How Can We Miss Mark-to-Market Rules If They Won't Go Away?

At The Atlantic's business site, Daniel Indiviglio wonders why nobody has noticed that the greatest financial villain of six months ago may be rising from the grave. The Financial Accounting Standards Board (FASB) is considering a return to the mark-to-market accounting rules that were buried in April, amid intense political pressure and bank bellyaching. Indiviglio checks out the minutes of the FASB's July 15 meeting and draws an ominous conclusion:

FASB is suggesting that all financial instruments -- the good, the bad and the ugly -- must be valued on a bank's balance sheet at their market value. Illiquid CDOs, property holdings, credit derivatives and anything else you can think of will all now be marked, mostly down, to what they would trade for in the market. Currently, banks can classify the most illiquid stuff on their balance sheet as "held for investment" or "held to maturity" and use whatever value they believe the assets are worth based on internal assumptions.

Full article here. The comment thread includes the inevitable "this writer obviously knows nothing about the subject as I will now prove by using some acronyms" snipe, and it is not clear that this proposal is going anywhere or that its effect would be as earth-shattering as Indiviglio suggests. Still, given the tsouris mark-to-market supposedly caused, it's notable that the idea is back in play.

The scapegoating of mark-to-market was one of the recession's more absurd phenomena. Clearly, it doesn't help a megabank's balance sheet to have to admit that an asset nobody is willing to buy is, by definition, not worth anything. But isn't that covered by the ancient principle of tuffibus shitibus? You'll find lenders aren't willing to value your Beanie Baby collection at the high price you know it would fetch if only people realized how valuable it may be someday. I've reluctantly had to remove "Admiral of the Bolivian Navy" from my résumé. We've all had to make hard concessions to reality. Why shouldn't banks?

Thanks to Rob McMillin for the find.

Comments

[Bob Smith]

The problem with mark to market is threefold.

First, why does the market value of an asset I have no intention of selling matter? Yes, there may in fact be no buyers for the asset, but that only matters if I'm looking for one.

Second, MTM triggers unnecessary margin calls on companies that are both profitable and cash flow positive. That can hardly be a good thing.

Third, MTM triggers cascading failures as company A's MTM of its assets forces B to lower the value of its assets, B forces C to downgrade, etc etc. A single large counterparty could take down the whole system.

[DJF]

"""First, why does the market value of an asset I have no intention of selling matter? Yes, there may in fact be no buyers for the asset, but that only matters if I'm looking for one."""

It does not matter as long as you do not use that asset as collateral in getting loans. Its not that the banks have assets that they don't want to sell, its that banks have assets which they might be forced to sell in order to cover bad debts and so their assets much be valued so that we can see if the bank is capable of covering its bad debts.

You can't have it both ways, say that you are not going to sell an asset and so there is no need to value it and at the same time use that asset as collateral on loans.

[robc]

Shouldnt the valuation of the collateral be a issue to be resolved between loaner and loanee?

And, yes, I know the obvious response, the solution is to get the government out of the loaning business.

[swillfredo pareto]

I've reluctantly had to remove "Admiral of the Bolivian Navy" from my r?sum?. We've all had to make hard concessions to reality.

Time Magazine's Person of the Year for 2006 still proudly graces my resume.

[Jim]

The very minute rule that has caused so much controversy is the one that forced the change from using mark-to-market for things that would probably be sold, to things that might be sold sometime. Anything might be sold sometime, any statistician will tell you in court, so the banks were forced to use MTM for everything, including, like Bob Smith said above, "profitable and cash flow positive".

[Billy]

That rusty old jalopy up on blocks in my front yard is worth a lot of money when it's fixed.

[Untermensch]

I read an example of the problem with MTM once. It was written be a guy in aeronautics. He talked about the problem of an inventory of replacement nose cones for 747s (IIRC): they have a value when there is demand for them (hundreds of thousands of dollars), but that demand is infrequent. Nevertheless parts companies like to hang on to them because when they are needed they are needed not today, but yesterday, and manufacturing on demand them takes too long. However, because there is usually no demand for them, they have to be valued as scrap metal under MTM (because that is their current market value). So rather than being able to list them as a valuable asset, they have to be listed as scrap metal, which lowers the value of the assets on the books, even though these things could be realized in the medium-to-long term for a reasonable value.

There are some things where MTM works, but this situation isn't all too different from a company hanging onto some presently illiquid assets in the hopes of a turnaround. Just because they don't have a certain market value right now doesn't mean that they won't down the road. Of course, we don't want banks saying that these things are worth a ton when they're not (hence the desire for MTM) and the long-term value is uncertain (but probably higher than MTM allows), so what is a bank to do? Declare it has these assets not worth the paper they are printed on (even if the people who own the mortgages that they are based on are paying their mortgages and delivering positive ROI) just because no one else wants to take that risk at present? It's not hard to see why a bank that knows its paper is good would object to MTM being used to devalue those assets...

[MJ]

As I recall the problem is not with mark to market by itself but the other regulatory requirements that kick in when market fluctuations devalue the banks assets too much. In other words, mark to market is reasonable in itself, but how it works with other regulations make for perverse incentives.

[This Dave]

In the case of the 747 parts, what sort of timescale does MTM demand? Is there a market if you sell one a day? One a week? One a
month? At what point do the nose cones become scrap metal, and why?

[I, Kahn O\'Clast]

Having worked on Wall Street most of my professional life, I have to say that there is no way to avoid MTM and have a reasonably functional financial system.

W/out MTM no firm should open lending and trading lines with any other firm since there is no reason to expect that your counter party is solvent. And how would one value one's investment portfolio if a huge number of financial assets (including the valuations of, say, stock of any given firm that hold said assets) are simply valued of mark to wishes?

In addition, deposit insurance does reduce the risk of bank runs, but when FDIC is used, it assumes that it is backing deposits of an institution that is illiquid and not insolvent (insolvency requires intervention and closure - theoretically before a run happens). As a taxpayer I do not want FDIC bailout money backed by vaults full of beanie babies.

[robc]

W/out MTM no firm should open lending and trading lines with any other firm since there is no reason to expect that your counter party is solvent.

How about you value the other firms assets? Or agree on a neutral standard. That standard could include MTM or not, as you both see fit.

[Suki]

I've reluctantly had to remove "Admiral of the Bolivian Navy" from my r?sum?. We've all had to make hard concessions to reality.

Time Magazine's Person of the Year for 2006 still proudly graces my resume.

Removed it from mine. 'twas a painful episode.

[Suki]

That rusty old jalopy up on blocks in my front yard is worth a lot of money when it's fixed.

If you hurry to a dealer it may be worth over $4,000 while the handouts last.

[P Brooks]

Speaking of clearly established market values, apparently our ol' pal Barney has been doing some serious arm-twisting to prevent foreclosures. Because the last thing we need is a legitimate price discovery process.

[Anonymous]

Just to phrase it a different way: the key to calculating the economic substance of an asset depends completely on what its estimated value is when it's going to be used as an input or liquidated under normal operating conditions. Otherwise, scrap metal values for plane nose cones and pawn-shop value of highly illiquid bank assets actually makes sense.

But if you're assuming something other than "normal operating conditions" for financial statement purposes, then doesn't that counter the fundamental "going concern" assumption? Otherwise you're justifying, on paper, spending a lot of money shaping quite a bit of metal for an airplane, yet not allowing that asset's book value reflect the added value.

If they want to switch to cash-flow statements instead of dealing with historical and economic costs, they should just say so.

[Billy]

That rusty old jalopy up on blocks in my front yard is worth a lot of money when it's fixed.

If you hurry to a dealer it may be worth over $4,000 while the handouts last.

Dammit, I thought it was "Cash for Cluckers"!

[Heinrick]

When the market price for some of these CDOs was done to .29 to the dollar they were originally valued at, lost of people were going around claiming that the market had failed because it was incorrectly pricing these assets. I remember thinking it was odd that noone seemed to consider the idea that right now they really were worth only .29

[Ray Gardner]

What are the time constraints in determining the market value of an asset?

I could see making a way to assess the value of assets in such a way as to reduce the volatility. Maybe some kind of running average over a certain period of time that would specifically applicable to a group or classification of assets.

Real estate would have a larger time frame for valuation, than say a portfolio of stocks.

[hmm]

Bob got it right. He missed one thing that has bothered me since the beginning of MTM, even before the realization that CDO and more importantly CMOs can actually increase risk rather than decrease it by complicating the ability to value the underlying asset.

If you get rid of the nefarious dipshittery involved with CMOs that caused a mountain of problems, namely the use of back scholes to evaluate derivative risks on long term products, the assanine traunching, and my favorite the complicit assclowns at S&P and Moodys rating the traunches and look at just the CMO you have an asset based product. If that asset is land, in the economic sense of land, then you have an asset that will not go to zero. Finite, indestructible, material assets don't hit zero, land is never worthless as long as humans exist. Therefore forcing a product that has its value based in land is never worth zero. CMOs and CDOs based in land(in the economic sense) should never be marked to zero.

I'm using land in the 3 (or four depending on how you look at it) factors of production basic economics sense.

MTM also assumes markets are working normally. But that is another story.

I'm glad someone hit the going concern argument too.

I've always had an issue with the FASB. They aren't appointed by congress, they are completely independent from the government, they do have a government counterpart and representative, but that person does not vote. Yet the FASB rules are made law, and then used in criminal proceedings by the DOJ. I'm all for industries having their own governing bodies, but the ability to influence criminal legal action of a non-government entity is a little wonky to say the least.

Real estate would have a larger time frame for valuation, than say a portfolio of stocks.

Land held for sale falls into two basic reporting requirements. If I remember correctly both use some sort of fair value based on market.
1) It is inventory or treated as such if the business is selling and buying land. Valued at fair value.

2) It is property held for sale, or a part of discontinued operations, if it is real estate that is just something you are looking to sell. Valued at either an impairment if a loss is expected or at book if no loss is foreseen. Market value used to determine this.

Market effects both, but the outcome on the company is different.

The MTM for banks effects investment and not land held since it is effecting CDOs and CMOs, which as I stated above can be based in land.

I assume I didn't use too many acronyms. Accounting and the military are brother and sister when it comes to acronyms.

[hmm]

Accounting is a cottage industry almost created by the government.

There is a need, but the level of need and complexity would be far less if government was the out of the picture.

[hmm]

On banks, we are almost to 70 FDIC failures this year.

[ransom147]

I've reluctantly had to remove "Admiral of the Bolivian Navy" from my r?sum?. We've all had to make hard concessions to reality.

Time Magazine's Person of the Year for 2006 still proudly graces my resume.
Removed it from mine. 'twas a painful episode.

i had to ditch United States Senator...

[Bob Smith]

Its not that the banks have assets that they don't want to sell, its that banks have assets which they might be forced to sell in order to cover bad debts and so their assets much be valued so that we can see if the bank is capable of covering its bad debts.

The lender should value the bank's assets as they see fit. So long as it's disclosed, why is it the government's business how assets are valued?

[Aresen]

I've reluctantly had to remove "Admiral of the Bolivian Navy" from my r?sum?.

How were you to know that the surplus battleship that your cousin helped you buy couldn't make it up the Rio Desaguadero to Lake Titicaca?

Goddam rules-bound Court Martial.

[Mad Max]

I'm sure Reason will post about this, but I thought I'd be the first to call attention to it:

Indian Health Minister says that TV is the best contraception:

'Ghulam Nabi Azad, the Health and Family Welfare Minister [of India], has called for the country to redouble its efforts to bring electricity to all of its huge rural population.

'The introduction of the electric light and television sets to those vast areas that still did not have them would discourage procreation, he argued.

'"If there is electricity in every village, then people will watch TV till late at night and then fall asleep. They won't get a chance to produce children," Mr Azad said. "When there is no electricity there is nothing else to do but produce babies."

'He added: "Don't think that I am saying this in a lighter vein. I am serious. TV will have a great impact. It's a great medium to tackle the problem . . . 80 per cent of population growth can be reduced through TV."'

[wayne]

I support MTM. Without it, how does an investor know what a bank (for example) is worth when he invests?

The lack MTM is, at least partially, what drove the economic chaos we are in the midst of now.

MTM is about honesty and transparency; those are things we need.

[hmm]

I support MTM. Without it, how does an investor know what a bank (for example) is worth when he invests?

The lack MTM is, at least partially, what drove the economic chaos we are in the midst of now.

MTM is about honesty and transparency; those are things we need.

So until 2007 all valuation of banks was wrong? Or we couldn't value banks as investors? I call bullshit. Valuation is based on the riskiness of future cash flow. The key in that sentence is future, not current market. Market value could possibly be seen as helpful in determining future risk, but no more than any other technical analysis. Mark to market does nothing for you in valuation.

How exactly did a lack of MTM have anything to with the melt down of MBS and their derivatives?

MTM has nothing to do with honesty or transparency. You could argue it is based in a conservative principle or some diluted variation of matching profit and loss to the same time, but that's about it. Nothing in accounting deals with honesty. Accuracy maybe. MTM actually clouds transparency by taking investments and moving their value to today when their value is sometime in the future. Which as mentioned violates the going concern and a vague application of the matching.

[hmm]

Tags, I fail at them.

But I like kittens so that makes up for it.

[wayne]

hmmm, so, presumably you are willing to pay $1M for a 2000 sqft house in Reno, NV. After all, they were selling for that price only a couple of years ago, and undoubtedly will sell for that much as soon as rationality returns to the market.

[wayne]

So until 2007 all valuation of banks was wrong? Or we couldn't value banks as investors? I call bullshit.

Yes, valuations based on lack of knowledge of the value of collateral held by banks was wrong, if it weren't they would be valued similarly today. Many did value banks correctly; they saw the house of cards for what it was: bullshit piled on top of horseshit by guys wearing pin-striped suits.

[hmm]

mmm, so, presumably you are willing to pay $1M for a 2000 sqft house in Reno, NV. After all, they were selling for that price only a couple of years ago, and undoubtedly will sell for that much as soon as rationality returns to the market.

What does my willingness to pay for a piece of real estate have to do with the valuation of an equity? The real estate is not what is being valued at zero, you don't seem to understand what is effecting what. Your assertion is that MTM has made the valuation of equities more accurate. Why are you looking backwards at what something was worth 1 year ago, something that is only remotely related to the actual value of the derivative it backs. (which is one of the problems and isn't addressed by MTM) I honestly think you don't know the first thing about the equity market and how technical or fundamental valuation works.

Yes, valuations based on lack of knowledge of the value of collateral held by banks was wrong, if it weren't they would be valued similarly today. Many did value banks correctly; they saw the house of cards for what it was: bullshit piled on top of horseshit by guys wearing pin-striped suits.

The value of the collateral isn't being valued the derivative is being valued at zero based on it's market value at one point in time without respect to the underlying risk or value in the collateral. The collateral will never go to zero, see my first post. You honestly think that prior to FAS 157 all banks and companies holding such derivatives were valued wrong? 200 plus years of the NYSE equity markets and until 2007 every derivative not using MTM was valued wrong? The house of cards was created by leverage not the underlying asset. The underlying asset served as the toothpick holding up the house. Who are they? Are you implying that the FASB and the SEC somehow saw the MBS meltdown coming and did nothing? You realize SFAS 157 is a response to Enron and marking to model manipulation correct? You realize MTM has been used in commodities markets to regulate margin accounts for quite some time. Adapting its use by commodity exchanges to other derivatives was sloppy and haphazard.

I'd like to see a mathematical break down of how MTM helps you in any valuation. Whatever means fundamental analysis for valuation of an equity you want to use. Maybe I'm missing what you are attempting to say.

[Robin Hanson]

Mark to market isn't obviously wrong, and is probably better on net. That doesn't mean all existing rules about what you do when accounting value goes negative make sense.

[Jim Stewert]

Wow, that is downright scary when you think about it!

RT
http://www.anon-web-tools.us.tc

[rm2muv]

I am not a financial wizard, but I can't make sense of arguments that we shouldn't count holdings at current market value when assessing assets of a bank.

My wife and I are both savers instead of throwers and we've saved a shitload of stuff in our 38 years together (trust me, we're trying to move into a new home), but no one in their right mind would try to put a value on any of it based on what we thnk it might be worth some day. That doesn't mean we should get rid of it (well, at least not MY stuff), but I don't think anyone would, or should, take it as colatteral for anything beyond current value.

Mark to market seems a pretty reasonable approach to me.

[hmm]

If you put your home on the market and can not find a buyer is your home worth nothing for the period of time for which you can not find a buyer? Do you report a write off for its entire value on your tax return if your home is for sale and has not sold at the time you file your tax papers?

There are issues with liquidity and value for banks, but to assume all assets are the same and then assume they are all to be valued at the same time using the same method is silly.

[James Anderson Merritt]

Hmmm wrote, "There are issues with liquidity and value for banks, but to assume all assets are the same and then assume they are all to be valued at the same time using the same method is silly."

Precisely. Assessed value is ALWAYS a fiction, so choice of valuation method only means selecting the most preferable or convenient fiction. Of course we can expect government to choose the method that favors or is more convenient for government, even if it is awkward or counterproductive in many cases, and bears little or no relationship to reality in any case.

Where mark-to-market rules seem to hurt the worst, in my opinion, is when someone who holds an asset is taxed on the imputed value of that asset, rather than on proceeds gained when the asset is sold or transferred. Exercise of stock options is one notorious example. Maybe after working your keister off for little or no pay for a year or so, being compensated primarily or exclusively in stock options, you finally get a "payday" after the stock goes public and its value shoots into the stratosphere. But now you may have a dilemma. Under rules that existed when I had options to exercise, which may not exist anymore because they were so evil, the option-holder would become liable for taxes on the full imputed value of the stock on the day of exercise (actually, the difference between that value and the strike-price actually paid to exercise). This was all well and good if what you did was to exercise the option and sell the stock the same day. But if you actually wanted to own the stock and held it, you would have to pay sometimes enormous taxes just to keep it. And woe be unto you if you later found yourself needing to sell the stock to pay the taxes, but only after the price has fallen so low that the proceeds from the tardy sale could not cover the tax obligation.

Although that particular rule for stock options may have been scuttled in the past decade or two, I have read where it or rules like it have bedeviled people in similar ways -- for example, tax on a gift of art which forced the recipients to sell the gift in order to pay the taxes. As I understand it, such horror stories are fairly common.

There ought to be some bedrock principle in the tax law, whereby transactions can only be taxed in-kind, and never if collection of the tax would injure (or require the injury) of a living being or destroy the integrity of a work of art or a collection. So if Mom and Dad gave Junior 100 head of cattle, and there were a 5% gift tax, the government would get five head. But if Mom and Dad gave Junior just 1 calf, the government couldn't touch it because taking 5% of the calf would injure the animal. Or if an artist gave his latest work of art to his longtime companion, the government couldn't touch it because to take 5% would be to destroy the work of art. On the other hand, if the companion sold the art, the government could take 5% of the proceeds. In my stock option example, I'd have to give the government 5 shares of stock per 100, but I wouldn't owe them cash money based on the potentially huge difference between the strike-price and the "fair market value" on the date of exercise.

But really, all my suggestions amount to are pleas for the government to respect reality, exhibit a little common sense, and show some mercy to the citizens whom it is supposed to serve. What are the chances of THAT ever happening?

[Mr. Chartreuse]

He added: "Don't think that I am saying this in a lighter vein. I am serious. TV will have a great impact. It's a great medium to tackle the problem . . . 80 per cent of population growth can be reduced through TV."'

"Your cable television is experiencing difficulties. Please do not panic. Resist the temptation to read or talk to loved ones. Do not attempt sexual relations, as years of TV radiation have left your genitals withered and useless."

[robc]

JAM,

The example you gave happened to a friend of mine. BK was the end result.

Partly he screwed up because he had no idea of the tax implications and he wasnt expecting the AMT either.

[Hazel Meade]

Supporters of MTM should remember it didn't exist before 2007. It was a new rule.

The problem with it is that it is tied to the bank's reserve requirements. If the value of what they have in reserve swings wildly every time the market value drops, they are suddenly overleveraged, and the reserve regulations kick in and force them to sell assets at the bottom of the market.

I think mark to market is fine, if it applies SOLELY to financial statements for the sake of other investors. It just shouldn't apply to valuation for the sake of capital reserve requirements. You can't have sudden market shock triggering sudden regulatory interventions. Daily market values can swing widely.

Maybe that means the banks should put their reserve capital into something other than mortgage bonds. They probably should. But unfortunately mark-to-market was introduced right when those mortgage bonds were imploding in value.

Mark-to-market did not cause banks to make bad loans or buy mortgage backed securities. It did, however, help make the crisis a contaigion by triggering cascading failures.

[hmm]

Supporters of MTM should remember it didn't exist before 2007. It was a new rule.

That's not entirely true. Several exchanges have used MTM to balance margin accounts at the end of trading. Part of the problem is that just that, it was adapted from commodities markets and another use. The idea has been around for a long time.

There is nothing inherently wrong with the idea of MBS, but like anything else the idea can be abused. Especially if you get enogh hands in the till.

[hmm]

god I can't get a decent sentence out, sorry.

[Hazel Meade]

There is nothing inherently wrong with the idea of MBS, but like anything else the idea can be abused. Especially if you get enogh hands in the till.

Well, the banks probably should be putting their reserves into something more secure.
Of course, (A) they would have stuck with treasury bonds if the fed hadn't dropped interest rates so low, and (B) everyone thought the MBSes were much safer than they actually were, due to the screwed up ratings.

And the ratings got screwed up because the housing market started becoming correlated, due to the bubble ... which goes back to the fed, again.

[James Anderson Merritt]

# robc | August 2, 2009, 9:06pm | #
# JAM,

# The example you gave happened to a friend of
# mine. BK was the end result.

# Partly he screwed up because he had no idea of
# the tax implications and he wasnt expecting
# the AMT either.

No one expects the Spanish Inquisition!

Seriously, should there ever BE laws, or rules, or regulations, which set people up for such nightmares, when they are just trying to mind their own business and get ahead? It was the existence of this kind of crap -- and the lack of acknowledgment that the situation was royally messed up, never mind any apology for it -- that convinced me that the government was out of control back in the 1980s. It's not a servant, or a protector, it's just a trap.

I'm sorry for your friend. I didn't have to go through BK, but I might as well have. The only bright side to the entire episode was that I met and married my wife despite the government shenanigans. Our son just turned 18 earlier this year, so obviously it worked out OK. But I know what I know.

[R C Dean]

The problem may not be so much how to value various assets, as what assets we allow banks to hold and count as equity.

Back in the day, banks were limited on what investments they could make. Turns out maybe that wasn't such a bad idea.

If the alternatives are mark to market and "Currently, banks can classify the most illiquid stuff on their balance sheet as "whatever value they believe the assets are worth based on internal assumptions", I know which I prefer.

[Invisible Finger]

I read an example of the problem with MTM once. It was written be a guy in aeronautics...

... who either didn't know what he was talking about, or was being obtuse, or was lying. Cost of replacement(less depreciation) is valid mark to market accounting.

[Invisible Finger]

If you put your home on the market and can not find a buyer is your home worth nothing for the period of time for which you can not find a buyer?

Yes. Detroit, for example.

[hmm]

Yes. Detroit, for example.

So you're telling me you would not take property in Detroit if it were offered to you for $1?