ziggy...and any interested others...an article on mark to market

[Lurker]

From a site called RealClearMarkets...this explains my point of view fairly well.  Mark to market is a valuation tool; the real culprit is the deteriation of the market for these "toxic" assets.

March 10, 2009
Mark-to-Market Doesn't Destroy, It Reveals Destruction
By John Tamny
Back during the Internet IPO boom, companies ranging from Netscape to Priceline to Expedia went public with no earnings to speak of whatsoever. Retail giant Amazon.com was jokingly referred to as 'Amazon.org' due to its lack of profits. Despite their heavy losses, investors bought into the aforementioned concepts based on the belief that in the future, their losses would turn into gains.

This is notable today given all the talk about mark-to-market (MTM) accounting. To its opponents, MTM lies at the heart of our economic difficulties. MTM naysayers argue that an accounting measure which requires firms to value assets at market prices discovered in very thin markets is in particular driving banks into insolvency. If a more liberal form of accounting were applied, presently insolvent banks would be healthier on paper and solvent.

The above is an appealing thought, but it seems mark-to-market?s opponents blame a rational theory of accounting for the real issue weighing on banks. In this case, accounting isn?t driving them into insolvency, but the federal government?s distortion of market prices is.

Going back to last spring when former Treasury secretary Henry Paulson asked mortgage lenders to ?voluntarily? reduce contractual mortgage rates, the market for mortgage-backed securities has never been the same. That is so due to the basic truth that the housing and mortgage industries have long been protected and subsidized by the political class in Washington, so when Treasury asks for voluntary changes, the ask is in fact a demand.

Moving to last fall, Paulson rushed the Troubled Asset Relief Program (TARP) through Congress, and its initial purpose was to remove the toxic mortgage assets off of bank balance sheets through purchase of same. But as we all know now, the latter never came to pass. And with TARP?s mission changing seemingly on a weekly basis, the value of the toxic assets corroding bank balance sheets became even more uncertain. Investors blanch at uncertainty in the way that vampires run from the Cross, and with governmental intention with regard to toxic mortgage securities a moving target, their value withered even more.

Then two weeks ago, in another blow for these down-and-out assets, President Obama announced a $275B mortgage relief plan, the details of which included the empowerment of federal judges to rewrite existing mortgage contracts. So while the federal government has been handing out free money to weak banks with one hand, with the other it has been taking through rulings meant to reduce the value of their frozen mortgage assets even more.

The above in mind, is it any surprise that banks with mortgage securities on their books are presently struggling? No doubt horrendous lending and investment decisions have played a major role in this regard, but when governments play with prices, they by definition create disorder such that markets freeze.

As the Wall Street Journal reported just yesterday, ?bond investors worry the government?s repeated modifications to its financial-rescue packages are undermining the very foundations of bond investing: the right of creditors to claim their assets first if a borrower defaults. Without this assurance, the bonds of even the most stalwart institutions are much riskier to own.?

The Journal story begs the question of where we might be had the federal government never intervened in mortgage markets to begin with. If not, it?s easy to suggest that the supposedly toxic securities would be far more liquid for a great deal of uncertainty with regard to government intervention having been removed. In a market free of governmental machinations, what investors refer to as toxic assets would be naturally priced, and mark-to-market accounting would be essential for revealing investor views on their future viability. In that case, it?s pretty easy to see that rather than a problem of accounting, we have a situation whereby accounting is showing how governments can turn down-and-out securities into assets that are untouchable.

Mark-to-market opponents could still point to regulations that make banks insolvent on paper, and there they have a point. But just as the Internet darlings of another era were able to raise cash amid real paper losses, there?s nothing keeping banks from raising capital against assets that are presently mispriced. Furthermore, solvency rules speak to a problem of regulation over solvency rather than a problem of market-based accounting.

In the end, it has to be asked if mark-to-market?s opponents aren?t mistaking cause and effect. Indeed, assuming a suspension of MTM, is it realistic to suggest that investors would somehow believe the numbers wrought by a less draconian form of accounting meant to make bad assets look better on paper? That seems a reach. Federal intervention in the mortgage markets has made admittedly weak securities toxic and illiquid, and no accounting fix is going to change this reality.

As we know from the Internet companies of a past economic era, investors will always buy into a positive commercial future no matter how ugly the present appears. Sadly, this in no way describes the assets on bank balance sheets, the ?value? of which changes with each alteration of government policy.

So rather than an accounting theory that is destroying banks, mark-to-market is merely a window into the real destruction of financial institutions by other, governmental means.


John Tamny is editor of RealClearMarkets, a senior economist with H.C. Wainwright Economics, and a senior economic advisor to Toreador Research and Trading (www.trtadvisors.com). He can be reached at jtamny@realclearmarkets.com.

link: http://www.realclearmarkets.com/articles/2009/03/marktomarket_doesnt_destroy_it.html

[Joe Vancil]

Interesting read, Lurker, but I simply can't agree.

With the statement, "investors will always buy into a positive commercial future no matter how ugly the present appears," the writer reveals his assumption that mortgage securities - essentially gambles on how many people are going to default - will be seen as a positive commercial future.  The slowdown caused people to see these securities as bad gambles, and nobody wanted them any more.  This simply exacerbated the underlying problem.  So, yes, I agree that the deterioration of the market for these "toxic" assets is somewhat to blame, but the fact is that since banks were so overvaluing these assets, MTM allowed them to mask what should have been an easily-understood weakness of the system.

Only MTM accounting gives *ANY* value to a gamble.  The old gambling adage is, "Never gamble more than you can afford to lose."  The appropriate value for these "securities" is *ZERO*, because the only gain they produce is in how much more a person is willing to pay than what you paid.  Purchasing any such security is a net loss that you must absorb - not a revenue stream.  And that is exactly what is happening.

A more traditional view of accounting applied to these securities would not make them look profitable, and therefore, expose them as the bad investments that they are.

Granted, I'm no accountant, but it seems rather straight-forward to me:  an asset cannot be valued at a "projected" value, but only at its underlying real value.  Future incomes are not guaranteed (with the exception of pre-payments recorded under accrual-based accounting methods).  Whether it's a hotel that sits with vacant rooms, or a company's warehouse full of obsolete computers, income cannot be reported on a "projected" basis.  Sure, my machine may be valued as $2000 in income TODAY, but until it is sold, it will lose value.  Next year, that computer will be worth less that it is today.  If I report that as $2000 income today, I'll be taking a loss every day that the machine goes unsold.  And it may never sell.  Only MTM allows me to claim that as $2000 income the moment it is produced - meaning that I can inflate my stock price by claiming revenues that I may not generate.

MTM seems to me to be a TERRIBLE accounting method.

[Lurker]

Interesting read, Lurker, but I simply can't agree.

With the statement, "investors will always buy into a positive commercial future no matter how ugly the present appears," the writer reveals his assumption that mortgage securities - essentially gambles on how many people are going to default - will be seen as a positive commercial future.  The slowdown caused people to see these securities as bad gambles, and nobody wanted them any more.  This simply exacerbated the underlying problem.  So, yes, I agree that the deterioration of the market for these "toxic" assets is somewhat to blame, but the fact is that since banks were so overvaluing these assets, MTM allowed them to mask what should have been an easily-understood weakness of the system.

Only MTM accounting gives *ANY* value to a gamble.  The old gambling adage is, "Never gamble more than you can afford to lose."  The appropriate value for these "securities" is *ZERO*, because the only gain they produce is in how much more a person is willing to pay than what you paid.  Purchasing any such security is a net loss that you must absorb - not a revenue stream.  And that is exactly what is happening.

A more traditional view of accounting applied to these securities would not make them look profitable, and therefore, expose them as the bad investments that they are.

Granted, I'm no accountant, but it seems rather straight-forward to me:  an asset cannot be valued at a "projected" value, but only at its underlying real value.  Future incomes are not guaranteed (with the exception of pre-payments recorded under accrual-based accounting methods).  Whether it's a hotel that sits with vacant rooms, or a company's warehouse full of obsolete computers, income cannot be reported on a "projected" basis.  Sure, my machine may be valued as $2000 in income TODAY, but until it is sold, it will lose value.  Next year, that computer will be worth less that it is today.  If I report that as $2000 income today, I'll be taking a loss every day that the machine goes unsold.  And it may never sell.  Only MTM allows me to claim that as $2000 income the moment it is produced - meaning that I can inflate my stock price by claiming revenues that I may not generate.

MTM seems to me to be a TERRIBLE accounting method.

Future cash flow is one of the most basic appraisal method, Joe.  Rental properties are based on projected cash flow.  Stocks are based on an underlying assumption of future revenues and cash flow.  Almost all market based valuations are based on cash flow.  Or comparative sales (which is the same as mark to market - value based on comparative sales).

As long as someone is willing to pay a price for something how can it be "overvalued"?  If I am willing to pay you $5,000 for your keyboard and Skander has an identical one why wouldn't he say his keyboard is worth $5,000?  That is what the last willing buyer paid?  He is going to say no mine is only worth $5?

So how do you think these mortgage securities should be valued?  I think you are confusing basic mortgage securities...which is a promise to make a series of known cash payments...with the derivatives that the financial institutions created to resell those same series of cash flows many times over.  And those derivatives had the value that a willing buyer and seller were able to agree upon.  This is the basic tenet of MTM accounting...adjusting the value of a security to what an open market would pay for it.  When the market disappears then there is no value.

[Skandery]

This is the basic tenet of MTM accounting...adjusting the value of a security to what an open market would pay for it.  When the market disappears then there is no value.

Right.  That makes sense.  But isn't that a bad thing?  Seems to me like very much a feast or famine way of doing things. 

Someone like Enron who out of thin air "created" the concept of marketizing energy distribution, could use market leverage to manipulate the so-called market price.  When the reality never bears out the phony price, the bottom falls out.  I just don't think this is a good way to run an economy.   

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In your analogy, I would think that Joe's particular, specific keyboard is worth $5000 because you paid him that for it.  While my "identical" keyboard is only worth what someone is going to pay me for it should I sell, and I can always put it on the market to gauge the value if I'm curious.  But its not necessarily $5000. 

[ziggy]

Lurker,
I need to read this through a couple of more times to make sure that I fully understand what he is saying.  After a quick read through I would say what he is saying is roughly analogous with my thoughts.  Mark-To-Market is not in an of itself bad.  I have tried to make that point before, but I am sure some of that has been lost in my rants.  It is pro-cyclical, so it makes market tops higher, and market bottoms lower.  That is its biggest flaw.

My biggest issue with mark-to-market is how it is being applied today.
1.)  It is valuing different securities the same.  Common shares of Microsoft are all identical so they can be valued the same.  6 month T-Bills are all the same, except interest rates, and that is addressed in the price.  No two MBS are the same.  They have different risk profiles, different security positions, underlined by different mortgages, in different locales, with different rates of return, and different tranches.  You cannot automatically apply the value fetched for one MBS to all other MBS.  The underlying securities are not the same.  They are basically saying that a share of GM sold for 24 cents today, so you must mark your Microsoft shares to 24 cents.  Microsoft shares may have been trading at $32 a share, and this value was determined by a well functioning market projecting expected future earnings, and placing a value on one share related to that.

2.)  There is not a well functioning market trading MBS, but you need a "market" to mark the securities to.  I agree that the actions taken so far by Bush/Paulson and Obama/Geithner have only made the situation worse.  They have created more unknowns, and making promises, and the dithering they have created enormous uncertainty.  This uncertainty has lead to paralysis, which has caused the market to wait, and then the only securities that actually get traded are those out of desperation.  That then sets the market.

I have heard that Obama's FDIC chief, and Bernanke are loathe to suspend MTM, but are willing to consider modifying its rules, clarifying some, and creating some rules that address the specifics of securities like MBS.  I have to wait to see what they actually propose, but if this is where we go then kudo's to them.

[Lurker]

Lurker,
I need to read this through a couple of more times to make sure that I fully understand what he is saying.  After a quick read through I would say what he is saying is roughly analogous with my thoughts.  Mark-To-Market is not in an of itself bad.  I have tried to make that point before, but I am sure some of that has been lost in my rants.  It is pro-cyclical, so it makes market tops higher, and market bottoms lower.  That is its biggest flaw.

My biggest issue with mark-to-market is how it is being applied today.
1.)  It is valuing different securities the same.  Common shares of Microsoft are all identical so they can be valued the same.  6 month T-Bills are all the same, except interest rates, and that is addressed in the price.  No two MBS are the same.  They have different risk profiles, different security positions, underlined by different mortgages, in different locales, with different rates of return, and different tranches.  You cannot automatically apply the value fetched for one MBS to all other MBS.  The underlying securities are not the same.  They are basically saying that a share of GM sold for 24 cents today, so you must mark your Microsoft shares to 24 cents.  Microsoft shares may have been trading at $32 a share, and this value was determined by a well functioning market projecting expected future earnings, and placing a value on one share related to that.

2.)  There is not a well functioning market trading MBS, but you need a "market" to mark the securities to.  I agree that the actions taken so far by Bush/Paulson and Obama/Geithner have only made the situation worse.  They have created more unknowns, and making promises, and the dithering they have created enormous uncertainty.  This uncertainty has lead to paralysis, which has caused the market to wait, and then the only securities that actually get traded are those out of desperation.  That then sets the market.

I have heard that Obama's FDIC chief, and Bernanke are loathe to suspend MTM, but are willing to consider modifying its rules, clarifying some, and creating some rules that address the specifics of securities like MBS.  I have to wait to see what they actually propose, but if this is where we go then kudo's to them.

I agree with your points ziggy.  It is the application of the tool not the tool that is wrong.  And you can always make a better mousetrap; but you don't throw away the ones you have until that better one is made.

[rickortreat]

There is a big difference between mark to market and actual value, and therin lies the problem.

On top of that the markets that these things blew up in were never liquid in the first place, being custom-made agreements between two private parties.  IF you want a market that allows free price discovery, there have to be standards to the contracts or agreements- some form of standardization that allow you to compare one to another.  A guaranteed clearing house that will execute trades when no one else will, and regulation to ensure that orders are paid for and delivered.  With these derivatives, the value was connected only to the solvency of the writer of them.  The fraud now is that the government by bailing out these banks is making good on the derivatives, giving the bill to the taxpayer.  I have no idea why we should be on the hook for someone else's stupid deal.

I say let them all go bust and go begging in bankruptsy court for their derivative money! It shouldn't be our problem.

By the way free-trading markets go up and down all the time, as there is continual disagreement about actual value by market participants.  They are not particularly orderly and not entirely suitable for the trading of all things.  Real Estate is less about the property itself and more about the general economy in the area.  If the people in a specific location all have jobs and money they will demand better living conditions and someone will build them homes to satisfy that demand.  A bank can use the revenue stream to project a certain value on a loan, but that is based on assumptions about the performance of that loan in the future. IF the parts factory that provided everyone with work shuts down, every house in the area is going to loose value, because there is less demand for housing at that price.

The future is always a gamble and insurance has to be looked at carefully to see if it can work. Anyone who trades in the options market knows that they are making or loosing money to a counter-party on their trade, but they also know that someone is there to make sure that the counter party or they pay up.  And they always know they can sell their option at some price to exit the trade when they want to. That doesn't protect you from loss, unless you can act, but at least with options you always can. 

No one is willing to be a clearing house in real-estate, so they're now going to force the government to do it, now that their market is broken.  The one thing about any market is that they are all subject to potential bubbles.  Everyone should be aware by now that when markets continue to rise at a certain rate for a protracted period of time, that a correction is certain.  Insurers of these markets should know this and price their insurance appropriately.  Judging by their insolvency, it's clear that they failed to do so adequately and mark to market was a tool they used to conceal their poor judgment.

[Lurker]

There is a big difference between mark to market and actual value, and therin lies the problem.

And what is that difference?

The same difference as there is between a yardstick and distance.

One is a tool for measuring the other.

[Lurker]

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In your analogy, I would think that Joe's particular, specific keyboard is worth $5000 because you paid him that for it.  While my "identical" keyboard is only worth what someone is going to pay me for it should I sell, and I can always put it on the market to gauge the value if I'm curious.  But its not necessarily $5000. 

So you put it on the market to determine the value then want to tell someone what your computer system is worth.  Do you use the value the market told you it was worth?  Or some arbitrary other value?  If you use the market value then you just used mark to market.