The Economic Populist - Comments for "What is Mark to Market and Why Should You Care?"

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.

mark to market is not a made up concept

it's saying one needs to put on the books the actual value of an asset in the real world.

Don't try to just listen to some pundit and not read for yourself.

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.

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.

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.

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.

Good question

I don't see how they could be traded on an open market with reforms that are needed.

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.

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

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.

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.

My take on all this madness

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

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.
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.
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.
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.
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.
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.

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.

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???

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.

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