Mark To Market Thoughts

In discussion from this post from a couple days ago, a commenter makes what seems to me a plausible point:

I firmly believe that the destructive effects of FASB’s change to a mark-to-market accounting standard in November 2007 cannot be overstated. It never made any sense, and the proof of this is that neither Paulsen nor Geithner have been able to do what they set out to do, which was to buy up the so-called “toxic assets.” The problem? They can’t determine a fair price for assets which have been devalued on paper to effectively nothing because of the new mandated accounting standards.

Yet Geithner said recently that these assets have “inherent value” that is not reflected by their current market price, which is an implicit repudiation of the mark-to-market standard. It’s also the reality he has to face. Hence the problem, a kind of Catch-22 of his own making. (He and others, to be fair.)

To buy up the toxic assets at higher than mark-to-market value would admit what everyone knows but won’t speak: that these assets are worth a lot more than the mark-to-market value and always were. If the government hadn’t forced the financial companies to grossly understate the value of their assets in the first place, this banking crisis might never have occurred or at least not nearly at this degree of severity.

Furthermore, if Geithner believes the assets are worth more than the mark-to-market value, then why not simply change the FASB rules back to what they were pre Nov2007 and let the financial companies mark them up on their own balance sheets instead of selling them back to the government? Same reason. Because if the government were to now admit that these assets are, in fact, worth quite a bit more — and that they always were — the smoking gun would be revealed. And so would the fingerprints of all those who helped pull the trigger.

I would hate to think that this is behind the resistance to restore the status quo ante 2008, but sadly, it wouldn’t be surprising. It would also be amazing to think that we wrecked the world economy with a single rule change, and could undo much of the damage by reversing it, but it can’t be ruled out.

[Update a few minutes later]

Commenters are accusing me of naivety, or lack of understanding of the situation, and in rereading my post, I can understand why.

No, I don’t really believe that if the rule hadn’t been changed, all would now be hunky dory, or that by changing it back, housing prices would skyrocket and all would be well with the world, and we’d rewind back to 2006. I understand that there was a huge bubble, perhaps more than one, and that supply and demand had to correct at some point. It’s why, after buying our house in South Florida five years ago, (unlike some of our neighbors) we weren’t going crazy and flipping condos a couple years later.

I am just pointing out that it might have played out differently, or more gradually, and perhaps even in a way that might have resulted in less panic in Washington last fall. I do think that our biggest problem now is not the underlying problems with the economy, which always work themselves out if allowed to, but panicked governmental responses to them that are exacerbating the situation. I do think that mark to market, or at least a sudden change in the rules, played a role in that. I think that it forced fire sales in the banking sector that might have been handled more gradually.

17 thoughts on “Mark To Market Thoughts”

  1. I recommend displaying extreme caution toward single-cause explanations for the meltdown, not only because complex systems fail in complex ways, but because of the nasty side effects if an American Dolchstoßlegende becomes popular.

  2. I agree with Jay. I would also like to point out that if these toxic assets were really worth more than the mark-to-market price somebody would be buying them at a discount. They really are either worthless, worth a small percentage of their original value, or are so mixed up that you can’t determine the underlying asset to make a valuation.

    If you want 1 thing that brought us down, it was the housing bubble popping (which it had to do eventually just like the tulips). Once housing prices come back down to historical trend lines (Median home prices only 2.5 to 3 time median income in an area) and the corresponding debt overhang rinsed from the system we will be able to come back. Anything that interfere’s with that drop only draws out the downturn and makes it worse.

    The guys in office have no clue and Obama will increase the national debt faster and to a much larger degree than any President in history – by his own words!!!

  3. if these toxic assets were really worth more than the mark-to-market price

    I think this comment might want re-examining, in light of the point that if something is “worth more” than market, it must be getting valued for something other than what a hypothetical buyer would offer.

    In other words, Buffpilot, I think your premise is a tautology that is belied by the very fact there is debate on that point.

  4. Rand, I read your blog regularly and like much of what you say, but you seem to hold so many misconceptions here that I don’t know where to start. I think you arguing without much appreciation of the context of the problem.

    Arguing about mark to market is like arguing about whether to disable the altimeter on a crashing plane. Yes, it might make you feel better, but reality is out there and it doesn’t care about your altimeter. Sure, you might be able to control the panic level of your passengers by doing this, but I think it better to try control that includes the truth rather than willful denial.

    The root of this financial crises is counterfeiting. Yes. I’m not kidding. In today’s world, there is often little difference between money and debt/credit. For five years, the investment banks and hedge funds have been counterfeiting debt. That is, they created debt that was inevitably going to default, and sold it as good debt, then levered the money gained through fractional banking to do it again. They used many layers of indirection to do it, including securitization, off balance sheet “SIVs”, insurance through CDSs, “mark to myth” on level 3 assets, and fixing ratings.

    In this way, somewhere between 6 and 20 trillion dollars were counterfeited, most of it contained to mortgages and related securitizations. I wish I could be more specific, but I haven’t been able to pin it down better than that.

    Now, this counterfeit cash contaminated the system. Many involved knew they were playing with fire, but they reckoned they could get out before the moment of truth arrived. They were wrong.

    Then we reached a point where the big banks realised that they were insolvent, and the other banks should be in the same position or worse. At that point, they weren’t willing to lend to other banks. The root of the “credit crunch” was a run on banks by other banks.

    Now we are in a situation where that debt has to be written off, but there is so much of it that the plague carriers would rather do anything other than that, and they have a lot of influence. They have hidden the junk off balance sheet in SIVs and as level three assets that they gave fraudulent valuations. Mark to market is a response to fragrant fraud in level 3 valuations. It might not be appropriate now, but it’s going to have to happen sometime, because business won’t happen until everyone trusts their counterparties’ balance sheets again.

    Now, writing that debt off is going to destroy dollars, thus making them more valuable. This is the monetary view of deflation (ie. that deflation and inflation are a function of money availability; looking at prices is a usually-correlated red herring). Now, if you take on new debt, you will be forced to pay it in dollars that become more dear with every hour that passes. Thus, nobody in their right mind wants to borrow. Hence, the credit crunch won’t go away. It has become a borrowing strike, on top of the lending strike.

    What is happening now is the reassertment of reality. The system is now righting itself. The thing not to do is to spread the problem around, which is exactly what the government has been doing.

    The problem is lack of trust through fear that a potential business partner is holding counterfeit money or debt. The solution is to flush out all of the counterfeit money and write it off. Until then, nobody will do business.

    The government’s solution is to spread the plague around and hope that everyone gets a little sick and nobody dies. The real solution is to force bad debt to be written off while fencing off important parts of the economy (letters of credit, personal bank accounts, and government debt). It would hurt terribly and would probably kill the top five banks in the USA, but it seems to be the option never spoken about or considered. At best we get “the consequences are unthinkable” and a change of subject.

    The government are pouring money into the system while claiming the problem is “liquidity”. The banks are hoarding the money and are unable to lend it anyway, as nobody in their right mind borrows in a deflationary environment. When the toxic debt is finally written off, that spare cash will then create insane inflation. Concurrently the government will have realised that its debt load is so high that is has to tax the country into the ground. If it is lucky it will be able to avoid defaulting on some of its debt. Spending now is insanity, as is borrowing.

    It’s true that forcing everyone to mark to market at the same time would cause a glut of supply and destroy their prices. The problem is not mark to market. The problem is forcing an supply/demand imbalance. If we had had mark to market all along, much of the counterfeiting would have been impossible.

    And, in the end, those who make bad decisions in the market should get to eat them. It makes them think twice next time.

    I have been screaming about the impending disaster since July 2007, and others beat me to it by at least a year. How could we do that if the problem was caused by a rule change later?

    I remember the story of the announcement of the FASB rule. Apparently you could hear a pin drop in a room filled with 800 people. That was the sound of 800 people realising their fraud was going to be exposed.

    Mark to market is the painful medicine. It is the pin that pricks the liar’s balloon. Perhaps it needs to be modified to try to create a safer landing, but it is the sensor in the negative feedback loop, and it needs to be there.

    Every time you spend a US Dollar, you are marking it to market. If the government keeps up with this stupid kabuki theatre, you may find your dollar gets marked down. Before then, its going to be marked up through sheer desperation to get at dollars to pay off debts.

    It won’t last.

  5. Mike,

    Yes! Karl Denninger is one of my guiding lights. He’s a bit excitable and heads off into the woods sometimes, IMO, but he has a great fundamental understanding of what’s going on.

    I’m always a little cautious about referring people to him though, because he comes off as a little, er, non-mainstream, and it devalues his arguments to the random passer-by.

    But, I owe him a large debt for helping me form my thesis. Finding his writings was like coming in out of the desert.

  6. How was this counterfeiting done? In his marvelous article about the Iceland meltdown, Michael Lewis offered this mechanism.

    One fellow owns a cat; another a dog. The dog owner buys the cat for $1 billion and the cat owner buys the dog for $1 billion and each place the billion dollar pet on their balance sheet. They then borrow money with that balance sheet and start buying overseas banks — like in England.

    Same mechanism (but less obvious) happened in the US derivatives market with the credit default swaps.

  7. Allowing for a safer landing for the popped balloon is exactly why AIG, Citibank and GM cannot be allowed to “fail” in public.

    They must fail and be re-structured in private, away from the media.

  8. I’m puzzled as to why people are still complaining about mark-to-market. It’s one thing to have a market crash because no one can grab enough liquidity that day or that hour to buy securities at a fair market price. And it’s another to complain about mark-to-market months later when the markets have settled down.

    I don’t believe that these securities are undervalued now. We should stay the course with mark-to-market. Let me explain.

    As I see it, a good valuation for a good or service is what someone will pay for it. As we’ve discussed, there are times when the market fails to value things properly. When a large portion of the market is forced to sell assets and the would-be buyers run out of liquid cash assets, then you have a market crash. That’s a short term thing.

    It’s been months since we had anything that could be considered of that nature. Whatever people are willing to pay for those assets now is probably as good a guess for the valuation as you can get. So why value that asset as some other price. What makes that other price better and the accountant smarter than the market?

    I also tire of hearing the tale of rental properties that are paying for themselves. The value of the property isn’t a function of the current rent rate on the property. A buyer also needs to consider the future rent. Sure, the property pays for itself now, but how about in a year or five years? The expected, risk and inflation-adjusted, future rent is also a factor in how traders value an asset.

    As for the commentor that blames the FASB change for the current economic crisis, consider this analogy. Suppose you’re the manager for a store and one of your cashier’s drawers ends up $200 short. Who’s fault is it? You for counting the drawer? After all, if you didn’t keep track of the money, you wouldn’t have noticed. Or the cashier for losing or pocketing $200 dollars?

    This I believe is the fundamental flaw with blaming mark-to-market for what’s going on. We’re blame the tools that allowed us to see the problem for the problem itself. The dellusion is that somehow if we can’t see the problem, then it doesn’t exist.

    For the foes of mark-to-market, I have a simple request. Find a best way to value assets that trade on a market than mark-to-market.

  9. I am just pointing out that it might have played out differently, or more gradually, and perhaps even in a way that might have resulted in less panic in Washington last fall.

    Well, I think we can agree that it would play out differently. Past that, I really don’t agree. This recession was going to be deep no matter what (though it could always be worse). I’m a bit surprised at the abruptness of the start. But aside from that, I really don’t see much that would be better in the absence of mark-to-market. Accounting is a crucial part of communicating a corporation’s true state to the rest of the world.

  10. Unfortunately accounting hasn’t been a core part of defining value for years. The rot has been coming for decades.

  11. Unfortunately accounting hasn’t been a core part of defining value for years. The rot has been coming for decades.

    I disagree. While some modern assets are hard to value and have large hidden risk, I think it’s better now than say a century ago. There’s more information available and accounting for traditional assets is stronger than it used to be. Even if one compare today to ten years ago, the situation has improved with the implementation of stock option expensing and mark-to-market. These accounting improvements close some big loopholes.

  12. “To buy up the toxic assets at higher than mark-to-market value would admit what everyone knows but won’t speak: that these assets are worth a lot more than the mark-to-market value and always were.”

    Um, the author here really doesn’t understand basic

    Assume a scenario, a Level 2 asset is purchased at
    $100, and Marked to market against other similiar
    assets on the books. Then One day a bank fails
    and sells all it’s Level 2 assets at $20/unit.
    The Mark to Market rule forces the mark down
    of the origin bank. Now the Origin Bank is
    looking to sell some assets. If the Inherent
    value is actually 90, a smart investor will
    be willing to buy these at 70, 80 or
    even 89 dollars to yield a premium.

    If one is to believe efficient market Hypotheses,
    despite what happens to one entity, the others
    will be fine. Smart investors would look at a
    Goldman and say “Mark To Market has forced
    them to mark down assets as worthless, i
    should buy them up and snap up their
    future enterprise value”.

    The Fact is Blaming Mark to Market for current
    conditions is like Blaming NOAA for Hurricane
    Katrina. The Banks have no equity, they
    bought and sold cruddy paper and took
    on tremendous risk. They thought AIG would
    provide all the cover in the world until AIG
    collapsed. The Real estate and Credit bubble
    was a wall street mania, and it is just taking time
    to clean up.

    Remember the days when you would get 3
    credit card offers in the mail every day?
    Didn’t that remind you of the AOL Disks
    that kept falling out of every magazine?
    Banks were issuing credit cards to
    anyoen with a pulse, hoping that 28% APR
    could grow to the sky. Now I thought
    Credit was the instrument of the devil, but,
    for people who lived fat, and happy, well,
    it was unsustainable to keep increasing credit
    to the casey serin’s of the world.

    Mark to Market is a vital tool, consider an
    Oil distributor. They have 1 million barrels of
    oil in storage tanks. Their asset is changing
    on a daily if not hourly pricing basis. They
    need to remark this asset, so as to reflect
    their real health. if they bought this and haven’t
    sold it, they need to post losses or gains.
    if you buy shares in an oil distributor and you
    find their tanks are full of $140/BBL oil
    and oil is at 40, you are going to be pissed.

    if you find their tanks are full of $40/Oil
    and Oil is at 140 and the managers have been
    quitely buying up shares, you are going to be

    The banks are complaining about Mark to Market
    because it’s forcing them to take losses, thats’ all

  13. > I would also like to point out that if these toxic assets were really worth more than the mark-to-market price somebody would be buying them at a discount.

    They’re trying, but the folks holding them think that they can get govt to buy the trash while they keep the better stuff.

  14. > For the foes of mark-to-market, I have a simple request. Find a best way to value assets that trade on a market than mark-to-market.

    The problem with mark to market is in what it’s used to do.

    Suppose that I have an apartment house that is throwing off enough cash to meet my obligations.

    On a day when no one offers to buy said apartment house or when no one buys comparable apartment houses, “mark to market” says that its value is 0.

    Should I be forced into bankruptcy on that day? Clearly the answer is “no” but that’s exactly what we did to banks and the like.

  15. andy freeman misunderstands M2M.

    M2M says the last sale of a similiar set of asset
    should be used to reset m2m.

    and if noone offers to buy an apartment building it may
    be worthless

  16. Jack, Andy hits pretty close to the mark. Your description does not change his basic point.

    These assets don’t have a secondary market, there is no stock market type mechanism for setting day to day prices for MBSs. They are packaged up and sold as long term assets. The only sales are distressed banks selling at liquidation prices to speculators who would never be able to get those prices from a going concern holding the exact same type of assets.

    When Mervyns has a going out of business sale and prices their jeans at 75% off, WalMart doesn’t write down the value of their substantially similar denim assets. Even if jeans are out of fashion at the moment.

    I think people keep getting hung up on the word market in mark-to-market. Mark to market is just a regulatory rule, regulatory rules do not make “market” prices, they are price controls which fix prices. The fact that they use a past transaction between a distressed seller and a predatory buyer doesn’t change that, it’s just a figleaf of cover to hide its true nature.

    Mark to market gives us all the price volatility disadvantages of short term speculation with all the commitment disadvantages of a long term investment and practically none of the advantages of either.

    A better way to value these assets is to ask how much they are paying out. If some AAA tranch security is still paying full value, price it that way. If it’s off by 50% treat it like the junk it is. But don’t let the sharks and the shark bait control the fish market.

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