What is Mark to Market and Why Should You Care?

Relax the rules! Override the FASB! No, it's all a Ponzi scheme enabler, it's Enron Style accounting!

What are these people even talking about with mark-to-market accounting methods?

Mark to market accounting simply means assets are valued at the current market prices. Where the controversy comes into play is in those assets which are not easily assessable since there is no actual market upon which to evaluate them.

So, what happened was we had fictional financial models created to evaluate the value for some types of derivatives. This is what the Enron scandal was in part about. There was no separate established market for energy derivatives, thus Enron with their conspirators, made up some over-inflated fiction on these contracts since there was no real world check to determine their true value.

So, the accounting guys, working to get corporate books to adhere to some financial market reality, created FAS 157, which defines how assets must be evaluated.

Enter in the controversy with today's financial crisis. As we now know there is an entire shadow banking system with all sorts of structured finance vehicles, particularly credit default swaps, that were based on bad loans and over-inflated home prices.

The controversy now claims that rule 157 causes artificial losses.

Former FDIC Chaiman Bill Isaac, who handled the S&L crisis, testified to the problems and wants to suspend mark to market, i.e. fair value accounting rules.

In layman's terms Isaac is saying when a sudden financial crash comes along, assets that really are worth something, by taking future and historical value into account, yet during this particularly bad financial time period are worth nothing by mark to market rules.

One argument Isaac implies in his testimony is (my interpretation only!) it is better to play accounting games that expose the truth and force the taxpayers to cough up in order to provide more capital to these institutions who just had to do a bunch of write downs. In other words, do you want to cook the books for a bit or cough up $1 trillion dollars to cover the reality of the situation of insolvency? hmmmm.....

Hey, considering what's going on with the massive bail out money, which midtowng wrote today is a disaster waiting to happen who can argue? (except to never have let many of these derivatives allowed to be created in the first place)

So, there one has the two sides. One side says stops fictional money and evaluations and the other side wants more of an average, or historical evaluation as well as future so in times of panic one doesn't sell the family jewels for nothing.

Which side is right? Good question, both sides have some merit, although from my layman's window, it seems to me derivatives based on fictional mathematics who then obtain fictional accounting to evaluate their value....
well, maybe we would not be having this debate if regulators no longer allowed black box gambling under the guise of structured finance in the first place.

Robert Hertz, chair of the FASB, gave testimony. These are the people who set up accounting rules.

In recent months, there have been calls by certain parties to suspend fair value accounting and, specifically, the application of Statement 157. Some commentators have asserted that the fair value standards promote undesirable “procyclical” behavior by requiring write-downs of financial assets that may be exaggerating losses, further driving down asset values, affecting capital ratios, and tightening the availability of credit, thereby causing a further downward spiral in assets prices.

While sound and transparent reporting can have economic consequences, including potentially leading to procyclical behavior, it is not the role of accounting standard setters or general-purpose external reporting to try to dampen or counter such effects.

Highlighting and exposing the deteriorating financial condition of a financial institution can result in investors deciding to sell their stock in the entity, in lenders refusing to lend to it, to the company trying to shed problem assets, and to regulators and the capital markets recognizing that the institution may be in danger of failing and need additional capital.

Indeed, individuals and families may take such procyclical actions when they see falling values of their homes and their 401(k)s and decide to spend less and to sell investments in order to raise cash in troubled times. But I think few would suggest suspending or modifying the reporting to individual investors of the current values of their investment accounts. Thus, to the extent there are valid concerns with procyclicality, these are more effectively and more appropriately addressed through regulatory mechanisms and via fiscal and monetary policy, than by trying to suppress or alter the financial information reported to investors and the capital markets.

Moreover, in our view, the standards are not the underlying source of the write-downs. Some of the most vocal critics of the standards have come from institutions that subsequently failed and have had to seek financial assistance from or been rescued by the federal government. As discussed in detail below, there is considerable evidence that underlying economic conditions are the fundamental source of those write-downs.

In the words of some investors, “Blaming fair value accounting for the credit crisis is a lot like going to a doctor for a diagnosis and then blaming him for telling you that you are sick"

What did he just say in a nutshell? He said trying to cook the books is not the answer to fictitious derivatives and over-inflated assets...like subprime mortgages.

During the questioning period, Grayson asked this:

Rep. Grayson - Bad Math & Real Motivations

Interesting corporate timing of these demands, huh?

Even more interesting the FASB has issued new guidance on mark-to-market after this hearing, where corporations can use their judgment more.

I would suggest reading through the testimony Kevin Bailey, Deputy Comptroller of the Currency. It's dry but is recommending the SEC fair value study as the recommended course of action.

I am a mere humble blogger but one thing is clear, just how these accounting rules are changed could assuredly affect transparency, evaluations and even possibly masking the real problem of needing strong regulation on derivatives.

The hearing chair, Representative Kanjorski summed it up best:

Illiquid markets have resulted in great difficulty in valuing sizable assets. Some have therefore complained about fair value accounting and sought to eliminate it. While companies need stability, investors still need accurate information. We therefore cannot allow for fantasy accounting that wishes away bad assets by merely concealing them

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Comments

Trying to scapegoat an accounting rule.

Over leverage and underestimation of risk caused this crisis.

FASB 157 involves transparency something that financial conglomerates dread.

Eliminating FASB 157 will still not address the problem of insolvency. These financial conglomerates are dead and nothing will bring them back.

Here is the actual standard: Link

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The point is that the fiction was the original ...

... fiction of the value of these assets ... and since De Nile aint just a river in Egypt, much of Wall Street is still clinging to the idea that while they may have been "overvalued", they had "some value", which is "not adequately recognized".

Mark to market brings down the asset side of a balance sheet during a downturn. That's what liquid contingency reserves are for.

The problem of "how do we mark to market when there is no market" is also simple ... it should not be on the balance sheet "as if" it was a liquid asset if there is no established public market to provide that liquidity. It should be on the balance sheet as an investment asset, and its positive value entered as that value in realized in actual returns.

All that time that Post Keynesians and American Institutionalists were saying that the "efficient market hypothesis" was just an excuse to let Wall Street do what it wanted to do, and letting Wall Street do what it wants to do will always, inevitably, end in financial collapse ...

... uhm, seems like we were right.

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pretty much my assessment

When I heard "CDSes are a valid instrument" in today's AIG CEO hearing I about gagged. Uh, not unless seriously reformed AND regulated.

So far that is my impression. These people are determined to hang onto these derivatives where even the base mathematical equation is fundamentally flawed.

But I think we need to go digging deeper to write about these things we find in layman's terms. I believe people jump on the executive bonuses because that is something they can clearly understand as outrageous...but digging around in financial products minefield to even figure out where the fraud lies...

is very hard. Even for financial people never mind lay people.

So, more "exercises for the reader" are in order.

I also caught from the AIG hearing today that CDSes are almost wound down but there are other derivatives, structured finance that I need to find out more about which is still $1.6 trillion at AIG alone in liabilities.

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CDS's are simply not a valid instrument ...

... they are an insurance-equivalent that pretends to not be an insurance-equivalent so that people with no insurable interest can take out insurance, to allow them to hedge or speculate, and so that firms can issue insurance-equivalents without meeting the balance sheet requirements imposed on an insurer.

And in this case, it makes little difference which it is allowing, hedging or speculating, because allowing firms to hedge with cheap CDS contracts where they ought to be hedging with liquid reserves against contingencies is part of the process of amplifying systemic risk.

In the mainstream marginalist economic fantasy, the most serious systemic risks are assumed out of the models (for example, a long term period of massive unemployment), and therefore are not allowed on the agenda for consideration. But being unable to discuss a systemic risk in the modeling framework that has been adopted is not a protection against systemic risk as much as an indictment of the modeling framework.

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not sure what you mean here exactly

There are also "different CDSes" as I understand things so far (but we're now deep in the financial jungle so it's easy to step on a snake and not realize it!)

Right I believe that capital requirements in the case of a default are one of the reforms.

I also am hoping that the potential liability is on the books in the case of a default. My understand is they just counted the premiums, the fees and never put on the books the payout amounts in the case of default.

I have some other obvious one, which is you cannot allow unlimited CDSes on one underlying asset to then be traded like baseball cards.

That's insane it's like issuing 1 million insurance policies for 1 million different parties that Joe Smith's house will not catch on fire and burn to the ground.

Even worse, these CDSes are being used as a "metric" for other CDOs, not historical default data.

On modeling framework, there are assumptions and then there is beyond belief "bad math".

As I understand things normally Academia, the field itself challenges and reviews itself so I don't know what happened in this case but there needs to be some sort of regulation
of the actual financial mathematics, i.e. the models.

I cannot believe they let "products" based on such obvious mathematical flaws out onto the market.

bad math post

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If you put sufficient regulation on CDS's so that ...

... they are not ticking time bombs, what would that be?

(1) The issuing party would have the CDS liability backed by financial assets sufficient to meet its liability obligations, and

(2) Only those with an insurable interest would be eligible to buy them.

(2) protects against the systemic risk that widespread losses creates liabilities far in excess of the original losses, amplifying systemic risks during a downturn (exactly when you want a shock absorber rather than an amplifier), (1) protects against the fundamental moral hazard in any contract to take a stream of income in return for an uncertain but potentially large liability.

But then they are insurance (for one thing, under (2) they are not tradeable) and with the costs of compliance with (1) and (2) offer no discount or other benefit compared to conventional insurance.

And short of that, they still amplify systemic risk.

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Pt Barnum Clause?

There's a sucker born every minute?
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Moral hazards would not exist in a system designed to eliminate fraud.

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Maximum jobs, not maximum profits.

That's trading them on the open market without ...

... the reforms that are needed.

Marginalist worshippers at the alter of the perfectly competitive market may not wish to admit it ...

... but for some things, you need a going concern operating under effective regulation. Insurance is one of those things, with the moral hazard of the ability of the insurer to make good on the claims, the moral hazard of the temptation of the insured to falsify claims, and the problem of multiplying systemic risks in the case of over-insurance.

The developers of Credit Default Swaps figured they were very clever in paying off against an externally verifiable credit event, but they do nothing for the moral hazard of the insurer to make good on claims, and are open to massive over-insurance.

Those problems are intrinsic ... in particular, you cannot trade insurance coverages in a competitive secondary market if coverage is limited to those with an insurable interest.

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Of VALUES and values

Reminds me of the interchange during a Senate hearing back around the late '90s or 2000, between the beleagured head of the FASB and that anti-American traitor and cretin, Phil Gramm, who absolutely would not have any standards applied to derivatives and securities, etc.

So, does that firm Markit still decide the valuation of credit default swaps???

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My take on all this madness

What's happening here is the collision of several realities:

  1. You had institutions, who years if not decades, believing the hype they built themselves to sell to their clients.  I remember several years ago reading about how when Goldman Sachs was expanding in the City of London, they would make themselves out to be bigger than they were through various stunts like having all their employees even come in on the weekend while their competitors were closed.  In a way, what you saw in these financial institutions was similar to what happened to Christopher Walken's character in the Deer Hunter.  Problem was, AIG and others thought they were dealing with a 100 chamber gun with one bullet, not a hundred chamber gun with one empty chamber.
  2. That you can't simply create your own damn financial instrument to meet a client's needs.  This could work if you wanted to create an index fund or a mutual fund that only invested in dividend-paying stocks.  But often these were mean't for a wider audience and that means at the very least putting it on an exchange.  What happened here was that mark-to-market was not instilled immediatly because they tried to make each CDO "unique".  When you invent a new financial instrument, it should be done with care especially in regards to counterparty risk.  Everytime an exchange like the Chicago Mercantile Exchange (CME) comes up with a product, they don't just launch the damn thing, it's put through it's paces with folks who do clearing.  These boutique investment firms thought they could essentially be an exchange and a broker.  Yes, you'll get that tailor-made product for your financial needs, but give up something in the end, nothing is truly risk free.
  3. Derivatives products work when they are designed well and implemented on a regulated environment.  Farmers have been using futures, for example, since the 1800s (actually Japanese farmers going back to the 1500s have been doing something similar), you never had a blow up like you see today.  Credit Default Swaps can and would work, if implemented on an exchange mechanism.  What you need is a standardized contract, clearing to assure counter-party risk, and a pricing mechanism. You actually had a pricing mechanism for CDSes, you even had an OTC exchange.  What you didn't have though was clearing.
  4. Many of these items will never be liquid.  This brings us to today.  The reality of the situation is that we now have to be discriminating between those derivatives that are somewhat liquid and those that aren't.  The former can have mark to market, but there needs to be a proper exchange for these things.  Both the CME and ICE are going to have such a thing, and these banks should be made to trade them on it to get these things off their books.  As for the iliquid ones, well unless our goal is to bankrupt these banks in some attempt to punish them, we will have to facilitate either a suspension of FASB 157 for these or some hybrid.  Now if there is a suspension or a hybrid, then I think that each of these will have to be re-engineered to reflect the reality of risk.  As you all know, 99% of these were developed in a way where it was always assumed that REI would go up.  That needs to change.  If they can come up with a risk model in the form of the Black Scholes formula for something like options, they can for CDSes and CDOs. 
  5. Banks holding on to these illiquid derivative step children, that must be re-engineered, will have to realize they won't get all their money back.  Indeed, if after the re-engineering it is deemed tradable, then place these fuckers on the exchange.  The goal is to work on these things so as to make them tradable, to go from completely illiquid to just having crappy liquidity.  There are many futures contracts that have drek for liquidity, but are still traded.  No different here, just that the banks are going to realize they won't get all their money back.
  6. Lastly, new accounting rules and financial regulations must be in place to keep in check the establishment of new positions.  In futures trading, you have a margin system, for example for corn it is $2025/lot to open a trade and $1500/lot for maintenance.  If you don't have the 2k to open, guess what you aren't doing the trade.  For sellers of CDSes, its really like selling a naked PUT option.  If I wanted to sell an at-the-money Put, I better have the margin.  The same should be for these institutions who want to establish a new CDS.  Fine, you can so long as it can be traded on a regulated exchange with clearing AND you have the financing to back up the claim of the contract. 

 

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The goal is to have a functioning banking system ...

... composed of banking operations each of which have a balance sheet that enables it to raise funds if a credit-worth borrower walks through its doors.

Regarding bankruptcy:

As for the iliquid ones, well unless our goal is to bankrupt these banks in some attempt to punish them, we will have to facilitate either a suspension of FASB 157 for these or some hybrid.

... having those banking operations is of far more important to the economy than the identify of those operations. If given money center banks are in reality insolvent, and need a fiction to avoid bankruptcy, then what we need rather than a fiction is a process for reconstituting a functioning, soundly financed banking operation from out of that mess.

Given those sound banking operations, we can leave the original shareholders and bondholders to sort out the mess under normal bankruptcy proceedings.

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I'm convinced, at this point

That "functional banking system" is an oxymoron. I never realized just how incredibly far from anything I'd consider sound, wealth-backed money our system had gotten to. We'd be better off with local, person-to-person barter and NO foreign trade than continuing to have these crooks in charge of our economy.

I've got to look into what it would take to amend the constitution to remove the right to coin money and negotiate treaties from the federal government and turn it over to the states. It's obvious that the banking system has gotten too big to succeed.
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Moral hazards would not exist in a system designed to eliminate fraud.

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Maximum jobs, not maximum profits.

Let's not oversimplify things

Mark to Market is a made-up concept as it is. If there is no market how much are these "toxic assets" worth? And yes, they are worth something. These loans are backed by property deeds. The problem is that there is no secondary market to purchase and resell these assets like there used to be. For good reason, no one wants to buy assets that have lost considerable value, and may lose more.

Regardless, these mortgage backed securities ARE worth something and keeping them "Mark to Market" is not fair. We have already beat the banks with a bloody stick. We cannot tell them that these assets are worth nothing and tell them that they have to deleverage at the same time. We shouldn't get rid of Mark to Market all together, but, at the very least, allow them to account for 60-70 of their former value. This would be well below the over all decline of housing prices accross the nation so would remain fair.

Then the banks can use fair leverage and by doing so a market will materialize as housing prices stop falling.

Banks will be much safer investments in the long run.

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Did you ever think that there is no

secondary market because these "toxic assets" are worth less? You said it "no one wants to buy assets that have lost considerable value".

A market has buyers and sellers. Buyers ask price and seller bid. In this case, buyers want $1 and sellers are saying no more like $.47. Buyers can't afford $.47 because that means they are insolvent. But that is what sellers are will to buy the "toxic assets" for - so there is no meeting of the minds - no sale.

Getting rid of Mark to market is not going to change that dynamic. These toxic assets are, at best, heavily discounted to worthless.

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