Thursday, October 9, 2008

Mark to Market Accounting

Below is an email I sent arguing in favor of mark to market accounting. I really don't think it is the cause for much blame of this.

First, and most importantly, the mark to market accounting has helped the U.S. make the situation much better than it otherwise would be. How? Because of mark to market accounting U.S. banks have been raising over 400 billion in equity over the last year. Grant it we need 4 to 5 times that but compare that to Europe whose accounting is much more opaque, not to market to market and they have been denying they have a problem at all. Besides UBS (who trade in the U.S. and thus follow GAAP) the European were in complete denial and did not raise equity even though I would argue strongly they are in worse shape than us. The European regulators as recent as a week ago Thursday were throwing insults at the U.S. and then over the weekend were forced to scramble and do the American two step bailing out four banks. The equity window is closed for banks and when the window was open only the U.S. banks took advantage of it though reluctantly. Europe didn't because they were able to fool themselves even more than we are able to fool ourselves, not an easy task.

Secondly, the banks are hardly valuing their assets at FV. That goes back to Bridgewaters contention that there are 500 billion in writedowns on the books of banks. That is why banks are trading at statistically cheap valuations. Everyone who actually knows what the marks on the books of banks are know they are BS. Banks also know they are BS which is why they aren't willing to lend to one another. Changing the accounting doesn't change the fundamental solvency issues at all. It just tries to put the man behind the curtain again. So what do you change by changing the accounting rules? I would argue you change almost nothing. Intrinsic value doesn't change so you are making the argument that banks are trading intrinsically below fair market value and I would argue regardless what the accounting rules are that across the board they are trading above intrinsic value. By changing the accounting, it creates more uncertainty, more obscurity, and focuses the attention once again on something that isn't the major problem which in itself is counterproductive. I would be more in favor of lowering the required capital ratios for a set period of time and actually forcing the assets to true market to get to the bottom of the problem versus doing what Japan did and continually try to obscure the problem.

Sure, some of the assets may be trading below fair market value (especially if the gov sets the market) but if a bank can't survive stress in the markets it tells you the problem is to much leverage. If I run a leveraged hedge fund, I can't send my analysis to my broker showing that I think the intrinsic value is X and it is trading at 30% below X and the market has it wrong. The broker is still going to declare a margin call. That is essentially what the market is doing to banks, saying there is a margin call, which is forcing down the leverage of the banks which is the problem in the first place.

I have much much more I could write about but I will save it if we talk about it at some point. Remember it was the banks who lobbied for mark to market accounting in the first place.

From two weeks ago:
"Blaming fair-value accounting for the credit crisis is a lot like going to a doctor for a diagnosis and then blaming him for telling you that you are sick." analyst Dane Mott, JPMorgan Chase & Co.,


Craig H said...

I agree. The whole point of setting reserves and leverage requirements is to make sure banks have enough capital if and when their asset values decline in market value (weathering the storm). Accounting is supposed to lean towards the extreme end of conservatism by nature. To do anything otherwise would undermine the first rule of accounting.

Anonymous said...

Jason--it's Ashley. Talk about the emperor has no clothes...a few quick thoughts:

1. If not a fair value based on cost to sell, what imaginary value would they like to use?

2. I suppose we are ready to abandon international accounting convergence? I don't see Paulson taking his proposal for companies to have the option of applying IFRS off the table. Yet by "relaxing" mark to market when the values are volatile, we are effectively giving the basis of international standards, opaque or not, a big "nevermind."

3. One of the former FASB board members gave a speech a few days ago I think you would appreciate. Katherine Schipper's argument was that if the selling value is so far below what they are really worth (as in banks complaining that the market is disjointed), she would expect to see people buying, not selling these assets.

Market Seer said...

Ashley - you better be careful. Your boss is leading the charge to suspend it. lol Him and I have had some heated email exchanges about the topic.

Completely agree on all your points. Lehman CDS had to pay back $.91 on the dollar. $.91!!!! So not only did the equity get nothing back but bonds were 90% worthless. Talk about lying about the marks. That is one of the major problems with the banks and why spreads are so high. Banks no other banks books are not marked correctly and basically insolvent. They know this because of what is on their own books.

Anonymous said...

One more item for you--and believe me around here I am in the minority--MARK TO MARKET IS NOT NEW!!!!!!!!
It's been around for 15 years.

The only "new" accounting standards are
1) FAS 157 which is a defintion of fair value intended to beat people over the head because they were ignoring the literature and
2) FAS 159 which is an OPTION to fair value debt for companies not required to do so but who would like to. The option part is weak, I agree, but since they can elect it instrument by instrument I am sure all the newer instruments aren't being marked anyway...

And I still haven't heard what value are they proposing using. Historical cost would certainly aid investors...

It makes complete sense that an overleveraged market without alignment of incentives is the fault of the accountants. If we had just let them lie to their investors, the investors would still be too stupid to have figured it out and we'd all be just fine...poor logic and I am disappointed to see so many highly intelligent investors succumbing to it.

Of course, it's always good to question our own biases...

P.S. A non-scientific survey found many people we invest with don't expect it to change values by more than 5%. Assuming that's true, what is the big deal...

Anonymous said...

To be clear the IBanks have to fair value their debt--it's the commercial banks that can elect the option