Sunday, March 8, 2009

Yes to Suspending Mark-to-Market

Steve Forbes has been beating a drum over the last month, repeating his call to suspend mark-to-market accounting rules. I think that I have finally been fully convinced that this is a good idea. Not permanent suspension, but perhaps a two year holiday from these requirements.

As an employee of one of these bailout blackholes, I have seen the damage to my firm from these kinds of rules. If it were not for them, I suspect that we would never have needed a single dime of government money. Companies with positive cashflow should not be going insolvent because the market value of assets that have not defaulted and they do not intend to sell have lost value.

Why is mark-to-market good?

It forces companies to report what the actual value of their securities are, and not just what they paid for them (like under book value accounting). As an analogy: Say Bob is applying for a new $2 million construction loan to build an apartment complex. He is using his existing complex, which he bought 3 years ago for $2 million as collateral. The problem is, that his old complex has been condemned by the city for health code violations. His collateral would only sell for $1 million on the open market as of today.

Corporations sometimes do the same thing. They buy assets at price X, those assets plummet to price Y, yet they report the value and solvency of the company based on a depreciation model or book value based on price X.

Why is mark-to-market bad?

When fears of corporate defaults are more random, it is fine. If it is feared that Company A will default, then companies B – Z write down any assets they held in company A. Fortunately, those losses are spread across a large number of companies. There is damage, but it isn’t that bad. Mind you, this can occur under the fear of defaults, and not actual default.

When fears of corporate defaults are widespread, it can cause a cascading effect of failures. If it is feared that companies A-I default, then J-Z have to write down those assets. Because of the large write downs by companies J-Z, fears of wider defaults grow. A vicious cycle develops, what we’ve dubbed “contagion”. A critical mass of write downs can lead to total meltdown like we’ve seen.

Using another analogy:

Imagine that you bought a house for $500,000. You had $100,000 down, so you borrowed $400,000. Imagine too that everyone in your city has done the same thing. Due to current market conditions the value of your homes fall by $200,000. Everyone in town now owes around $400,000, but has homes that are only worth $300,000.

As it is right now, the vast majority will just ride it out. They will keep paying their mortgages and prices will eventually rise over the coming years and you will all be back in the black some day. My parents did this during the Oil Bust here in Houston during the 80s.

Now, let’s assume that all home loans required mark-to-market accounting. That is, if your home lost value, you were required to post more collateral to cover the loans. Everyone in town now had to come up with $100,000 of assets to add as collateral. Anyone who failed to do so within 3 months would have their homes repossessed.

What do you think would happen to this town? As repossessions soared, prices would fall further, requiring even more assets to be posted. The town would be destroyed. Virtually no one would be able to keep their home.

In short, I think Mark-to-Market is good 95% of the time, but it creates a systemic risk during a financial slowdown. I agree with Steve Forbes, and I think there should be a 2-year suspension for most firms.

8 comments:

Doug Keegan said...

Newt was calling for elimination of mark-to-market - or using a three year rolling average, if memory serves - back in September as part of / in place of TARP.

Brian Phillips said...

Good or bad, I am curious why you think the government should even be setting accounting standards. Isn't that something that should be left to the private sector?

Brian Shelley said...

Doug,

I suspect that Newt got it from Forbes. I think I've seen him write on this 3 times now.

Brian,

Complete deregulation? All in good time. Regardless though of the regulatory body, public or private, this type of rule needs to have an escape clause in times like this.

At my work I calculate Risk-Based Capital, which has the same basic flaws as mark-to-market. When times are good, we need to hold very little, when times are bad our capital requirements could head to infinity. With RBC, they instituted a smoothing mechanism which helps prevent some of the problem.

Vincent said...

@ Brian

You're right to point out some flaws in mark to market, but I'm in trouble with laws that are "good one day, bad another one".

The problem with "variable in time" laws, is that nobody can tell when the "good" rule becomes a "bad rule".

I agree with Brian Phillips proposal, there should be a set of competing privately made accounting rules, and companies should choose the rule they use, and the market should select which rule is better

that said, we don't live in a perfect world, and, if a "state made" rule must be set, I would say that short time (e.g 4 quarters ?) amorticization of potential losses would be a better arrangement than a volatile "mark to market" rule which turns every market downturn into a mess.

The short delay should mandate toxic asset holders to find a way to make them liquid again, either by accepting deals with hedgers, or by breaking securities loan by loans and recomposing new simple securities, some with "good loans", other with bad ones, and writing down effective losses on bad ones.

I'd add that primary state interventions (Helping the Bear Stearns Bailout) increased the badness of mark to market rules, since toxic asset's holders became eager to wait for a government purchase of this bullshit, instead of trying to trade them at a negociated price with people like Lone Star's John Paulson. "Better hank than John"... It contributed heavily to "freeze" the MBS market.

Rick Neaton said...

Hello Brian,

Why doesn't your company simply classify its debt securities as a Level 2 asset and mark them to a model that it discloses in a note in its financial statements? If it believes that current credit markets are disorderly, it can do so and disclose the difference in the model valuation and market prices in another note. Then, it would only have to writedown shareholder equity without impacting its income statement.

FASB 157 requires fair value accounting. It does not require that all assets always be marked to the market price closest to the closing date of the financial statement. The SEC clarified this point six months ago.

Of course, in a Sarbanes-Oxley world, marking all assets to the market gives cover to the CEO and CFO who must sign their financial statements under oath and to the auditors who saw what happened to Arthur Andersen when it was prosecuted criminally.

Brian Shelley said...

@ Vincent

Brian P. is right, and that's what I would like to see. Ocassionally, though, I like to talk about reforms that may actually be considered. Suspending mark-to-market is better than "temporary" bank nationalization.

@ Rick

Unfortunately, my bosses have not seen fit to put a Sr. VP title in front of my name, so such discussions on accounting treatment do not include me. I am a mere financial/actuarial modeler.

Anonymous said...

I have a cardboard box that I'm selling for 500,000. In my model, I project it will be worth a cool 2 mil in 2011. Any takers?

Pretty much, suspending mark to market ratings will only keep prices high and protect rich people from losing their money. What is the sense of it if we are going to have to pay the piper at sometime? Is it true that people would act responsibly and we would have a safe landing or would the problem progress similar to what actually occurred? Aren't we just playing musical chairs and that delaying the music isn't going to make another chair appear?

Brian Shelley said...

Anon,

With my models, I am also required by law to rigorous document and defend them to state regulators. I would prefer that regulators be a free enterprise, but it's not as loosy goosy as they make it out to be on TV.