Mark to Market, Again
March 5th, 2009By David Goldman
How much of the damage to financials is self-inflicted? Here’s another lesson in the subject of mark to market accounting from Gary Townsend at Tom Brown’s Bankstocks, a followup to an equally sound critique of FAS 157 and its effects. Townsend writes:
Defenders argue that fair value accounting provides clarity and has only helped indentify market problems. There may be some truth to their argument, but in the present economy, mark-to-market accounting offers a better reflection of sellers’ desperation than it does the value of securities sold or investments held on the balance sheet.
I’ve noted here before that FAS157-driven accounting results depend greatly on whether a particular asset is treated as a loan or an investment. Look again at the example of The Bank of New York Mellon, which in the fourth quarter wrote down the value of its $5 billion Alt-A MBS portfolio by $1.24 billion, roughly a 25% mark to market. In its disclosures, the company noted that if that same asset were given loan accounting treatment (and what is a MBS but a collection of mortgage loans, after all?), its expected loss, based on estimated cash flows, would have been only $208 million, a mark of just 4.1%. The difference between the two accounting results: more than $1 billion.
Capital One’s just-released 2008 10-K provides another apt example of how FAS 157 yields disparate and unrealistic valuations, even as it creates substantial market confidence, capital adequacy, and solvency problems for banks, insurers, and others. Note in the accompanying table that, at the end of 2008, the carrying amount of loans held for investment was $101 billion, compared to an estimated fair value of $86.4 billion. Net of a $4.5 billion allowance for loan losses, net loans held for investment were $96.5 billion, $10.1 billion or 11.7% more than the fair value estimate. One should note that at the end of 2007, the estimated fair value of loans held for investment exceeded the carrying amount by more than $3 billion.
Paul Volcker and the Group of 30 proposed to revisit mark to market, but as I noted earlier today, Volcker appears to have been shut out of the Obama inner circle, per Charles Gasparino’s report in today’s New York Post. Closet to Obama, it appears, is White House economic advisor Larry Summers, the man who ruined the Harvard Endowment. As a part-time tout for hedge fund D. E. Shaw, I reported here, Summers tried to persuade Asian sovereign funds to buy AAA-rated tranches of collateralized debt obligations, the same “toxic assets” he proposes to take off banks’ books.
As I have been arguing (and as Townsend shows in the cases of Mellon and Capital One) there is an enormous discrepancy between the expected loss of well-structured AAA’s with a thick buffer of loss protection, and the mark-to-market losses. At least some of the damage is self-inflicted, that is, inflicted by academic economists with an ideological commitment to MTM and not the slightest practical knowledge of how markets actually work.
March 5th, 2009 at 10:59 pm
David,
The shorts are putting excessive downside pressure on anything financial. This is what the prior administration tried to block with the temporary restriction of shorting financials (which I didn’t agree with). Even if the shorts take all bank commons down to pennies, at the end of the day companies like JPM, USB, WFC are cash flow positive. Once we get clarity on the Govt. stress test and the market sees that the dministration “really wants” the banks to pass, hopefully we can gain some stabilization and force the shorts to cover. Based on your analysis of what the insurers are holding, it appears that the Trust Preferreds are going to possibly be defended. I also understand that many banks hold each other’s lower level hybrid securities which is even more incentive to defend said securities.
March 5th, 2009 at 11:49 pm
To me, the most convincing argument I’ve heard so far is that it’s pro-cyclical. If mark-to-market is bad for banks, that just sounds like a problem for ‘greedy evil’ bankers. If mark-to-market exaggerates depressions and asset bubbles then that has impact directly on the wider society and makes a stronger argument politically.
March 6th, 2009 at 1:59 am
David, I find it interesting that it’s mostly the financials that are taking the brunt of the stringent accounting requirements. What if we apply the same principles to nonfinancial firms, by writing off the good will on their books to zero. How would credit spreads look then?
March 6th, 2009 at 6:52 am
One of my associates at Bank of America looked at which balance sheets lived off good will a few years ago and produced what the FInancial Times called “The Bank of America hit list.” Even at the top of the cycle the results weren’t pretty (in 2005).
March 6th, 2009 at 8:22 am
David,
what would we replace mark to market with? Also, v few investors trust the bank’s own valuations by now.
March 6th, 2009 at 3:21 pm
DG:”One of my associates at Bank of America looked at which balance sheets lived off good will a few years ago and produced what the FInancial Times called “The Bank of America hit list.” Even at the top of the cycle the results weren’t pretty (in 2005).”
That does make the pro-cyclical argument less strong on the bubble side, though we’re pretty clearly seeing the downside of this right now.
You know, come to think of it, I can’t imagine how you’d mark good will to market. That’s a strange concept.
I’m just thinking, that if a bank has deposits that can be withdrawn at any time, it does make sense to have assets that can be sold right now to pay back these deposits. And so in this simple case, it kind of intuitively makes sense.
What’s not so clear is if a bank’s depositor has a CD that matures in 10 years (or something similar), then maybe it matters only that the bank has money 10 years from now, not right now? If they have an asset that goes up and down in value in the meantime, it’s not that relevant as long as long as there’s going to something to sell at the future date. I don’t know how Mark-to-Market accounts for this.
March 6th, 2009 at 4:55 pm
The banks don’t have to sell an asset every time a depositor pulls money (unless everyone pulls a substantial portion of their money at once, alla 1929). The bank will draw on fed funds, and short term borrowings from other banks (LIBOR). If in the normal course of business the bank sees abnormal outflows then they raise interest rates on deposits to bring money back in. I do understand your point in theory.