoid reality.

    Basically, these asshats fought tooth and nail to prevent judges to modify mortgage contracts while lobbying for modifying the rules of accounting. Said rules can be viewed as a contract between public companies and investors. Now THAT kind of contract should, of course, be modified pronto, right?

    Why won’t they allow us receive the same favored treatment? Because the same politicians who bend over, Surgilube (Astroglide and K-Y jelly works too) at the ready, for the big money despise ordinary folks like us.

    It’s that simple; and we need to remember that the 4th of November.

  70. Rajul Johri says:

    I had a question. Does FASB 157 apply to Hold to Maturity securities as well? If not, can’t the institutions do a reclassification and move along? Govt is essentially doing the same.

  71. Uncle Jeffy says:

    No Beanie Babies? No Star Wars toys? What’s Larry Kudlow’s portfolio gonna do if you cut him off from those asset classes?

    I just got back from a presentation by Michael Moskow (former President of FRB of Chicago), Diane Swonk (Chief Economist at Mesirow Financial), David Hale (formerly Chief Economist at Kemper/Zurich), and William Osborn (Chairman/former CEO of Northern Trust). Unless I heard him wrong, Moskow seemed to say that the SEC was already allowing banks to step back from mark-to-market (I thought that was one provision of the bailout bill). What’s going on???

  72. Blackhalo says:

    “It’s that simple; and we need to remember that the 4th of November.”

    It sure would be nice if some entity could start a “remember the 4th of November,” non-profit, who’s sole purpose would be to provide support to the opposition of any congressperson who votes for this bill. If the fund was used to provide matching funds/or a loan to opposition candidate in each district, we could vote with our dollars like the financial and if it got large enough, would get congress attention.

    I suspect that there would be a substantial number of well to do business donors who stand to lose a lot of money/opportunity if this bailout goes through.

  73. JuanTwoThree says:

    I agree 100%.

    Financial institutions hid these assets so well that not even they where the assets are now. They wanted to make a killing without hassle from any regulator, investor or clearing house. Doubting their credit standing or valuation models was obviously a sacrilege.

    We need to bring these assets to light, it wont be pretty but investors need to see some rational buyers before pulling they will pull their wallets out again.

  74. bold'un says:

    If there is one area of accounting that is famously opaque it is insurance accounting. For many products such as reinsurance or annuities, even the insiders can’t know if they are on track to win or lose for many years. Think asbestos; or who can know if 2010 holds an avian flu pandemic or a miracle cure for cancer?

    CDS and CDO-squared of mortgages share some of the problems of insurance: the genuine answer as to their value is “time will tell.” This can’t be marked to market. Insurances employ actuaries to mark their liabilities to model and we have to take their word for it.

    This natural assumption of mark-to-actuaries may be what lead AIG astray: receiving margin calls are just not in the DNA of the insurance industry (No insurance contract I have seen specifies a time limit by when the insurance company needs to pay claims!)

    Similarly if banks have chosen to offer insurance-type products, their accounting cannot be marked to market; there is not enough history to prove that CDS price quotes are an accurate measure of probabilities.

  75. bold'un says:

    If there is one area of accounting that is famously opaque it is insurance accounting. For many products such as reinsurance or annuities, even the insiders can’t know if they are on track to win or lose for many years. Think asbestos; or who can know if 2010 holds an avian flu pandemic or a miracle cure for cancer?

    CDS and CDO-squared of mortgages share some of the problems of insurance: the genuine answer as to their value is “time will tell.” This can’t be marked to market. Insurances employ actuaries to mark their liabilities to model and we have to take their word for it.

    This natural assumption of mark-to-actuaries may be what lead AIG astray: receiving margin calls are just not in the DNA of the insurance industry (No insurance contract I have seen specifies a time limit by when the insurance company needs to pay claims!)

    Similarly if banks have chosen to offer insurance-type products, their accounting cannot be marked to market; there is not enough history to prove that CDS price quotes are an accurate measure of probabilities.

  76. bold'un says:

    If there is one area of accounting that is famously opaque it is insurance accounting. For many products such as reinsurance or annuities, even the insiders can’t know if they are on track to win or lose for many years. Think asbestos; or who can know if 2010 holds an avian flu pandemic or a miracle cure for cancer?

    CDS and CDO-squared of mortgages share some of the problems of insurance: the genuine answer as to their value is “time will tell.” This can’t be marked to market. Insurances employ actuaries to mark their liabilities to model and we have to take their word for it.

    This natural assumption of mark-to-actuaries may be what lead AIG astray: receiving margin calls are just not in the DNA of the insurance industry (No insurance contract I have seen specifies a time limit by when the insurance company needs to pay claims!)

    Similarly if banks have chosen to offer insurance-type products, their accounting cannot be marked to market; there is not enough history to prove that CDS price quotes are an accurate measure of probabilities.

  77. mw says:

    with this bill as currently written,can any foreign bank with a branch here grab any toxic debt and foist it on us?? I have heard this is possible.

  78. Tarzan says:

    Barry Ritholtz, you rock SO hard.

  79. AGG says:

    Thank you, Barry.
    Take that, Mauldin!

  80. AGG says:

    Unckle Jeffy,
    What’s going on? I guess you’ve been laboring under the ilusion that the SEC in general and Cox in particular are concerned with the common weal. With Cox it’s always been about selective enforcement. It’s called perception management. Integrity plays no role. Anyone with integrity doesn’t “go places” in the SEC and is assigned low level bean counting. Wake up, pal. The crooks like to make believe they work for us. It’s only make believe.

  81. debreuil says:

    The beautiful take away point I get from this, is there are two types of assets – one based on inherent value, one based on fashion. So the whole argument of how to price the latter kind of side steps the real problem, in that last years bell bottom craze is over.

    Computer Science has exactly this split and problem as well. There is the useful practical stuff that solves real problems in a predictable way, and there is the fashion industry. Short term people make and lose killings in the fashion part, but in the long run it is a net drag on the industry. Basically it contributes nothing useful, but sucks up a lot of resources while distracting quality people.

  82. fresno dan says:

    Exactly how I look at it – I’m glad someone finally wrote it. Live by the thinly traded asset, die by the thinly traded asset. It should not astound me anymore as I have been observing it for 30 years now, but there are damn few business men and Republicans who actually believe in the profit and LOSS system. But LOSSES are just as important as profits to the price signals that an economy sends

  83. David Merkel says:

    Thanks for the mention, Barry. That post got picked up by a lot of blogs, probably thanks to you.

    David

  84. Ultimately, the answer here is simple.

    For the purposes of calculating legally-required reserves, banks and other financial institutions should be allowed to hold only those assets for which there is either:

    1) A liquid and recognized public market. No “over the counter” deals, “private contracts” or any other such garbage. These assets would be marked to market prices.

    2) Known future cash flows which would allow the asset to be valued on “hold to maturity” cash flows. Values would be adjusted only to reflect changes in interest rates (which impact NPV) or changes in anticipated cash flows (for example, if more mortgages default than expected, or less for that matter).

    They would have to pick one or the other valuation mechanism when it came onto the balance sheet and not be allowed to switch.

    If such insitutions wish to invest in other types of instruments that cannot be valued using one of these two mechanisms, they would be allowed to, but should not be able to count these other illiquid investments as part of their regulatory capital base. There is a place in the world for such investments, but banks are not the place.

    Yes, ultimately what I’m suggesting is getting rid of all tier-3 and most tier 2 assets. “Observable inputs” my ass! The only inputs that should be allowed should be actual cash flows or actual market prices.

    Will screw up a lot of investment bankers’ incomes and probably lead to a property crash in the Hamptons. Good for the seagulls!

    -btc

  85. Mikey says:

    Bravo, Barry.

    When a mark-to-model value is used, I would expect, in the minimum, that the following be required:

    1) Disclosure of the model itself.
    2) Disclosure of the inputs to the model.
    3) Some explanation justifying the use of fiction in lieu of reality.

  86. OhNoNotAgain says:

    Thank you btc. That was exactly what I was trying to convey, but you stated it in a much clearer fashion.

  87. Lance Free & Jay Dee says:

    Rule Waiver Continues Problem – Not A Solution

    Simply stated, the mark-to-markdown rule states you must assign the value of your bank’s assets according to what the market says they are worth at the time. When the market value of a home drops, the buyer has defaulted on the mortgage, the artificially created demand for homes all across the board has collapsed and years worth of supply has to be worked through, there is no value to the property the bank holds since there are all sellers and no buyers. The value is zero according to the market value. Plain and simple, if you are not willing to make significant concessions to rid yourself of the property in order to keep the defaulting party in the home or find a new buyer (doubtful) at a steep loss, you are required to carry the property at the total loss of mark-to-markdown. Similarly, a third-party will never buy the mortgage which has failed. Banks and investors are not in the business of home ownership and maintenance until the housing supply is exhausted and the mortgage purchaser can recoup the price of the home plus carrying costs on the original mortgage terms acquired by the third-party!

    Suspension of the mark-to-markdown rules would be a return to the over leveraging of capital that created the mess in the first place. One, it allows the banks to create a subjective value for an asset (the mortgage and underlying price of the physical asset of the home) which the market says is worthless and the bank has failed to find a buyer for (at any price). Two, this is the same situation which infected Freddie and Fannie since it encouraged them to by theses assets on the faulty assumption the home market would be climbing, the underlying mortgages were payable on reasonable terms, mortgage payments would be made and values maintained in perpetuity. NOT! Finally, the suspension of the accounting rules would be a market ruse which essentially permits the bank to again over leverage by over valuing assets for more cheap Fed money. And, lacking confidence on how any other bank has subjectively valued its unsaleable assets, no bank is going to loan another bank money or issue new loans into a market which has been artificially created.

    As the L.A. Times reported,. “Accounting purists say a rule change would raise the risk that the banks would resort to fantasy accounting — “mark to make-believe” — that would overstate the value of their assets to investors. The Center for Audit Quality, an advocacy group for the accounting industry, issued a statement Tuesday urging Congress to reject any suspension of mark-to-market rules, saying that would undermine investor confidence by allowing companies “to mask the actual value of financial assets at a given point in time.”

    No one can say the investment banks, which effectively started the dominos tumbling, were not part of and fueling the mortgage problem. And yet, it was in 2004 that the same investment banks petitioned an obtained SEC approval to allow them special status to leverage their assets up to 40 times compared to the previous 12 times applicable to themselves and banks. This was known as the “Alternative Net Capital Requirements for Broker-Dealers That Are Part of Consolidated Supervised Entities” and which allowed investment banks, including Goldman Sachs being run by Paulson, to subjectively determine “net capital to include securities for which there is no ready market”. Now, the proposal is to allow every financial institution to make its own determination of market value! Talk about not learning from a mistake.

    As an relevant aside, everyone should be calling for Paulson to step aside from participation in the execution of this plan – whatever the final terms. In February 2006, at the latest, Paulson’s Goldman Sachs Group began using an internal and copyrighted Powerpoint presentation entitled “A Primer on the Sub-Prime Market” by the “Goldman Sachs Structured Products Strategy” division. That document indicates how to sell the securities and then states, “Given the belief that house prices in the U.S. are too high, there are several trades that can be executed to short house prices”. In the Spring, Goldman Sachs thereafter sold mortgages tronches, totaling $496 million, to the unwitting clients who lost an estimated 300 million. Goldman however handsomely profited again on the failure of these securities by shorting the market and sales!! See, Sloan article in Washington Post. Instead, notables like PIMCO Investment founder Gross, and David Einhorn of Greenlight Capital, are knowledgeable about the debacle and the house of cards on which it was built. In fact, Mr. Gross stated on CNBC he would run the program for free!

    A more appropriate response to the “mark-to-markdown” rule would be allow a limited waiver of the rule for any mortgage renegotiated with the “primary residence” homebuyer which puts them back in the foreclosed or abandoned home. As a result, the home would be sold, the home occupied, a simplified mortgage based upon actual ability to pay in place, renegotiation taking place at the local level with knowledge of local markets, federal intervention avoided, excess supply removed from the market, a bottom up approach utilized and liquidity enhanced. The changed mortgage could the be valued at the new market as reasonably estimated by the bank. The “Plan” would then be buying assets which tend to both create and re-establish the fair market value, and others are more likely to step in when the toxicity is removed. Liquity through FDIC or “Plan” buying is promoted. The plan is not overpaying for the asset. Note the proposed rule waiver would only be applicable to a primary residence. Sorry, no help for flippers and speculators.

    For any one interested in an examination of the greed in sub-prime mortgage the NY Fed noted the overreaching of the effects of the usurious terms ” begs the question why such a loan was made in the first place.” Please search, read and digest: “Understanding the Securitization of Subprime Mortgage Credit”, Staff Report No, 318, by the Federal Reserve Bank of New York, March 2008

    Sorry, we were so rude as to inject a comment on the issue of “mark to market” and its application.

    Lance Free & Jay Dee
    Lance Free Consulting

  88. Lance Free & Jay Dee says:

    Rule Waiver Continues Problem – Not A Solution

    Simply stated, the mark-to-markdown rule states you must assign the value of your bank’s assets according to what the market says they are worth at the time. When the market value of a home drops, the buyer has defaulted on the mortgage, the artificially created demand for homes all across the board has collapsed and years worth of supply has to be worked through, there is no value to the property the bank holds since there are all sellers and no buyers. The value is zero according to the market value. Plain and simple, if you are not willing to make significant concessions to rid yourself of the property in order to keep the defaulting party in the home or find a new buyer (doubtful) at a steep loss, you are required to carry the property at the total loss of mark-to-markdown. Similarly, a third-party will never buy the mortgage which has failed. Banks and investors are not in the business of home ownership and maintenance until the housing supply is exhausted and the mortgage purchaser can recoup the price of the home plus carrying costs on the original mortgage terms acquired by the third-party!

    Suspension of the mark-to-markdown rules would be a return to the over leveraging of capital that created the mess in the first place. One, it allows the banks to create a subjective value for an asset (the mortgage and underlying price of the physical asset of the home) which the market says is worthless and the bank has failed to find a buyer for (at any price). Two, this is the same situation which infected Freddie and Fannie since it encouraged them to by theses assets on the faulty assumption the home market would be climbing, the underlying mortgages were payable on reasonable terms, mortgage payments would be made and values maintained in perpetuity. NOT! Finally, the suspension of the accounting rules would be a market ruse which essentially permits the bank to again over leverage by over valuing assets for more cheap Fed money. And, lacking confidence on how any other bank has subjectively valued its unsaleable assets, no bank is going to loan another bank money or issue new loans into a market which has been artificially created.

    As the L.A. Times reported,. “Accounting purists say a rule change would raise the risk that the banks would resort to fantasy accounting — “mark to make-believe” — that would overstate the value of their assets to investors. The Center for Audit Quality, an advocacy group for the accounting industry, issued a statement Tuesday urging Congress to reject any suspension of mark-to-market rules, saying that would undermine investor confidence by allowing companies “to mask the actual value of financial assets at a given point in time.”

    No one can say the investment banks, which effectively started the dominos tumbling, were not part of and fueling the mortgage problem. And yet, it was in 2004 that the same investment banks petitioned an obtained SEC approval to allow them special status to leverage their assets up to 40 times compared to the previous 12 times applicable to themselves and banks. This was known as the “Alternative Net Capital Requirements for Broker-Dealers That Are Part of Consolidated Supervised Entities” and which allowed investment banks, including Goldman Sachs being run by Paulson, to subjectively determine “net capital to include securities for which there is no ready market”. Now, the proposal is to allow every financial institution to make its own determination of market value! Talk about not learning from a mistake.

    As an relevant aside, everyone should be calling for Paulson to step aside from participation in the execution of this plan – whatever the final terms. In February 2006, at the latest, Paulson’s Goldman Sachs Group began using an internal and copyrighted Powerpoint presentation entitled “A Primer on the Sub-Prime Market” by the “Goldman Sachs Structured Products Strategy” division. That document indicates how to sell the securities and then states, “Given the belief that house prices in the U.S. are too high, there are several trades that can be executed to short house prices”. In the Spring, Goldman Sachs thereafter sold mortgages tronches, totaling $496 million, to the unwitting clients who lost an estimated 300 million. Goldman however handsomely profited again on the failure of these securities by shorting the market and sales!! See, Sloan article in Washington Post. Instead, notables like PIMCO Investment founder Gross, and David Einhorn of Greenlight Capital, are knowledgeable about the debacle and the house of cards on which it was built. In fact, Mr. Gross stated on CNBC he would run the program for free!

    A more appropriate response to the “mark-to-markdown” rule would be allow a limited waiver of the rule for any mortgage renegotiated with the “primary residence” homebuyer which puts them back in the foreclosed or abandoned home. As a result, the home would be sold, the home occupied, a simplified mortgage based upon actual ability to pay in place, renegotiation taking place at the local level with knowledge of local markets, federal intervention avoided, excess supply removed from the market, a bottom up approach utilized and liquidity enhanced. The changed mortgage could the be valued at the new market as reasonably estimated by the bank. The “Plan” would then be buying assets which tend to both create and re-establish the fair market value, and others are more likely to step in when the toxicity is removed. Liquity through FDIC or “Plan” buying is promoted. The plan is not overpaying for the asset. Note the proposed rule waiver would only be applicable to a primary residence. Sorry, no help for flippers and speculators.

    For any one interested in an examination of the greed in sub-prime mortgage the NY Fed noted the overreaching of the effects of the usurious terms ” begs the question why such a loan was made in the first place.” Please search, read and digest: “Understanding the Securitization of Subprime Mortgage Credit”, Staff Report No, 318, by the Federal Reserve Bank of New York, March 2008

    Sorry, we were so rude as to inject a comment on the issue of “mark to market” and its application.

    Lance Free & Jay Dee
    Lance Free Consulting

  89. Lance Free & Jay Dee says:

    Rule Waiver Continues Problem – Not A Solution

    Simply stated, the mark-to-markdown rule states you must assign the value of your bank’s assets according to what the market says they are worth at the time. When the market value of a home drops, the buyer has defaulted on the mortgage, the artificially created demand for homes all across the board has collapsed and years worth of supply has to be worked through, there is no value to the property the bank holds since there are all sellers and no buyers. The value is zero according to the market value. Plain and simple, if you are not willing to make significant concessions to rid yourself of the property in order to keep the defaulting party in the home or find a new buyer (doubtful) at a steep loss, you are required to carry the property at the total loss of mark-to-markdown. Similarly, a third-party will never buy the mortgage which has failed. Banks and investors are not in the business of home ownership and maintenance until the housing supply is exhausted and the mortgage purchaser can recoup the price of the home plus carrying costs on the original mortgage terms acquired by the third-party!

    Suspension of the mark-to-markdown rules would be a return to the over leveraging of capital that created the mess in the first place. One, it allows the banks to create a subjective value for an asset (the mortgage and underlying price of the physical asset of the home) which the market says is worthless and the bank has failed to find a buyer for (at any price). Two, this is the same situation which infected Freddie and Fannie since it encouraged them to by theses assets on the faulty assumption the home market would be climbing, the underlying mortgages were payable on reasonable terms, mortgage payments would be made and values maintained in perpetuity. NOT! Finally, the suspension of the accounting rules would be a market ruse which essentially permits the bank to again over leverage by over valuing assets for more cheap Fed money. And, lacking confidence on how any other bank has subjectively valued its unsaleable assets, no bank is going to loan another bank money or issue new loans into a market which has been artificially created.

    As the L.A. Times reported,. “Accounting purists say a rule change would raise the risk that the banks would resort to fantasy accounting — “mark to make-believe” — that would overstate the value of their assets to investors. The Center for Audit Quality, an advocacy group for the accounting industry, issued a statement Tuesday urging Congress to reject any suspension of mark-to-market rules, saying that would undermine investor confidence by allowing companies “to mask the actual value of financial assets at a given point in time.”

    No one can say the investment banks, which effectively started the dominos tumbling, were not part of and fueling the mortgage problem. And yet, it was in 2004 that the same investment banks petitioned an obtained SEC approval to allow them special status to leverage their assets up to 40 times compared to the previous 12 times applicable to themselves and banks. This was known as the “Alternative Net Capital Requirements for Broker-Dealers That Are Part of Consolidated Supervised Entities” and which allowed investment banks, including Goldman Sachs being run by Paulson, to subjectively determine “net capital to include securities for which there is no ready market”. Now, the proposal is to allow every financial institution to make its own determination of market value! Talk about not learning from a mistake.

    As an relevant aside, everyone should be calling for Paulson to step aside from participation in the execution of this plan – whatever the final terms. In February 2006, at the latest, Paulson’s Goldman Sachs Group began using an internal and copyrighted Powerpoint presentation entitled “A Primer on the Sub-Prime Market” by the “Goldman Sachs Structured Products Strategy” division. That document indicates how to sell the securities and then states, “Given the belief that house prices in the U.S. are too high, there are several trades that can be executed to short house prices”. In the Spring, Goldman Sachs thereafter sold mortgages tronches, totaling $496 million, to the unwitting clients who lost an estimated 300 million. Goldman however handsomely profited again on the failure of these securities by shorting the market and sales!! See, Sloan article in Washington Post. Instead, notables like PIMCO Investment founder Gross, and David Einhorn of Greenlight Capital, are knowledgeable about the debacle and the house of cards on which it was built. In fact, Mr. Gross stated on CNBC he would run the program for free!

    A more appropriate response to the “mark-to-markdown” rule would be allow a limited waiver of the rule for any mortgage renegotiated with the “primary residence” homebuyer which puts them back in the foreclosed or abandoned home. As a result, the home would be sold, the home occupied, a simplified mortgage based upon actual ability to pay in place, renegotiation taking place at the local level with knowledge of local markets, federal intervention avoided, excess supply removed from the market, a bottom up approach utilized and liquidity enhanced. The changed mortgage could the be valued at the new market as reasonably estimated by the bank. The “Plan” would then be buying assets which tend to both create and re-establish the fair market value, and others are more likely to step in when the toxicity is removed. Liquity through FDIC or “Plan” buying is promoted. The plan is not overpaying for the asset. Note the proposed rule waiver would only be applicable to a primary residence. Sorry, no help for flippers and speculators.

    For any one interested in an examination of the greed in sub-prime mortgage the NY Fed noted the overreaching of the effects of the usurious terms ” begs the question why such a loan was made in the first place.” Please search, read and digest: “Understanding the Securitization of Subprime Mortgage Credit”, Staff Report No, 318, by the Federal Reserve Bank of New York, March 2008

    Sorry, we were so rude as to inject a comment on the issue of “mark to market” and its application.

    Lance Free & Jay Dee
    Lance Free Consulting

  90. Lance Free & Jay Dee says:

    Rule Waiver Continues Problem – Not A Solution

    Simply stated, the mark-to-markdown rule states you must assign the value of your bank’s assets according to what the market says they are worth at the time. When the market value of a home drops, the buyer has defaulted on the mortgage, the artificially created demand for homes all across the board has collapsed and years worth of supply has to be worked through, there is no value to the property the bank holds since there are all sellers and no buyers. The value is zero according to the market value. Plain and simple, if you are not willing to make significant concessions to rid yourself of the property in order to keep the defaulting party in the home or find a new buyer (doubtful) at a steep loss, you are required to carry the property at the total loss of mark-to-markdown. Similarly, a third-party will never buy the mortgage which has failed. Banks and investors are not in the business of home ownership and maintenance until the housing supply is exhausted and the mortgage purchaser can recoup the price of the home plus carrying costs on the original mortgage terms acquired by the third-party!

    Suspension of the mark-to-markdown rules would be a return to the over leveraging of capital that created the mess in the first place. One, it allows the banks to create a subjective value for an asset (the mortgage and underlying price of the physical asset of the home) which the market says is worthless and the bank has failed to find a buyer for (at any price). Two, this is the same situation which infected Freddie and Fannie since it encouraged them to by theses assets on the faulty assumption the home market would be climbing, the underlying mortgages were payable on reasonable terms, mortgage payments would be made and values maintained in perpetuity. NOT! Finally, the suspension of the accounting rules would be a market ruse which essentially permits the bank to again over leverage by over valuing assets for more cheap Fed money. And, lacking confidence on how any other bank has subjectively valued its unsaleable assets, no bank is going to loan another bank money or issue new loans into a market which has been artificially created.

    As the L.A. Times reported,. “Accounting purists say a rule change would raise the risk that the banks would resort to fantasy accounting — “mark to make-believe” — that would overstate the value of their assets to investors. The Center for Audit Quality, an advocacy group for the accounting industry, issued a statement Tuesday urging Congress to reject any suspension of mark-to-market rules, saying that would undermine investor confidence by allowing companies “to mask the actual value of financial assets at a given point in time.”

    No one can say the investment banks, which effectively started the dominos tumbling, were not part of and fueling the mortgage problem. And yet, it was in 2004 that the same investment banks petitioned an obtained SEC approval to allow them special status to leverage their assets up to 40 times compared to the previous 12 times applicable to themselves and banks. This was known as the “Alternative Net Capital Requirements for Broker-Dealers That Are Part of Consolidated Supervised Entities” and which allowed investment banks, including Goldman Sachs being run by Paulson, to subjectively determine “net capital to include securities for which there is no ready market”. Now, the proposal is to allow every financial institution to make its own determination of market value! Talk about not learning from a mistake.

    As an relevant aside, everyone should be calling for Paulson to step aside from participation in the execution of this plan – whatever the final terms. In February 2006, at the latest, Paulson’s Goldman Sachs Group began using an internal and copyrighted Powerpoint presentation entitled “A Primer on the Sub-Prime Market” by the “Goldman Sachs Structured Products Strategy” division. That document indicates how to sell the securities and then states, “Given the belief that house prices in the U.S. are too high, there are several trades that can be executed to short house prices”. In the Spring, Goldman Sachs thereafter sold mortgages tronches, totaling $496 million, to the unwitting clients who lost an estimated 300 million. Goldman however handsomely profited again on the failure of these securities by shorting the market and sales!! See, Sloan article in Washington Post. Instead, notables like PIMCO Investment founder Gross, and David Einhorn of Greenlight Capital, are knowledgeable about the debacle and the house of cards on which it was built. In fact, Mr. Gross stated on CNBC he would run the program for free!

    A more appropriate response to the “mark-to-markdown” rule would be allow a limited waiver of the rule for any mortgage renegotiated with the “primary residence” homebuyer which puts them back in the foreclosed or abandoned home. As a result, the home would be sold, the home occupied, a simplified mortgage based upon actual ability to pay in place, renegotiation taking place at the local level with knowledge of local markets, federal intervention avoided, excess supply removed from the market, a bottom up approach utilized and liquidity enhanced. The changed mortgage could the be valued at the new market as reasonably estimated by the bank. The “Plan” would then be buying assets which tend to both create and re-establish the fair market value, and others are more likely to step in when the toxicity is removed. Liquity through FDIC or “Plan” buying is promoted. The plan is not overpaying for the asset. Note the proposed rule waiver would only be applicable to a primary residence. Sorry, no help for flippers and speculators.

    For any one interested in an examination of the greed in sub-prime mortgage the NY Fed noted the overreaching of the effects of the usurious terms ” begs the question why such a loan was made in the first place.” Please search, read and digest: “Understanding the Securitization of Subprime Mortgage Credit”, Staff Report No, 318, by the Federal Reserve Bank of New York, March 2008

    Sorry, we were so rude as to inject a comment on the issue of “mark to market” and its application.

    Lance Free & Jay Dee
    Lance Free Consulting

  91. Sing Expat says:

    If I were a convicted Enron exec, I would be lining up my lawyers for a new appeal as soon as this is passed. I would also open up a hedge fund, fill it with feces, tell CNBC I am managing $1.5 billion, send out a press release claiming things are going badly, and then stuff the “assets” into Uncle Same.

  92. andre lee says:

    I love this site!! Thank you, Mr. B.R and informed commenters.

  93. KK says:

    Mark to market works great when you have broad, liquid markets with tons of transparency and price discovery. Like options, or stocks.

    But, frankly, it can wreak havoc when those conditions don’t exist.

    Here’s the analogy. Suppose both my neighbor and I own our houses and we bought them at the same time. They’re basically the same house. (I have nicer decorating tastes, but that’s neither here nor there). Anyway, the market’s very illiquid for houses, but I don’t have a problem meeting my payments; I can still fund my house.

    Meanwhile, my neighbor, for whatever reason (maybe he found a SI swimsuit model who has expressed affection and he needs to exit marriage right away), gets into a panic and sells his house for 35% less than what he (and we) bought our houses for. I intend to hold onto in my house for another 15 years, minimum. However, my bank comes to me and says, “sorry, there’s a risk YOU’RE selling your house for 35% less so we want much much higher payments.”

    Nothing has really change for me, but I HAVE to “mark to market?” Really? I am supposed to scramble for more cash flow or de-leverage?

    Because of what somebody ELSE did?

    So, multiply this effect by millions and millions of instances, and what do you have?

    A Depression. I know some who comment on this blog REALLY want to see one, but trust me, it’s not pretty.

    See, here’s the thing: Henry Paulson knows this. And there’s a reason Henry Paulson made a ginormous amount of money at Goldman, because Hank understands the concept of net interest margin. He can take my morgtage off my bank’s hands for 3% and I will never know the difference, while he keeps the spread.

    And if neighbors everywhere want to run off with swimsuit models, let ‘em.

    Believe me, my sensibilities are quite libertarian. I have no problem with write downs or business failures. Life is full of risks and we all need to be adults.

    However, what I think we need is an ORDERLY process of de-leveraging and write downs. No one benefits from bank runs and super-fast evaporation of values.

    There’s a very disturbing set sensibilities that run in a bunch of strange bedfellows. On the one hand we have the socialist types who believe more regulation and punishment of rich fat cats is what we need. And then on the other hand we have the rabid free marketers, like Ron Paul, who believe in a kind of end of days economic fundamentalism– you know, let the whole” house of cards/fractional reserve banking” system fall apart. The left crowd has no problem with government controlling the levers of power as the Obamajugend singt the praises of the Great Leader. The other side has no problem moving into the basement with shotguns, bottled water, and canned goods to hold out until the financial nuclear winter ends.

    It’s insane, frankly.

    Instead, we need to work this problem so we can get back to business of creating the greatest country in the history of mankind, warts and all.

  94. KK says:

    Mark to market works great when you have broad, liquid markets with tons of transparency and price discovery. Like options, or stocks.

    But, frankly, it can wreak havoc when those conditions don’t exist.

    Here’s the analogy. Suppose both my neighbor and I own our houses and we bought them at the same time. They’re basically the same house. (I have nicer decorating tastes, but that’s neither here nor there). Anyway, the market’s very illiquid for houses, but I don’t have a problem meeting my payments; I can still fund my house.

    Meanwhile, my neighbor, for whatever reason (maybe he found a SI swimsuit model who has expressed affection and he needs to exit marriage right away), gets into a panic and sells his house for 35% less than what he (and we) bought our houses for. I intend to hold onto in my house for another 15 years, minimum. However, my bank comes to me and says, “sorry, there’s a risk YOU’RE selling your house for 35% less so we want much much higher payments.”

    Nothing has really change for me, but I HAVE to “mark to market?” Really? I am supposed to scramble for more cash flow or de-leverage?

    Because of what somebody ELSE did?

    So, multiply this effect by millions and millions of instances, and what do you have?

    A Depression. I know some who comment on this blog REALLY want to see one, but trust me, it’s not pretty.

    See, here’s the thing: Henry Paulson knows this. And there’s a reason Henry Paulson made a ginormous amount of money at Goldman, because Hank understands the concept of net interest margin. He can take my morgtage off my bank’s hands for 3% and I will never know the difference, while he keeps the spread.

    And if neighbors everywhere want to run off with swimsuit models, let ‘em.

    Believe me, my sensibilities are quite libertarian. I have no problem with write downs or business failures. Life is full of risks and we all need to be adults.

    However, what I think we need is an ORDERLY process of de-leveraging and write downs. No one benefits from bank runs and super-fast evaporation of values.

    There’s a very disturbing set sensibilities that run in a bunch of strange bedfellows. On the one hand we have the socialist types who believe more regulation and punishment of rich fat cats is what we need. And then on the other hand we have the rabid free marketers, like Ron Paul, who believe in a kind of end of days economic fundamentalism– you know, let the whole” house of cards/fractional reserve banking” system fall apart. The left crowd has no problem with government controlling the levers of power as the Obamajugend singt the praises of the Great Leader. The other side has no problem moving into the basement with shotguns, bottled water, and canned goods to hold out until the financial nuclear winter ends.

    It’s insane, frankly.

    Instead, we need to work this problem so we can get back to business of creating the greatest country in the history of mankind, warts and all.

  95. CB says:

    KK,

    You need to look at the mark to market rule from the lender point of view.

    Suppose that you ( as a highly leveraged borrower) asked a lender for a home equity loan, would you expect them to ignore the recent home sales in the neighborhood?

    Suspending mark to market would be equivalent to leaving the lender in ignorance of recent neighboring home valuations.

    Lenders would have to be much more cautious in their loans, increasing collateral requirements and interest rates.

  96. Good post.

    One question the lack of a liquid market for these assets raises: why haven’t the institutions that own them attempted to create one, perhaps in coordination with one of the major exchanges?

    I’m also curious whether there are any advocates of suspending mark-to-market rules who also happen to be efficient market hypothesis adherents, and if so, how they reconcile the disconnect between the available market prices for these securities and their supposed values if held to maturity.

  97. Kevin McBride says:

    The problem with credit derivatives is that many of them were never assigned a fair market value to begin with. This problem goes to the “mark-to-market” issue so well described in this article.

    The process of assigning a value to credit derivatives by some investment banks and hedge funds is very much the way ordinary taxpayers assign value to, say, a beat-up old car that is donated to charity. The old useless car may be worth only $500. But inevitably, for donation purposes (and income tax purposes) the old car gets valued at something much higher—say $2000. The charity who receives the old car never questions this valuation. The IRS who gives the tax deduction never questions the valuation (as long as it is not too high) and the taxpayer pays artificially lower taxes as a result of the inflated value of the old car. This “wink-and-nod” system goes on every day in the United States as an acceptable practice that encourages the donation of old cars to charity. If you understand the fallacy of this valuation process—and everyone does—you also understand the ridiculous “wink-and-nod” valuation process for derivative securities.

    The flaw in this valuation system is, of course, that a junk-yard dealer would never have paid more than $500 for the old junk car, and so the car was never worth more than $500, even though the taxpayer claimed its value was $2000. But today is audit day. Like a taxpayer with an inflated tax deduction at audit time, current holders of credit derivative securities are fighting with every tool at their disposal to maintain the fictional valuation of the derivative-based securities they hold. The current bailout proposals floated in Congress do nothing more than maintain fictional valuations of derivative securities for a short while longer without fixing the real problem of faulty valuations to begin with—hardly a good use of taxpayer money.

    Real assets in a capitalist economy (like a car, a bottle of water or a loaf of bread) are valued by the amount a willing seller and willing buyer are willing to pay at the moment of sale—i.e., their “fair market value” at the time of sale. Tangible assets are identified and abstracted into property titles. The property titles are then sold on a secondary market in place of the tangible assets themselves. This is how the commodity and stock markets work—this is the very definition of capitalism.

    Not so with many credit derivatives. There is no liquid market of buyers and sellers for credit derivatives. Credit derivatives are one-off bets on the likelihood of default under a jumbled set of intertwined financial contracts (promises to pay) that defy standardization—and hence defy capitalization. Derivatives (including credit default swaps) are therefore not valued by an open market of buyers and sellers; but rather are valued by a mathematical model of the likelihood of default of an arbitrary set of underling contracts.

    Because each derivative contract is based in small part on many, many different companies throughout the global economy, the mathematical probability of a default of any one derivative security is theoretically very low, since a default would require chain-reaction default by many different companies. (Sound familiar?) And because the mathematical probability of default is very low, the price for buying this default insurance was also very low, and reserves held against the default insurance were even lower. In short, the mathematical models that valued credit derivatives were based on the assumption that no single derivative would fall because that would require fall of the entire system—a statistically unlikely event. Except, now we are in a situation where the entire financial system threatens to fall.

    The core problem of this entire financial crisis is that we didn’t assign a fair market value to credit derivative securities to begin with. Now that some defaults have occurred and buyers want to collect on their derivative bets, nobody can identify who owns what, derivative contracts cannot be easily verified, companies that promised to pay on derivative contracts in the event of default cannot be made to pay their debts, resources cannot conveniently be turned into money, ownership of these derivatives cannot be identified and divided into shares, descriptions of these derivative assets are not standardized from company to company, and therefore cannot be easily compared, and many of the rules that govern these derivatives vary from company to company and investment bank to investment bank. This problem is precisely the description of the third-world economies articulated by Prof. de Soto in “The Mystery of Capital.”

  98. cablenator says:

    A couple of thoughts from an MSA student:

    Why does “Steve in Fly-over Land” refer to the booking of profits or losses on assets that have not been sold? When did this disappear from the balance sheet and appear on the income statement of a company?

    I thought FASB 157 only applied to certain types of securities, such as, I would guess, CDOs. I see that yield-to-maturity securities have been mentioned. These securities do not use mark-to-market valuations, correct?

    “Mashedpo” refers to illiquid markets. Plenty of trading is still going on. The market for CDOs may be illiquid, but I would hazard a guess that this is due to perceived value. Why the push away from the acknowledgement of value assigned through the free market system because of one bad sector?

  99. Andy says:

    Good article and I think M-2-M accounting is fine for most assets, but in illiquid markets it can really magnfiy the problems as we are seeing today.