Friday, March 13, 2009

The Mark-to-Market Debate


Early this week, someone asked me about the mark-to-market (MTM) debate. Was there some validity to the idea that a significant part of the financial crisis is being caused by the MTM requirement. I said that I didn't think so and thought about writing something up. I'm glad I didn't because David Reilly at Bloomberg has now made the case against MTM reform for me.

First some background. The banks assets are categorized into 3 classes: Level 1, Level 2, and Level 3 assets. Level 1 assets are fully liquid and are actively traded in a market. Thus, they have well-known prices associated with them. These are MTM assets. Level 2 assets are also known as "mark-to-model" assets. They are illiquid and don't have active markets associated with them. From Minyanville, they "have quoted market prices for similar instruments in active markets, quoted prices for identical or similar instruments in markets that are not active, and model derived valuations in which all significant inputs and significant value drivers [are - D.O.] in active markets." Level 3 assets have been called "mark-to-myth" or "mark-to-make-believe" assets. They are very illiquid and their prices can't even be estimated by decent models because inputs to the models would be unknowable and/or inadequate. They have no or few "observable inputs" and are therefore priced by the management's "best guess."

Markets for liquid assets tend to be rather volatile and right now, they have beaten rather low. The complaint against MTM is that many of these assets are worth more than the beaten down markets are claiming. After all, we know that in a recession (especially a significant one), equity markets for example tend to over-correct on the down side. So it would be unfair to force these banks to mark these "troubled assets" to market prices when we know that as the economy recovers (actually before), these markets with bounce back up.

But Reilly shoots big holes in the movement to "reform" MTM requirements.

Of the $8.46 trillion in assets held by the 12 largest banks in the KBW Bank Index, only 29 percent is marked to market prices, according to my analysis of company data. General Electric Co., meanwhile, said last week that just 2 percent of assets were marked to market at its General Electric Capital Corp. subsidiary, which is similar in size to the sixth-biggest U.S. bank.

What are all those other assets that aren’t marked to market prices? Mostly loans -- to homeowners, businesses and consumers.

Loans are held at their original cost, minus a reserve that banks create for potential future losses. Their value doesn’t fall in lockstep with drops in market prices.

Yet these loans still produce losses, thanks to the housing meltdown and recession. In fact, bank losses on unmarked loans are typically bigger than mark-to-market losses on securities like bonds backed by mortgages.

For most big bank assets, MTM simply isn't relevant because the assets are either mark-to-model or mark-to-myth. At this point, one might call them mark-to-broken-model. Nevertheless, they aren't Level 1 assets. Further, there is the transparency problem.

These investors already believe banks are underestimating just how bad losses will be on their unmarked loans. GE investors, for example, fled the stock due to concerns over its corporate loans and lending to Eastern Europe.

If investors could get a better sense of the losses actually facing GE, they might have more confidence in its financial strength. In other words, we need more mark-to-market accounting, not less.

On top of this, there is the banks' problematic business model of borrowing short and lending long.

This makes banks very different than, say, a homeowner who borrows a lot of money. In most cases, the homeowner has locked in funding. So long as the homeowner makes payments and doesn’t need to refinance, market prices aren’t that important.

Banks must tap debt markets for new money all the time. Investors buying that debt want to know how much the bank’s assets are worth. That tells them how much of an equity cushion the bank has to absorb losses.

For those investors, the current value of an asset, not what management thinks it will be worth, is vital. After all, their biggest concern is getting paid back in the event of default.

If they can’t gauge that likelihood, they stop lending. Banks then can’t finance themselves.

So why all the fuss over MTM.

So why is mark-to-market such an issue? It is being used as a scapegoat by banks and others to dodge two big issues -- their reckless use of borrowed money to boost returns and their inability to make sound loans and investments.

I would add one more point. The idea that we can fix a significant part of the crisis by fiddling with accounting regulations presupposes that this is a "liquidity crisis" and not a solvency issue. But this is what banks always assume when the levered scat hits the fan. "We're fine. Our business model is fine. All we need is a little more short-term cash to get us through the next few months." But this mess is hardly a short-term shortage of liquidity. It isn't even a garden variety recession. These assets are the product of a gigantic, unsustainable, cheap credit, debt-fueled bubble. Trying to re-blow the bubble is a terrible idea but it doesn't matter because it's not going to happen. And for assets like houses, they are still somewhat overpriced when compared to historical data (even after the big hit they've already taken).

Housing prices are not going to bounce back any time soon and may not stop falling for quite a while. These assets are not getting a big haircut from the market because the market is over-correcting. They are getting hammered because they have been massively overvalued. CDOs based on credit card, auto loan, and other non-mortgage debt were also unsustainable. Thus, these assets are not going to return to normal after bouncing off of an artificial market floor. Instead, the market is currently trying to push them back down to normal after bouncing off of an artificial and unsustainable ceiling. The banks are not in a liquidity crisis, they are in a solvency crisis.

The mark-to-market debate is a red herring. The big banks are levered up to Pluto with now-crappy assets bought using borrowed money during a period of massive debt bubble expansion (i.e., a Ponzi economy). And as sure as the purge must follow the gluttonous binge, the bubble is now in full deflationary mode. The big banks ate too much. Way too much. That yakking sound you hear is not an accounting fiction. It is quite real as is the smell of regurgitated CDOs.

(end of post; ignore continue reading statement below)

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