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Banks and "Mark to Market"

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Rearden_Steel

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*** Mod's note: Split from another thread. - sN ***

It looks like investors and the banks are trying to change the mark to market rules and I belive Warren Buffet said something to the effect. But without the MTM I wonder how banks are going to value their assets. Can the just write down anything? Kendall, I would appreciate any of your thoughts on the topic

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It looks like investors and the banks are trying to change the mark to market rules and I belive Warren Buffet said something to the effect. But without the MTM I wonder how banks are going to value their assets. Can the just write down anything? Kendall, I would appreciate any of your thoughts on the topic

OT, but my take is that "market" values are in appropriate when the reasonable cash flow profile of the asset is different. Market is far too low for some assets that have been beaten down by uncertainty. Economic or expected cash flow NPV value is probably overstated when economy is turning down, but I'd rather see that used. Note that MTM is only about 2 yrs old as an accounting rule. How ever did we make it through the last century of banking without it? Oh heavens!

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It looks like investors and the banks are trying to change the mark to market rules and I belive Warren Buffet said something to the effect. But without the MTM I wonder how banks are going to value their assets. Can the just write down anything? Kendall, I would appreciate any of your thoughts on the topic

More than likely they'll keep the assets valued at whatever price is most favorable to their balance sheets. This probably won't be as arbitrary as it sounds though since there are econometric models which can value them. The problem with MTM is that it depends upon a market. Right now, there simply isn't a market for a lot of these derivatives banks are holding are their balance sheets. That doesn't mean they have no value - the overwhelming majority continue to produce income - it only means no one wants to take the risk to buy them. Once confidence returns, banks will be able to offload them.

Banks won't write anything down if they can help it, but MTM forces them to write things down. This creates a vicious cycle where their assets are suddenly a fraction of what they were, which means their reserve ratios are out of wack, which means they need to raise capital, which if they can't do means they're insolvent.

In my opinion, removing the MTM rule would be a smart move. Despite what the article says, it wouldn't just be a "quick fix." It would allow banks to unwind these assets in an orderly way. Remember, 90% of the population still pay their mortgages on time. These derivatives are suffering from, if I may steal a term, irrational fear. It's possible that another bubble could form, but bubbles are always going to form as long as we have a central bank controlling the money supply and interest rates.

It's interesting that the article actually says, "The only way to get out of this mess is to let the free market do its magic." Well, what's so free about government telling companies how to value their assets?

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That article explains the issue well, but his solution is off base. He suggests that if one cannot get a price-quote, one should be forced to sell 10% of the asset in order to get a price. That's trying to solve a problem caused by one control, by instituting more controls. Instead, the real solution is to remove the control.

In general, the government has no business telling companies what standards they must follow in evaluating their assets. The government must decide this only for those businesses where the government itself is standing behind that business in some way: e.g. by guaranteeing its debt directly or via institutions like the FDIC. In such cases, the solution is to remove that underlying government interference, so that the government no longer has a reason to specify standards.

As an interim solution, some temporary suspension of MTM while doing government-required calculations of things like "required capital" does make sense as a step toward removal of government control.

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That article explains the issue well, but his solution is off base. He suggests that if one cannot get a price-quote, one should be forced to sell 10% of the asset in order to get a price. That's trying to solve a problem caused by one control, by instituting more controls. Instead, the real solution is to remove the control.

In general, the government has no business telling companies what standards they must follow in evaluating their assets. The government must decide this only for those businesses where the government itself is standing behind that business in some way: e.g. by guaranteeing its debt directly or via institutions like the FDIC. In such cases, the solution is to remove that underlying government interference, so that the government no longer has a reason to specify standards.

As an interim solution, some temporary suspension of MTM while doing government-required calculations of things like "required capital" does make sense as a step toward removal of government control.

All true, within the context of an LFC economic model. That was not where the author was coming from. It is also not where we are likely to be anytime soon. So yes, there is some pragmatism showing through there. The object of the article was to explain MTM, and propose a possible solution in the current politico-economic climate.

Given the alternatives (as he sees them), this is pretty close to the lesser of all evils. YOMV.

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A lot of this type of accounting was only introduced(mandated) a few years ago, wasn't it?

It's been around for decades. As a trader, I've been dealing with it since I've been in the biz. In the 1980s, banks and corporations began doing it. Then, FASB put FAS 157 into action in November of 2007 - which is basically what we're talking about. It's this rule which lays out the specific ways to value assets.

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  • 2 weeks later...

I'm a layman when it comes to the markets, but the only problem I have with mark-to-market is the way it's enforced. I'm sure everyone was all too eager to play the game when the housing market was getting inflated, and they started raking it in; but now they want to change the rules. Although these entities can't get much for their troubled assets, that doesn't mean that there is no market for them; it may mean that the market isn't performing to their desires, and they can't get a good price to sell their assets, which also makes similar holdings look like garbage, but why wouldn't/shouldn't they look like garbage? Also, what would be the point of setting the value of these particular assets higher than what their value is in the current market; wouldn't deviating from the current values no longer render the asset toxic, and if it doesn't, why? The only reasons I can see are nefarious, from cooking the books to the little spoken about bailout plans by these asset holders and the government--as if the government hasn't already sexed up some of these entities enough by claiming them too big to fail, and granting them the full backing of the government.

Besides the ability to make the balance sheets of these asset holders look more presentable, getting rid of mark-to-market may allow for further, even more unwarranted spending by the government in future bailouts. This is important given the recent plans of the Federal Treasury, to create and use their 'Public Investment Corporation' to buy these assets. Getting rid of mark-to-market would be a way for these asset holders to sell their assets at higher prices, more than they are worth, pre-bubble, etc..., to the government. If such a thing is engaged in, the cost of the plan by the Treasury is going to exceed well over $1 trillion dollars. Although, we all know the plan is going to exceed $1 trillion anyway, there's no need to exacerbate the spending. Just imagine the heroics of Geithner and the Obama administration, presented to the American people, after resend mark-to-market: asked by the asset holders to pay approximately pre-bubble prices for toxic assets, they negotiate the evil asset holders down to a lower, although most likely still inflated price, thereby bailing out but sticking it to the evil capitalists, all the while spending too much for the assets--this example was put forth on a website of which I cannot remember the URL.

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OT, but my take is that "market" values are in appropriate when the reasonable cash flow profile of the asset is different. Market is far too low for some assets that have been beaten down by uncertainty. Economic or expected cash flow NPV value is probably overstated when economy is turning down, but I'd rather see that used. Note that MTM is only about 2 yrs old as an accounting rule. How ever did we make it through the last century of banking without it? Oh heavens!

Correct me if I am wrong, but doesn't M2M say that you must provide a current value for your assets?

If that is the case, then isn't that going to cause a ridiculous amount of trouble for just about any bank or insurance company whose assets have maturity dates and so their current market value should be less (sometimes far less) than what it will be at maturity? I'm not trying to discredit the accounting method, just wondering if this is something appropriate for some business models and inappropriate for others.

So, for example, let's say you have an asset that will be worth $1,000 20 years from now. Today, it is only worth $250. If that brings you below mandatory reserve requirements, then the Government just caused you to go bankrupt or forced you into a liquidity problem (of which, if you are large enough, they will bail you out of).

...or do I have something wrong?

Edited by prosperity
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Correct me if I am wrong, but doesn't M2M say that you must provide a current value for your assets?

If that is the case, then isn't that going to cause a ridiculous amount of trouble for just about any bank or insurance company whose assets have maturity dates and so their current market value should be less (sometimes far less) than what it will be at maturity? I'm not trying to discredit the accounting method, just wondering if this is something appropriate for some business models and inappropriate for others.

So, for example, let's say you have an asset that will be worth $1,000 20 years from now. Today, it is only worth $250. If that brings you below mandatory reserve requirements, then the Government just caused you to go bankrupt or forced you into a liquidity problem (of which, if you are large enough, they will bail you out of).

...or do I have something wrong?

Fluctuations in the values of "fixed income" assets such as bonds or more exotic securities like Collateralized Mortgage Obligations are the natural result of changes in interest rates. For example, if you own a bond that pays interest (its coupon) at 5% and the prevailing interest rate for bonds with similar credit characteristics rises to 10%, then the market value of the bond will decline. For fixed income securities, their prices move in the opposite direction of interest rates. When interest rates fluctuate, bond prices also rise and fall.

For financial statement purposes, fair value is defined as: "the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date." [Just as a semi-funny aside, it took the Financial Accounting Standards Board (FASB) approximately 160 pages to define the term "Fair Value" in SFAS 157. Sheeeesh! ;) ] In other words, fair value is calculated at a specific point in time. Since a company's balance sheet also lists assets and liabilities at a point in time, the fair values of those assets and liabilities are necessarily their values on the date of the balance sheet, not 5 or 10 years out in the future. It isn't really any more relevant to declare that you think the price of a bond will be $1,000 when it matures in 5 years than it is to say that you think the price of GM stock is currently undervalued. For financial statement reporting purposes, one should look at the current fair values of the assets and liabilities in question.

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Fluctuations in the values of "fixed income" assets such as bonds or more exotic securities like Collateralized Mortgage Obligations are the natural result of changes in interest rates. For example, if you own a bond that pays interest (its coupon) at 5% and the prevailing interest rate for bonds with similar credit characteristics rises to 10%, then the market value of the bond will decline. For fixed income securities, their prices move in the opposite direction of interest rates. When interest rates fluctuate, bond prices also rise and fall.

For financial statement purposes, fair value is defined as: "the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date." [Just as a semi-funny aside, it took the Financial Accounting Standards Board (FASB) approximately 160 pages to define the term "Fair Value" in SFAS 157. Sheeeesh! B) ] In other words, fair value is calculated at a specific point in time. Since a company's balance sheet also lists assets and liabilities at a point in time, the fair values of those assets and liabilities are necessarily their values on the date of the balance sheet, not 5 or 10 years out in the future. It isn't really any more relevant to declare that you think the price of a bond will be $1,000 when it matures in 5 years than it is to say that you think the price of GM stock is currently undervalued. For financial statement reporting purposes, one should look at the current fair values of the assets and liabilities in question.

I am familiar with how bonds work, but I'm talking about bonds where the value is dependent on the future, like zero coupon bonds. They don't pay interest. They mature. These are the types of assets insurance companies love BTW because of exactly what you began to hint at. It gives the institution a way to mitigate interest rate risk for assets that they know they will have to pay out on (i.e. insurance policies).

My question remains...if M2M demands current market value, then how does mark to market accurately account for these types of assets that may be held by large financial institutions? These companies may end up looking financially distressed when in reality, they are not. If this "distress" causes them to fall below the legal reserve limit, then the Government has effectively caused a problem here, haven't they?

Edited by prosperity
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I am familiar with how bonds work, but I'm talking about bonds where the value is dependent on the future, like zero coupon bonds. They don't pay interest. They mature.

Maybe I misunderstood you then because any investment that pays anticipated future cash flows is going to fluctuate in value as interest rates change and as the investor’s perception of the risk associated with those future cash flows changes. Even though zero coupon bonds don’t pay interest, they do have a single future cash flow at maturity. As a result, their current fair value will increase and decrease with the general level of interest rates. In fact, the fair value of zero coupon bonds has greater volatility associated with a given change in interest rates than would a normal bond with a coupon. Because of their longer duration, zero coupon bonds are actually more risky than plain vanilla bonds with coupons.

My question remains...if M2M demands current market value, then how does mark to market accurately account for these types of assets that may be held by large financial institutions? These companies may end up looking financially distressed when in reality, they are not. If this "distress" causes them to fall below the legal reserve limit, then the Government has effectively caused a problem here, haven't they?

The controversy over M2M has arisen because certain securities which were valuable at one time have dropped in value. Nobody complained about M2M when asset prices were rising. Given the capital and reserve requirements that the government imposes on financial institutions and insurance companies, decreased asset values resulting from M2M meant that some of these businesses had to raise additional capital.

To answer your question, M2M accurately accounts for these assets because it presents their value at a given point in time (usually the date of the balance sheet). Despite what some people might claim, the value of these assets is uncertain in the future because there is a question as to whether the principal amounts will be repaid. Remember, we’re not dealing with zero coupon government bonds here. We’re talking about much more exotic securities like CMOs or CDOs which are both illiquid and of questionable credit quality. Given these circumstances, the M2M fair values of these securities must reflect the disadvantages associated with their negative attributes.

Rather than suspending M2M accounting, why don’t the regulators simply change the relevant reserve and capital requirements? Even if you get rid of M2M accounting, securities analysts will still calculate the current fair values of the balance sheets that they are analyzing. Those fair values will then show that a company’s book assets are overstated and this will be reflected in the market value of the stock. This sort of work has been done by analysts for years and it would continue even if M2M went away.

In my opinion, M2M is just an easy target for politicians who want to look like they’re doing something about the financial crisis. On the other hand, these politicians ignore the positive effects of M2M, mainly the enhanced transparency that it provides to investors.

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Rather than suspending M2M accounting, why don’t the regulators simply change the relevant reserve and capital requirements?
Exactly! If they did, few would be complaining about using market-valuation. The main reason banks are complaining about using market-valuation is that they fear they will be forced to raise more capital when the calculations show they have less than the required regulatory capital.

Buffet's suggestion (from his recent CNBC interview) is to keep mark-to-market for the balance-sheet/P&L and allow managers to report model-based figures as footnotes. He also thinks the regulatory capital calcs should not take only the point-in-time market-valuations. This would be analogous to the rules for funding pensions, where changes in market valuation do not have to be made up immediately.

Of course, the root of the problem is that the government is setting capital requirements in the first place; but, given the history that brought us here, they cannot stop setting such requirements either, unless they do so as part of a planned change of the current system.

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Thanks for the various explanations of what "mark to market" means, because I didn't know what the controversy was all about. In some cases, markets change, and they can change drastically, leaving assets very difficult to evaluate. For example, I've worked for art galleries that do picture framing for about twenty years. Up until about five years ago, we made significant sales by selling pre-frame art, and it would sell at the price marked. These days, however, pre-framed art doesn't sell well, accounting for less than ten percent of sales, and local galleries have to rely on custom picture framing to survive. Now if we were a publicly held company, it would be very difficult to come up with a market evaluation of our hundreds of pre-frame art, since they aren't selling right now. Does that mean they are worthless? Do we evaluate them at the prices marked? Do we evaluate them at the price we could get if we sold the gallery?

I tend to agree that cash flow might be more important and will determine if we remain in business or not, but if we had to evaluate those assets to shareholders, it would definitely come across as the company not being worth much, even though custom picture framing is significant at one of our galleries. Similarly with certain financial assets that may not be selling right now due to questions about their evaluations. If a bank has good cash flow and is making a profit for the shareholders, changing the rules in the middle of the game will give them a false signal. And it comes across to me as short sighted if bonds or other assets have to be evaluated at what the market will pay for them now even though they won't mature for ten or twenty years.

I don't know enough about accounting to say how those financial instruments ought to be evaluated for the shareholders, but I can definitely see that the government is once again manipulating markets with force that will cause distortions.And may even drive some financial institutions out of business, even while they are, in fact, making a profit.

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I follow you. Actually SNerd hit on what I was thinking. It's not that I think M2M is inherently bad. But, I think the market should decide which accounting standard to use...and in the insurance and banking industry the M2M coupled with legal reserve requirements has - I think - caused a huge problem.

I agree that you probably can't just start yanking regulations out left and right though. I think a nice transition would be first to lower the legal reserve limit and then allow banks and insurance companies to move away from mandatory risk-based capital requirements.

Maybe I misunderstood you then because any investment that pays anticipated future cash flows is going to fluctuate in value as interest rates change and as the investor’s perception of the risk associated with those future cash flows changes. Even though zero coupon bonds don’t pay interest, they do have a single future cash flow at maturity. As a result, their current fair value will increase and decrease with the general level of interest rates. In fact, the fair value of zero coupon bonds has greater volatility associated with a given change in interest rates than would a normal bond with a coupon. Because of their longer duration, zero coupon bonds are actually more risky than plain vanilla bonds with coupons.

The controversy over M2M has arisen because certain securities which were valuable at one time have dropped in value. Nobody complained about M2M when asset prices were rising. Given the capital and reserve requirements that the government imposes on financial institutions and insurance companies, decreased asset values resulting from M2M meant that some of these businesses had to raise additional capital.

To answer your question, M2M accurately accounts for these assets because it presents their value at a given point in time (usually the date of the balance sheet). Despite what some people might claim, the value of these assets is uncertain in the future because there is a question as to whether the principal amounts will be repaid. Remember, we’re not dealing with zero coupon government bonds here. We’re talking about much more exotic securities like CMOs or CDOs which are both illiquid and of questionable credit quality. Given these circumstances, the M2M fair values of these securities must reflect the disadvantages associated with their negative attributes.

Rather than suspending M2M accounting, why don’t the regulators simply change the relevant reserve and capital requirements? Even if you get rid of M2M accounting, securities analysts will still calculate the current fair values of the balance sheets that they are analyzing. Those fair values will then show that a company’s book assets are overstated and this will be reflected in the market value of the stock. This sort of work has been done by analysts for years and it would continue even if M2M went away.

In my opinion, M2M is just an easy target for politicians who want to look like they’re doing something about the financial crisis. On the other hand, these politicians ignore the positive effects of M2M, mainly the enhanced transparency that it provides to investors.

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I follow you. Actually SNerd hit on what I was thinking. It's not that I think M2M is inherently bad. But, I think the market should decide which accounting standard to use...and in the insurance and banking industry the M2M coupled with legal reserve requirements has - I think - caused a huge problem.

I agree that you probably can't just start yanking regulations out left and right though. I think a nice transition would be first to lower the legal reserve limit and then allow banks and insurance companies to move away from mandatory risk-based capital requirements.

As usual, Snerd is right on target. It is the fact that government mandates capital requirements and accounting standards that is the primary problem here. Market participants should be the ones allowed to make these kinds of decisions, not faceless bureaucrats and regulators.

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