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Prophets of Accountancy
Here is Franklin Allen and Elena Carletti, circa 2006:
When liquidity plays an important role as in times of financial crisis, asset prices in some markets may reflect the amount of liquidity available in the market rather than the future earning power of the asset. Mark-to-market accounting is not a desirable way to assess the solvency of a financial institution in such circumstances. We show that a shock in the insurance sector can cause the current value of banks’ assets to be less than the current value of their liabilities so the banks are insolvent. In contrast, if historic cost accounting is used, banks are allowed to continue and can meet all their future liabilities. Mark-to-market accounting can thus lead to contagion where none would occur with historic cost accounting.
Here is a comment on that same paper. I thank Scott Cunningham for the pointer.
Posted by Tyler Cowen on October 3, 2008 at 03:58 PM in Economics | Permalink
Comments
I think you need to separate the questions (1) Should financial institutions report the results of mark to market accounting and (2) What method should regulators etc... use for determining capital adequacy and insolvency.
Not reporting mark to market accounting is a little like an ostrich sticking its head in the sand. That said, an unintelligent, mechanical, and pro-cyclical interpretation of those results by regulators can lead to problems.
Posted by: mgunn at Oct 3, 2008 5:01:11 PM
Well said, and I'd bet it's even worse than mechanical and unintelligent. I'd wager that the regulators, as were the ratings agencies, are now, of all times, practicing aggressive CYA.
Posted by: Andrew at Oct 3, 2008 5:10:03 PM
Ahh, yes, let us conveniently ignore liquidity in our valuations. After all, no one would ever NEED to unwind under ANY circumstances in the mind of a theoretician.
(Sorry for the snark. Usually the posts are AAA here).
Posted by: caveat bettor at Oct 3, 2008 5:16:17 PM
While in general I agree with this, investors are free to ignore mark-to-market just as they are (were?) free to ignore interest, taxes, depreciation, and amortization. If investors beleived bank assets were immensely undervalued they'd adjust the numbers and buy. Personlly I think a lot of investors do beleive this; they are simply afraid that no one else does. Invalid mark-to-market values is a symptom of the crisis, not a cause.
When assets are on the balance sheet as liquid, or nearly liquid, and available for sale, mark-to-market is appropriate. Had they kept this toxic stuff on balance sheet as long term investments and not used it to lever up and make more loans we wouldn't be in this mess.
Posted by: David at Oct 3, 2008 5:23:47 PM
Haven't read the links but:
If using assets as a form of collateral then their value needs to be calculated as if an immediate sale is necessary to cover a default - hence mark-to-market. The issue isn't so much the accounting but the decision to leverage and to keep insufficient cash (and, more generally, insufficient asset diversity) to cover those liabilities.
In the provided quote the part that goes - "...if historic cost accounting is used, banks are allowed to continue and can meet all their future liabilities" - is meaningless. Cash flow, not assets, determine whether a company can meet their liabilities. Regulation aside, if there is no default then asset levels are somewhat unimportant - ignoring capital level agreements. Those agreements, however, if between private parties, can and should be negotiated individually and not blanket defined.
Long-term makes no sense either if the company ends up folding tomorrow and indeed has to sell those assets at the current market price to (partially) cover its liabilities.
Yes, something needs to be reported in GAAP form, and that probably needs to be looked at again since in many cases assuming a company is going to have to sell its assets immediately is being too conservative - especially if there are other ways to make the riskiness of the asset coverage known.
Posted by: David J at Oct 3, 2008 5:26:15 PM
Way back in March, Michael Mandel writing in Business Week pointed out that mark-to-market makes fixed-income securities behave more like equities, with considerable volatility in valuation.
But investors usually demand an equity premium for volatile, perceived-risky investments. In fact, for psychological reasons, humans tend to demand an unreasonably large equity premium, far more than logic or math would justify.
As Mandel suggests, you can't expect investors to buy "equities" that don't have equity-premium returns. Hence, all the apparent bargains out there that no one is snapping up, which dramatically worsens the credit freeze.
Suspending mark-to-market may be economically illogical, but it may be exactly what psychologically irrational human investors need at this time.
Posted by: at Oct 3, 2008 6:05:59 PM
Blaming mark to market accounting for a bank's insolvency is like blaming your cancer on the scientific literature that describes it. Ignoring either doesn't mean you're ok.
Banks chose to overleverage their balance sheets with illiquid assets at overvalued prices. FASB certainly didn't.
The only reasonable way to eliminate mark to market is to use cost accounting but mandate disclosure of all Level II and Level III assets (that is assets that have no readily observable price) and provide the assumptions behind the current reserves held against those assets. So for instance if you hold a Mezzanine CDO comprised mainly of RMBS, you disclose the reserve you are holding against it, and your assumptions that lead to that reserve such as default rates, loss severity, weighted average life of the underlying collateral, etc... This way, investors will have the necessary information to decide if they find the reserving policy to be aggressive or conservative.
Posted by: joe at Oct 3, 2008 8:18:24 PM
I can understand how Mark To Market has clearly been an additional variable to a host of variables that are contributing to this perfect storm.
But why is mark to market is a problem in a crisis?
What caused the crisis? Certainly not mark to market.
Once again another red herring to divert discussions and investigations from the root causes. Government Intervention in the markets.
Posted by: Luis at Oct 3, 2008 8:51:21 PM
Lets just mark everything at 3 times the purchase price. That way we don't have to bail them out for at least the next 3 crises.
Posted by: Yancey Ward at Oct 3, 2008 10:22:29 PM
And while we are at it, lets make sure pawn shops don't get our watches for anything less than what we paid for them.
Posted by: Yancey Ward at Oct 3, 2008 10:23:51 PM
So, instead of a financial crisis, we get a bunch more Enron's
Yay?
Posted by: Robert Olson at Oct 4, 2008 12:06:28 AM
Why was mark-to-market instituted in November, 2007?
Posted by: Sean at Oct 4, 2008 12:59:44 AM
I was disappointed that Buffett on Charlie Rose failed to explain what he meant when he said that banks should be permitted to mark to market. Given the context, I think what he meant was cost -- i.e., market cost.
Mark to market rules didn't cause the bubble. But they sure have made the crash much worse than it needed to be.
Posted by: Michael F. Martin at Oct 4, 2008 2:55:46 AM
Way back in March, Michael Mandel writing in Business Week pointed out that mark-to-market makes fixed-income securities behave more like equities, with considerable volatility in valuation.
But if you are going to hold fixed-income securities for only a short period of time (say, because they are being used as the long portion of a carry trade) then you are trading them as if they are equities. The market value of those assets is of great concern to your lenders and shareholders. If you intend to hold the assets to maturity -- just like your grandmother used to tell you to do -- there is no requirement to mark them to market. If you intend to have your trading department flip them eventually, tough luck if the market price goes down -- that's the only price you are going to get for them.
The only way we would not be having these problems we are seeing now is if investors were simply ignorant of how little capital so many large banks have left. Mark to market is just the bearer of bad news.
Posted by: Ricardo at Oct 4, 2008 4:49:16 AM
As an outsider I have to say that "mark to market" appeals as a political slogan on the back of a naive faith that the experts will choose the correct market. The value of part ownership of a car company could be marked to the market in the companies shares. If it is a small company, making speciality cars, there may be little trading in its shares, yet it could be selling hundreds of cars a month. There is market for the companies products and the price that the product commands in that market is a pretty interesting price to mark to.
Seeing a car maker as a maker of cars is the obvious perspective. It doesn't make it the right one. It is also an owner of land, buildings and machine tools. There are markets for those too. So an asset stripper can sometimes make a good profit by buying land, buildings and machine tools on the market for shares in car manufacturers. You just arbitrage between the different prices for the same assets in different markets.
Since there is good money to be made arbitraging between prices on different markets, saying "mark to market" in a way that skips lightly over the implications of which market you chose could be the start of a scam.
Posted by: Alan Crowe at Oct 4, 2008 7:46:20 AM
There seems to be a collective suspension of disbelief that assets can be reallocated. It is most evident among finance professionals, echoed by "professional journalists", nuanced by career politicians, but never analyzed.
Let's analyze it --
Every up-side has a corresponding down-side. That's a market.
Our current congress critters decided that a suspension of short selling was preferable to a suspension of insider trading rules. That supports the fiction that a market is working -- and punctuates the reality that a market does not exist.
The obvious reallocation of wealth, or "creative destruction" that needs to occur is now set to a timetable and process owned by the critters.
This is SOP. Now is the timer for claiming honor and taking credit for rescuing the patient to whom you've induced a heart attack.
God bless America. Confidence?
Posted by: SheetWise at Oct 4, 2008 7:57:25 AM
The comment labeling traditionally fixed income vehicles as equities is, I think, the right perspective. Anyone trading in equities should understand that should the stock hit the pink sheets, liquidity goes way down. That, however doesn't change the intrinsic value of a share. It reflects the reality that they're in very little demand.
Posted by: meter at Oct 4, 2008 9:16:46 AM
All banks are insolvent. That's what makes them *special*. None have enough cash to cover short-term liabilities, but they are fine as long as demand depositors don't all come in at once. So, when people are freaked and they look at the equity that has taken a hit due to long-term asset values, that's the problem that causes the solvency problem.
And while we are doing all these other draconian things in the economy, all I want to do is relax this arbitrary rule that is causing a lot of the consternation. The rules are there intended to PREVENT runs, NOT TO CAUSE THEM!!!
Posted by: Andrew at Oct 4, 2008 9:51:02 AM
So if we just let them commit accounting fraud, that ends the crisis. Cool.
Us accountants would have never thought of that. It took a bunch of economists and lawyers to develop that concept.
To be fair, no financial accounting system works well in front of an avalanche.
The bankers put poop in a silk bag and declared it had become gold. This little stunt of attempted alchemy was bound to fail.
Posted by: save_the_rustbelt at Oct 4, 2008 11:55:54 AM
"If using assets as a form of collateral then their value needs to be calculated as if an immediate sale is necessary to cover a default - hence mark-to-market. The issue isn't so much the accounting but the decision to leverage and to keep insufficient cash (and, more generally, insufficient asset diversity) to cover those liabilities" --- David J
1) That's well said, and accurate too --- but your point can and should be taken a good step or two further.
2) Specifically, the calls being sounded for alternative creative accounting from over-extended financial institutions --- many of the enterprises in them way over-leveraged and stuck with dubious or downright worthless assets --- are intended to conceal the disastrous mistakes made by their managers for several years now.
All investments no matter what kind are risky and volatile. All the banks of various sorts along with the brokerage houses and independent mortgage dealers and insurance firms and complex "virtual banks" and hedge funds that got involved in concocting complex financial derivatives in the housing market --- including vast amounts of repackaged mortgages and credit-swaps and other hedging galore --- were only too happy to use mark-to-market accounting when the housing market was booming. Now that it has tanked, their managers --- who undertook very risky actions, thinking they were clever and could pass on the risk to others --- cry foul and want to use some alternative to fair-value pricing that involves their subjective selection of a discount rate for the future, predictions about the housing market into the future, and some number of fantasized years as the basis of juggling their current assets around.
3) The underlying motive for such alternative accounting is clear: to conceal that the managers of these tottering enterprises didn't assess properly the risks of such asset-based accounting and the likely volatility effectively. Instead, they involved themselves in a largely non-transparent network --- global in reach --- of various structured derivatives and insurance schemes and credit-swaps that the initial and mid-point enterprises in this lengthy network had no information about. There was, in short, no transparency and accountability in what was happening in these runaway networks. Risk was simply being passed down the line.
And now that these unregulated credit-swaps and the like have blown apart, with a confidence-crisis hovering somewhere over them that has already fed back to scarcity in credit markets for the business world and households, we are told that some creative accounting will make everything suddenly look all peaches-and-cream. And then voila, banks and other financial firms that don't trust one another now will suddenly --- along with tens of millions of individual investors --- embrace one another's dreck-concealed accounting sheets, see only the peachy-creamy figures, and start trading and buying with enthusiasm again.
Right?
.........
The White Queen: "Can you do addition? What's one and one and one and one and one and one and one and one and one and one?"
Alice: "I don't know. I lost count."
.....
Michael Gordon, AKA, the buggy professor
Posted by: the buggy professor at Oct 4, 2008 12:34:25 PM
"The underlying motive for such alternative accounting is clear"
Actually, you can know a lot of historical detail, but you can't know other peoples' motives, even if they tell you, but I'll try.
If credit-granting institutions go out of business, unfortunately so does the credit market, because these institutions are the market. Now, I'd like to stick it to the banks just as much as the next guy, but I'd prefer not to screw myself if I don't have to. In the future, I wish we could have something like the stock market where all kinds of companies can go broke and the market itself is relatively unaffected. But, when we don't have that, and when the government is forcing companies out of business, while at the same time taking lots of my money to keep them in business, I'm going to look for a short-term alternative.
Posted by: Andrew at Oct 4, 2008 1:10:14 PM
"So if we just let them commit accounting fraud, that ends the crisis. Cool."
No, fraud would be breaking the rules to lie. I'm saying we should change the rules to further reflect the truth. If you intend to hold a loan to maturity, and the only reason you will go out of business and need the market value is if you have to reduce your equity to reflect a market price, then this is not accurate accounting.
"And then voila, banks and other financial firms that don't trust one another now will suddenly --- along with tens of millions of individual investors --- embrace one another's dreck-concealed accounting sheets, see only the peachy-creamy figures, and start trading and buying with enthusiasm again."
"Right?"
No. The idea is to increase the cost of finding inaccurate information so that people who are likely to panic will not panic, and thus avoid the self-fulfilling prophecy, while people who know (Warren Buffett, John Hussman, etc.) can get about establishing real values for these assets based on the idea that the companies will be hit, but will not die due to irrational runs.
http://hussmanfunds.com/wmc/wmc080922.htm
"The key is to recognize that for nearly all of the institutions currently at risk of failure, there exists a cushion of bondholder capital sufficient to absorb all probable losses, without any need for the public to bear the cost."
If they survive, bailouts are not needed. In other words, in this case, UNIQUE TO THE CURRENT SITUATION, the evil will be in forcing these companies to go broke. And, even though it is now moot, making accounting more rational might have been a better alternative than the bailout.
Posted by: Andrew at Oct 4, 2008 1:19:44 PM
One last thing, then I'll desist. What I lack in eloquence, I make up for in volume.
As Antonin Scalia said, evenhandedness is not always fairness. We encourage banks to operate differently on the one hand, but we have systems on the other hand that don't take this into consideration. Some of these institutions are solvent if they aren't forced to raise capital to cover artificial/unbooked losses. The capital requirements were supposed to keep banks OUT of this situation, not doom them once they got here. If we want honest banking, the solution is not to have dishonest banking until all the dishonest banks fall apart, and then reconstitute the system with more dishonest banks and greater Federal involvement.
The fact that these companies had to use 30 to 1 leverage to make money on houses, is to me an admission of defeat. This bubble was their battle of the bulge. Centralization, diversification, and leverage have reached their zenith. There will be plenty of time for them to die slow agonizing deaths and free up people to get about the business of making real investments in real things, if we have an economy left.
Liquidity and visibility matters. People never worried about their home prices like they worry about their stock portfolio. Why? Because you couldn't. You bought what you knew was a good house for a fair price and you intended to hold it for a decade or so, which, ironically, is exactly what Warren Buffett recommends for stock purchases.
But, mark-to-market accounting is a bit like someone coming to you and making you cough up the difference in your current home price and what it was at the peak. You wouldn't like it. And, when you couldn't roll over that debt because all your neighbors were in the same predicament, you wouldn't be able to make your other bills. The lights go out, then the phone, then you can't pay for gas and all of a sudden you understand the paradox of thrift.
I too want to change the system. I too want us making good investments rather than wasting resources and destroying value. But, that's going to be an evolutionary process and it can't be done right now. In fact, we are getting the opposite. There are some people who are saying we should pass draconian measures because if the bailout fails we'll get even more draconian measures. I think I advocate a better offer. Let's undo some of the most damaging interventions we already have.
Posted by: Andrew at Oct 4, 2008 1:44:56 PM
"Risk was simply being passed down the line." --- the buggy professor
This is what the whole things boils down to, and it is systemic in the way our society works. Risk cannot be "passed", it can only be "acquired". Too many institutions readily acquired risk in the search of ever greater returns and economic growth. Those decisions were made for millions of taxpayers through 401Ks and other inter-connected activities. Even our desired goal fuels this fact - we want to avoid economic stagnancy. From this perspective there is no difference between targeting 4% GDP growth compared to 1% GDP growth as there is between 10% GDP growth compared to 5% GDP growth. Our country, its corporations, and its people, exhibit this behavior constantly - desiring ever greater returns to either fuel yet even more growth or fund expenditures.
Since we are not likely to change our National obsession with wealth we might as well do whatever it takes to minimize the bad times as they come and worry about the future when it arrives (which, ironically, is never - that is why we are so inept at planning). This is exactly what is happening; those in power are being given the chance to exercise that power to try and affect change on a massive scale. Their egos, not rational expectations, are driving their calls for intervention. It is the logical and expected outcome for our system of government. The community can throw forth ideas but any idea the does not involve the government exercising power is going to be tossed immediately - people in power are generally disposed to believing that their actions are always more effective then letting things be (at least when a "crisis" occurs since its very occurrence implies - to them - the letting things be will only cause the crisis to worsen).
Posted by: David J at Oct 4, 2008 3:02:58 PM
The problem is that the market is just going ahead and marking all of a banks assets to market anyway. So telling banks they don't have to will just mean there's even more uncertainty in the system, since investors don't know the extent of the mark-to-model (frankly, investor don't really care what you think it should be worth). This makes it harder to differentiate between good firms and bad firms, widening the number of banks in trouble and forcing the good banks to delever faster.
Posted by: Kyle at Oct 4, 2008 3:34:34 PM
