Mark to Market
One of our correspondents has been hounding me for an opinion on “Mark to Market” accounting at the banks. So I’ve been doing some research and asking friends. My Princeton classmate Vince Farrell had a pretty good answer.
Thomas Patrick was CFO at Merrill Lynch until he was thrown under the bus by Stan O’Neil. He is now at a place called Vernon Capital and recently called m-t-m a “swamp.” His firm recently reviewed $1.4 trillion in Alt-A mortgages. These are a sort of in-between prime and subprime mortgages where financials were not diligently checked. Of $948 billion of these loans that are current on both interest and principal, currently performing loans, the mark-to-market value is at 50% of par. Such a value reflects a last sale that indicates “financial desperation of sellers (not) the value of the securities.” Patrick feels the paper would be carried at par in a normal world.
Since mark to market forces all banks to mark down to the “last worst sale” of a security, it is probably causing more harm than good. Why performing loans should be marked down by 50% just because some desperate hedge fund unloaded some Alt-A paper in a fire sale escapes me. Hopefully the Treasury Stress test could straighten some of this out.
“Swamp” is the right description. This is a great question because the pro/con answers don’t line up neatly with our stupid red/blue political prejudices.
MtM is actually a bit of an innovation, which too many people are now treating as some kind of sacrosanct tradition. Traditional accounting has always had running debates about the proper way to value “inventory” — based on a set of physical intuitions about goods in warehouses and such — which reflected the awkwardness of setting the “correct” price of something which hasn’t been sold yet.
MtM actually reflects a bit of a ‘market fundamentalist’ dogma — everything must have a market price RIGHT NOW! — regardless of the fact that not all markets are equally liquid. So the supercharged, libertarian capitalists tended to be “pro MtM”. But now that complaining about MtM is convenient for Wall Streeters, they’re all “agin” it and progressive minded people are a little too quick to insist on MtM as the only honest thing to do. Hey, if it hurts banksters, it must be a good idea
Seth
February 12, 2009 at 4:54 pm
MtM is why lending hasn’t happened since the first bailout. The value of the assets they have on hand, even though they are performing to task, keeps going down.
It makes everything appear worse than it is. We should fix it first, before we see if more bailout money is warranted.
It makes one wonder why the leadership is INTENTIONALLY working with cooked books…
To ask the age old question, who benefits?
Morgan Warstler
February 12, 2009 at 7:02 pm
Jon,
Here’s an article from The Economist that you might find interesting:
http://www.economist.com/finance/displayStory.cfm?story_id=13104022
Valerie Curl
February 12, 2009 at 7:12 pm
The MtM valuations, while at this point may be somewhat low, were used to fuel, at least in part, this lending spree.
The idea is to get some sort of equal and fair market value. While MtM may not be helping at this point, it is not an unrealistic rule to use, as long as everyone is playing with the same rules.
Changing definitions at this point seems to me to only be a game playing device and dangerous one at that. The taxpayers are the ones who will ultimately foot the bill – they should be getting very good deals and MtM will help that I think.
Also, I think most insiders don’t want to use MtM right now and their opinion of it is a bit suspect in my book.
Redefining the market value and capitalization is another Wall Street tool to keep on playing the same game – for a little longer, just one more nice bonus [though we won't call them that] please sir?!
It does all sound wonderfully logical, but the graphs you showed with the balloons showing the present vs. 2007 capitalization tell the real [ or optimistic] picture – MtM or no.
Jon, I have a good deal of faith in your predictions, they have proven to be very accurate – I do think this time you are a bit off track – if only on the MtM issue.
woodnsoul
February 12, 2009 at 11:07 pm
Is this same economic sleight of hand that has happened with people’s lines of credit? People with excellent credit scores and long histories of paid on time credit cards, mortgages and LOCs suddenly found that the mtom on their property cost them their LOC with no recourse. The same with credit card limits for small businesses that were rescinded to former low levels simply because the economy has changed even though the borrower hasn’t and again had been timely with its payments. I realize part of this can be put to computer programs that analyze the data but then isn’t that one of the ways the credit swaps got so out of hand, lenders blindly following computerized models?
I think mark to market would have been of more use before this all happened. Its use now just worsens an already sad situation.
rhbee
February 12, 2009 at 11:16 pm
I understand the reservations about changes to MtM accounting that would re-price assets based on the sellerseller’s desperation, and not the underlying value of the colleteral, but in the context of the current crisis, isn’t this a bit academic?
As the Economist notes, with regard to several big banks:
They’re souring for another reason too: these assets were never worth what anyone ever paid for them due to the outright fraud at the ratings agencies.
I understand the argument that says the ‘underlying assets’ have taken a big – but artificial – hit, and that banks would be reluctant to sell and actualize their losses when temporary and extraordinary conditions are what’s making these things toxic, as opposed to a real devaluation in the assets.
It sounds reasonable. However, it’s complete bullshit. By this logic, every asset worth less than what was paid for it is ‘toxic’. What makes these toxic is the fact that they were created, bought, and resold many times over as AAA securities.
In other words, people were passing around lead, telling themselves it was gold, and have now gotten screwed because the music has stopped, and they’ve got no one left to hustle (except, perhaps, the taxpayers).
So now they want to sit on these products in the hopes of one final sale.
That vicious hope is at the heart of this entire catastrophe. It’s not about ‘realizing’ losses on products for which the market has momentarily vanished. The market for these things is never coming back, because these things were never real to begin with. And now that fact is out in the open.
Smarter banks who realized that the ratings agencies had gone off the rails started doing their own risk assessments, and stayed away from this crap. The ones that didn’t are now, in all likelihood, insolvent.
It’s worth noting that a ‘toxic’ asset is a contradiction in terms. If it’s toxic, it’s not an asset.
The fact that an obvious misnomer is central to the issue speaks to the larger problem in play. The ‘toxic’ part is not the assets at all. They are, as they always have been, pieces of lead, and carry whatever value lead commands. The ‘toxic’ part is the bankers who say ‘no no, we performed alchemy, and alchemy is real, therefor these pieces of lead are actually gold’.
That’s the real problem with MtM. The soundness of the arrangement is 100% dependent on independent ratings agencies who aren’t fudging the definitions of what things actually are.
You may think my house is worth $250,000 because it needs work. I may think it’s worth substantially more, because I can get the necessary work done for below market rates – given the time. In one sense, we’re both right, and have reached a point of genuine disagreement. It’s an honest disagreement that’s reflected on opposing sides of the MtM debate.
But if I turn around and say, actually, I want $42 million and not a penny less, because this house is really the QE2, and $42 mil for a whole ship is a deal, then I’d be…
…I’d be the CEO of a major bank with a boatload of lead I’m trying to sell as gold, that’s what I’d be.
Alex Bowles
February 13, 2009 at 1:10 am
I have recently discovered the work of Australian economist Steve Keen. His work is refreshingly iconoclastic.
See for instance this piece which takes apart Bernanke’s analysis.
http://www.debtdeflation.com/blogs/2009/01/11/bernanke-an-expert-on-the-great-depression/
Gordon
February 13, 2009 at 4:41 am
@Alex-
I think you nailed this issue right on the head.
No matter what the rule, the evaluator or evaluation method is still going to be done by some schlub who, likely, helped get us into this mess and has a vested interest in lying about it.
I think the basic MtM concept is valid. And, Alex, you’re right – there are legitimate disagreements, but there is simply too much riding on the definitions to change them at this point, especially when the folks who are doing the changing are the very same folks who brought us this mess and their motives highly suspect, at least in my mind.
I still haven’t heard what happens if we just let these dinosaurs die and natural death??? The necessary functions they fill will be immediately snapped up by institutions that are sound and we’ll get over this illness and move the interregnum of of TDC.
woodnsoul
February 13, 2009 at 5:28 am
If given the choice between MtM and allowing the banks to specify an arbitrary valuation for their assets (the entire Level 3 asset debacle that various people were pointing out right before all this went south), I’ll take MtM. If some one wants to come up with a fair valuation system, I’d be more than happy to listen to their pitch. But the current system simply encourages collusion between the banks and the rating agencies to unnaturally inflate asset prices, despite mass evidence to their diminished value. And to me, that is unacceptable.
When you get right down to it, value is a completely subjective measure. The least subjective measure of value is what someone else is willing to pay for it. It is probably possible to make more ‘accurate’ measures of value, but requires a set of assumptions about the asset and predictions about the future. Unless those assumptions are rigorously policed and controlled for ‘truth’ then you cannot trust any of the measures of value they produce.
Jesse C
February 13, 2009 at 9:25 am
Morgan,
You’re right that MtM plays a big role in the lack of lending. If a bank sells some CDO at a distress price and then immediately has to value all their other CDOs at that same low level, it means their regulatory reserves take a big hit. They’re hoarding cash to help keep their reserve ‘gas tanks’ high enough.
MtM is awesome when you sell into a rising market — sell something at a really high price and then revalue all your other assets upward, woohoo! Now that prices are falling, revaluing downward is a LOT less fun, and all of us who resented bankers in the good times are indulging in some schadenfreude.
Who exactly do you think is benefiting? To me it seems like a combination of people reacting in anger and “cutting off their nose to spite their face” and politicians who want to be seen responding to this wave of public outrage. Add in some genuine befuddlement about accounting. If accountants have been arguing about inventory valuation for centuries, why would non-accountants suddenly have penetrating insight into the issue?
I’m used to thinking of the banks, politicians and regulators as being too cozy, but if they were going to conspire they would be acting in concert to suspend MtM, not disagreeing about it.
As Napoleon is supposed to have said: “never ascribe to malice what can be explained by stupidity.”
Seth
February 13, 2009 at 9:37 am
Alex and Seth, implicit in your remarks is what to me is one main part of “the problem.” Money economies can get really big and complex, but they are based on a tacit agreement not to point out that the Emperor is naked. Accountants arguing about how to value “inventory” of WHAT? The stuff isn’t something you can or would want to hold in your hand or, God forbid, EAT.
I’m reminded, for some reason, of a tale from one of my college classmates who attended a prep military academy. Hazing included being drug out of the rack at 3 a.m. to stand braced, heels against the wall with a couple of dozen barracks mates, and being forced by upperclassmen to pass a steaming turd from hand to hand until somebody admitted to being the person who had dared to use the toothbrush-polished toilets after lights out on the night before a big inspection.
Not lead, not gold, just the other stuff.
“Follow the money”? How the hell can you, in this morass?
JTMcPhee
February 13, 2009 at 11:56 am
This is over my head, but here’s how one ignoramus sees it: it all has to do with the fundamental question: are the big banks solvent, or are they all bankrupt?
An analogy. Guy owns a GMC truck dealership, and he goes to the bank for a loan to keep in business. ‘Hey, I’ve got 100 Hummers on the lot, with sticker prices of $100,000 each – that’s $10 million in assets! More than enough to cover this loan for collateral!’
To which Mr MtM-banker would quite reasonably reply, ‘Now son, you just know you aren’t going to be able to sell those Hummers at full retail…’
Why are CDOs and other junk any different from 2009 Hummers?
pond
February 13, 2009 at 12:18 pm
Seth,
You know who could shed some light? Physicists, that’s who.
My own knowledge is very limited on this front, but when reading quantum mechanics in college, we came to a similar ‘unsolvable’ problem when it came to defining matter at very small scales. The question was whether the tiniest things we can ’see’ are particles or waves.
The answers is ‘both, but never at the same time’. The more certainty you have about position, the less you an determine about velocity and direction. The converse is equally true. So the answer – particle or wave? – depends on how you view your object. In other words, subjectivity is inseparable from objective judgments.
You can visualize this by imagining a baseball photographed at 1/1000th of a second. The ball appears crisp, suspended in the air, every stitch clearly visible. Shot at 1/10th of a second, it becomes a blur. However, you can draw a line through this blur and determine trajectory – something that the crisp, frozen in mid-air image could never reveal. Accordingly, accounting for what you actually know about the ball must include an account of the subjective view used to gather your raw data (1/1000th or 1/10th?)
This is a gross oversimplification, (see the Copenhagen interpretation for more depth) but the nature of the problem – that of the observer’s influence, and the effect of measurement itself – is deeply connected to the question of financial measurement faced by banks holding toxic ‘assets’.
Seth points out that problems of relativity – where determinations are based upon the differing sets of incomplete information held by observers, along with the methods they’re using to measure the object, and the ways they account for their own presence within the system – can lead to endless debate.
That debate is compounded in this case by the role of extreme self-interest. At this point, asking the banks who are holding this toxic trash to account for it properly is like asking a man found guilty of murder to pass his own sentence.
So like I said, all questions about the relative virtues of MtM vs. the alternatives are academic at this stage. When the banks have compromised themselves themselves, they are no longer trustworthy. Therefore their own judgments – whatever their potential worth in less compromised times – are rendered irrelevant.
The reason is that their internal valuations assume that the valuing agent (the banks) is making fair and accurate judgments. In other words, they’re factoring their own (non-existent) credibility and ongoing solvency into the price as though it were real, when the absence of any market for this trash demonstrates, irrefutably, that these are chimeras.
Basically, the point where the banks became dead men walking was the point where the ratings agencies lost credibility. In the absence of objective assessments by a disinterested third party, internal valuations became meaningless. What’s transpired since then is equivalent to the delay between the moment when the Titanic actually hit the iceberg, and the moment when enough water poured into the ship to create negative buoyancy.
The point, in other words, is not whether MtM makes sense in general. Assuming that the ship is basically intact, the debate is fair and necessary. However, once the basic integrity of the system has been compromised, the fate of the ship becomes a foregone conclusion, and concerns shifts to the fate of passengers.
What’s going on now is, essentially, an exercise in denial. Instead of executing a rescue plan, there’s a concerted effort underway to deny the basic insolvency of the banks. Obviously, this is putting lives at serious risk, while diminishing the ability to conduct an orderly escape plan.
Again, all this nonsense about the toxic ‘assets’ having a ‘momentarily’ incalculable value is a complete charade. It’s like saying that dinner will not be served at eight due to exceptionally heavy chop, and the interference this causes in the kitchen.
One could equate this to the steps the government might take to shut down a market in the event that a computerized system went haywire, and started issuing sell orders at a furious rate.
But as we all know, that’s not what’s happening. Fraudulence in the ratings system generates products that contain fraudulence as a intrinsic element – like salmonella in peanut butter from processing plants full of mouse shit, roaches, and toxic mold.
In the same way it would be absurd to think that the contaminated peanut butter can’t be pulled from the shelves (needing to be bought instead, at full retail, using taxpayer money) it’s absurd to think that the guys who created a market for toxic product can now demand that we buy the inventory at the price they set, or else it will remain on the shelves (in this case, their books) and continue to completely fuck up the market, along with everything that depends on it.
The peanut guy is going to prison, if he doesn’t kill himself first. For reasons that escape me, the CEOs and shareholders of the guilty banks don’t appear to feel pressure anything like this.
That needs to change.
Alex Bowles
February 13, 2009 at 12:54 pm
What also needs to change is my attention to proofreading. That’s what I get for rushing stuff out on a busy day. Happy Friday all.
Alex Bowles
February 13, 2009 at 1:00 pm
Cognitive dissonance is an amazing thing. I’ve been studying it a bit and find that when mostly conservative folks are presented with facts that contravene their ideas [preconceived or otherwise], they simply don’t take that information up, deny its existence and, in fact, create other scenarios out of whole cloth to support their feelings. They can do it on a very grand scale too it seems.
It seems that is what is happening here isn’t a lot different that other SNAFUs of these folks. The solution is to let the institutions die. I really believe Jon is right – other vehicles need to be born/developed/etc. and take over the functions these have been doing.
And no one has explained, in any sort of real world way, what happens if a bunch of these firms just die. Somehow, I think will will experience a whimper and not even miss much of a beat as se move past their carcasses.
woodnsoul
February 13, 2009 at 1:20 pm
Alex,
Economists definitely need to learn some new math tricks from physicists. I doubt that straight quantum mechanics is the best place to start, though. The economic concept of equilibrium has a somewhat different provenance, but anybody in economics could stand to study the physical concept of equilibrium associated with heat flow (boundary value problems in elliptic PDE). Economists have some standard hand-waving, slightly apologetic excuses for ignoring boundary conditions by calling them “exogenous variables”. Another promising direction is phase transitions in simple network models of exchange.
I’m hopeful that the current bonfire of economists’ vanities may elicit a new generation of more adventurous economists. Adventurous both in their choice of mathematical tools and in overcoming their (almost Freudian) “repression” about the role of politics in economics.
JTMcPhee:
The toxic assets in question vary quite a bit. Where there was a purblind assumption that ‘AAA means safe’ there is now an almost equally unsubstantiated ‘CDO = radioactive waste’ assumption.
Think of the current peanut scare. Yes some peanuts were bad, some people got sick. But not everyone did, not all the peanuts were infected. We now have a presumption that it’s unsafe to eat the peanuts. We do that because it’s impractical to measure each bit of peanut-laden food individually.
But for large pools of mortgages which have a higher-than-anticipated default rate? Are they ALL completely worthless? I rather doubt it. The problem at the moment is that it’s really hard to unravel the layers of securitization, repair the broken default models and recompute what a sensible price would be. But I expect private investment pools will eventually start buying. John Paulson, for example, is already involved as are many other hedge fund managers.
Seth
February 13, 2009 at 4:18 pm
Guys, the point is that each and every debt, like a mortgage, has a payment schedule, and a total payout value. That is it’s value. If you, or a business are making those payments on time and according to schedule, that instrument is at par value. There is no need to discount it.
If the market is doing well, and the value of your asset goes up, you don’t suddenly pay more, the schedule is exactly the same – the value is exactly the same. If you REFINANCED on the asset, then it is a new debt instrument with a new “par” value – the question again becomes, ARE YOU MAKING THE PAYMENTS. This is what Jon’s friend alluded to.
Now that said:
- if you are missing payments, then using surrounding properties to determine the absolute bottom value of the bank asset IF they recover it from you make sense. That same logic gives the bank good reason to work with the mortgage holder, before the bank claims the house. Now suddenly, you (the bank) don’t want to foreclose, you want to re-negotiate and try and kept the value of the instrument higher and bottom of the barrel prices. reread that.
With MtM, keeping people in their homes, isn’t about ending blight, or about, helping for altruistic causes – keeping them in their house means you don’t have to massively mark down that debt.
- it also makes sense, to stop the stupid practice of no recourse loans. people wouldn’t have taken half these loans if they couldn’t mail in the keys. so, when banks offer to re-do the loans to keep people paying on a new debt instrument (and keep the asset from going bottom barrel)
——-
Now then, two SMALL simple changes and we suddenly have a completely different situation on our hands. A MASSIVELY different situation on our hands. It isn’t a sledge hammer… it is surgery.
Seth,
I’m 150% sure this change wasn’t made under Bush, because the banks preferred some cheap money. And now, it isn’t happening under Obama, be he prefers to keep the crisis ongoing to try and do a New New Deal.
My point isn’t that the system isn’t sick, it is that before anything drastic happens, we need to agree on the measuring sticks.
And telling banks they have to treat a contract in good standing, that it’s value is based on the contract not in good standing next door -MEANS that the bank has less reason to renegotiate with the guy who just needs to re-do the debt slightly. They are already having to treat it as bottom barrel.
Morgan Warstler
February 13, 2009 at 7:05 pm
Speaking of using the correct measuring sticks:
http://www.shadowstats.com/article/53
Try to read that and not vomit.
Morgan Warstler
February 13, 2009 at 10:44 pm
Seth,
You’re much more knowledgeable in this area than I am. And my interest in quantum mechanics is really limited to the interesting questions about the old subject / object debates that are of perpetual interest to philosophy majors.
It just seemed worth noting that the ‘impossible’ problem of valuation is only ‘impossible’ in this particular realm (and according to people who don’t like the idea of a clear, but unfavorable solution.)
There are other realms that deal with questions like this all the time, and have evolved very sophisticated frameworks for doing so.
And I agree – there’s a bizarre, almost superstitious avoidance of concrete evidence in economics. I’m generalizing, to be sure, but still, the emphasis seems to be on the side of pure mathematics, and this now fully debunked idea of fully rational agents as the basic units in economic systems.
Alex Bowles
February 13, 2009 at 11:47 pm
“markets are not always rational.” They often over shoot to the upside and the downside. Let me give you an example. You bought a 3 family house 3 yrs ago for 300k. The rents are enough to pay the mortgage. Now today the house is only worth 150k but no one makes an offer “does that mean the house is worth nothing”. These accounting rules would want you to mark that asset as Zero. Now maybe if the economy gets worse it is worth 120k or possibly the economy gets better and its worth 300k again in the future. As long as the cash flow is there who cares? Now maybe a bank should only be allowed to use 75% of the value if no market currently exists or is currently illiquid but to force the mark to zero is punitive. That is why the banks are not lending. Most importantly it doesn’t cost the government a penny of tax payer money!!! This might not be the best example but it give you the idea of what the banks are facing. Also the need for more regulation is just plain silly. The regulators knew about Maddof and subprime lending, and the woes of the auto industry. The government looked the other way as they were getting there campaign donations. The bottom line is the government is not even good at running the government. Imagine the politics and control the government would have if they could decided what companies and individuals got loans. It would be a political fiasco and the end to the American Economy as they guys as so corrupt that they would sell any of us out for there own special interest including the president! Clinton was such a good president because he did not have the House and Senate. He had to compromise. Obama would be a good president if he were in the same situation but because he has absolute power he is going to wreck the economy to pass a social agenda. The key to change in incremental change. For example how would it look if we had a republican president and republicans with majority in the house and Senate. They could not just say starting tomorrow no one will receive welfare it would create anarchy. Same with this president punishing wall street. Wall street and main street are the same street. Wake up all the folks with IRA’s, 401ks and pensions are getting wiped out. My question is was that the plan? To make us all depend more on government so they can control more of our lives? Wake up people and open your eyes!!!
gabe
March 7, 2009 at 9:38 am