REVISITING MARK-TO-MARKET
As the market spirals lower and lower the blame game gets louder and louder. One of the “culprits” in this crisis has purportedly been mark-to-market accounting, FASB rule 157. Steve Forbes wrote an article in the WSJ accusing President Obama of continuing George Bush’s disastrous policy of mark to market:
The most disastrous Bush policy that Mr. Obama is perpetuating is mark-to-market or “fair value” accounting for banks, insurance companies and other financial institutions. The idea seems harmless: Financial institutions should adjust their balance sheets and their capital accounts when the market value of the financial assets they hold goes up or down.
That works when you have very liquid securities, such as Treasurys, or the common stock of IBM or GE. But when the credit crisis hit in 2007, there was no market for subprime securities and other suspect assets. Yet regulators and auditors kept pressing banks and other financial firms to knock down the book value of this paper, even in cases where these obligations were being fully serviced in the payment of principal and interest. Thus, under mark-to-market, even non-suspect assets are being artificially knocked down in value for regulatory capital (the amount of capital required by regulators for industries like banks and life insurance).
If a market dries up in poor economic conditions does that not reflect the supply and demand of the market? If you can’t sell your house in the current market does it make any sense to simply list it at the 2006 high price? Does that reflect reality or does that send a misleading message about current market environments? That is essentially what Mr. Forbes and other critics are in favor of doing with these illiquid assets. As I said last month, changing mark-to-market is nothing more than a clever attempt to conceal the cancer that is plaguing our banks. Mr. Forbes continues:
If this rigid mark-to-market accounting had been in effect during the banking trouble in the early 1990s, almost every major commercial bank in the U.S. would have collapsed because of shaky Latin American and commercial real estate loans. We would have had a second Great Depression.
Oh really? Did Mr. Forbes ever think that mark-to-market accounting would have helped keep us out of this mess entirely? If banks had been forced to mark their books to market for the past 20 years they would have never overallocated trillions in illiquid assets. Marking to model encourages firms to take on more risk because they can mark their books to fantasy prices – whatever management believes they are worth. This only encourages mismanagement and excessive risk taking.
But put aside for a moment the absurdity of trying to price assets in a disrupted or non-existent market, of not distinguishing between distress prices and “normal” prices. Regulatory capital by its definition should take the long view when it comes to valuation; day-to-day fluctuations shouldn’t matter. Assets should be kept on the books at the price they were obtained, as long as the assets haven’t actually been impaired.
Mark-to-market accounting does just the opposite. When times are good, it artificially boosts banks’ capital, thereby encouraging more investing and lending. In a downturn it sets off a devastating deflation.
Mr. Forbes acts as if the accounting rules are to blame here rather than the poor managerial decisions behind the asset purchases. Accounting rules did not force banks to leverage themselves up on housing related products. Poor management and poor risk management resulted in these bloated balance sheets. If anything, stricter rules would have helped keep us out of this mess. The call to change the rules when the game isn’t going in your favor is nonsense. FASB 157 is good for the long-term health of our economy. Changing it now is almost as foolish as thinking that you can solve a debt crisis with more debt. Yes, let’s relax the accounting rules because lax accounting rules got us into this mess. That makes ZERO sense.
My biggest concern with repealing FASB 157 is that it encourages banks to avoid dealing with their problems. We need to force these banks to write-down assets and attack the cancer that is killing them. If it results in massive bank failures and more short-term pain then so be it. It will make the system healthier in the long-term. Waiting for the market to rebound is not a viable strategy. If these problems persist for 5-10 years the same banks will continue plaguing the entire system with their cancerous balance sheets. Hiding the problems through fictitious accounting is entirely counterproductive in the long-term and very risky.
There is a Congressional hearing this week on mark-to-market and many investors think the rule will be overturned. This is more reactive counterproductive policy. As John Hussman said, repealing mark-to-market “is like not opening your account statements.” It doesn’t change the value of the bank’s assets it just hides them. The market is likely to rally on any mark-to-market repeal, but don’t expect the rally to last – the market will quickly realize that the problems are still with us whether they’re swept under the rug or not. The rule change will not improve the balance sheets of the banks. The only thing that can do that is continued de-leveraging and economic improvement.
UPDATED 3:45pm – Apparently Ben Stein is out with a similar piece in yesterday’s NY Times. Few people have been more wrong about this crisis than Ben Stein and Steve Forbes. They have remained optimistic and bullish throughout the entire downturn. And now prominent publications turn to them for solutions? This is almost as hilarious as Tim Geithner or Hank Paulson solving the problems they helped create. The beat goes on….
awesome post. did you read john mauldins take over the weekend?
I read that. This is one of the few times where I disagree with him. I think we need to be more proactive. This is anything but….
Great post, Forbes is an ass. He's been so shrill / hysteric, as if M2M is the reason why we're in this mess. Yeah, Steve, put it all in the closet and shut the door, nobody will know there's a black hole in the bank balance sheets. What a goddam fool. "It's all good, look, the loans are marked at par!" Just another fool helping to drive the economy off a cliff, into the ocean, and down to the bottom of the sea.
"Yet regulators and auditors kept pressing banks and other financial firms to knock down the book value of this paper, even in cases where these obligations were being **fully serviced in the payment of principal and interest.** Thus, under mark-to-market, even non-suspect assets are being artificially knocked down in value for regulatory capital."
I don't think you adequately addressed his central point, above. Should a long term asset, which is paying an income stream, be valued at its market price, or at its life-of-loan value? A bond held to maturity is not a "loss" when the price fluctuates. For that matter, even a put option that has lost value can be profitable to the writer if it expires worthless: and it can show up as a market loss right up to a day before expiration, even with no move in the underlying. Market valuation and maturity should be accounted for separately.
Look at a specific example: a tranche of 30 year loans with 7% default rate is not worth merely $.20 on the dollar to the bank over the 30 years… but M2M demands it be priced as such, which is unpragmatic.
By the reasoning you seem to assert here, that Bush did a good thing with the FASB 157 rule, anyone with a home equity loan should have their loans be called by the bank immediately if the house has lost significant value.
Mauldin: "Let's say a bank has a loan portfolio of 1,000 individual mortgages valued at an average $200,000, for a total portfolio value of $200 million. The loan officers were not very good, and it turns out that 18% of the homes went into foreclosure and lost an average of 50%. That means 180 homes went into foreclosure and that the bank lost an average of $100,000 per home, or $18 million overall. The bank was charging 6% interest, so in a few years it would at least have its original investment back, although the losses would eat into capital.
To make those loans of $200 million, the bank would need at least $20 million in capital, and so would need to go raise some money or reduce its loan portfolio by selling the performing loans. The reality is that for a bank to have such a large mortgage book, it would probably be a much larger and better-capitalized bank. If it were not, it would soon be taken over by the FDIC. *****Note that the remaining 82% of loans are still performing and are carried on the books at full value (again, oversimplified). There is real value in the remaining loan portfolio.***** But what if the bank invested in a RMBS that was rated AAA, and 18% of the loans in the security went bad? Remember, the AAA tranche gets the first 92% of income. The loss to the RMBS is 9% of capital. The losses to the AAA tranche are only 1%. Hardly a catastrophe. Annoying, but something you can deal with. Except for some very nasty rules.+++
Remember, a bond is downgraded to junk if it loses even $1. Now, let's take it to the real world.
Say a bank buys a $1-million AAA portion of that large RMBS. It can use that AAA debt in its capital base, and can actually lever it up about five times, as the rules only make the bank take a 20% "haircut" on an AAA bond. But if the bond goes to CCC, the bank must now move the entire bond to its "risk-impaired" portfolio. And because most institutions cannot buy junk paper, there are very few buyers out there who will want to buy it — mostly hedge funds and private capital. The price on that paper might easily drop to $.50 on the dollar because of the potential for a 1% loss."
I find it hard to see how anyone can disagree with this analysis.
"The accountants, being conservative and living with new mark-to-market rules, make the bank take a $500,000 loss. This directly reduces regulatory capital by $500,000. Banks are required to have a maximum of 8% of risk-impaired assets as compared to solid capital to be considered adequately capitalized. Keeping the asset on the books means they have $1 million of risk-weighted assets. If they have to sell to get the capital required to follow the regulations, they will lose $500,000."
Thus, Mauldin, Forbes, and many others are right. The FASB rules are ridiculous. From AAA to CCC is a huge drop, and not warranted.
TPC Reply:
March 9th, 2009 at 4:55 PM
Mauldin makes great points (as do you), but I think he fails to blame the proper culprit. He is blaming the accounting rules rather than the ratings agencies and rules regarding capital requirements. The problem is that the banks were manufacturing AAA rated products and the ratings agencies were dishing out AAA ratings like it was the norm.
The problem is not M2M, but rather the faulty regulations regarding the relationship between banks and ratings agencies. M2M is not perfect, but mark-to-model is terribly flawed. Personally, I would be in favor of allowing level 3 assets to be priced on a 5 year price weighted basis, but allowing CEO's to mark the prices to whatever "model" they prefer is simply absurd.
Mauldin's thinking assumes two things: 1) assets will reflate over the long-term and 2) long-term assets will be redeemed at par. Neither of those are necessarily true. Long-term bonds are marked to market for a reason – there values change day in and day out based on supply and demand. Nothing guarantees that long-term assets will be redeemed at par or that the economy and these assets will reflate back to their 2006 levels so why should we apply accounting standards based on these false assumptions?
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