How to Fix Mark to Market
In stark contrast to the mad dash toward the promised Nirvana of more government regulations, one issue that may prove to be the elusive holy grail of the economic recovery is, in fact, the abolition (or at the very least the severe curtailment) of a disastrous government regulation. – FAS 157. The numbered acronym alone carries all the thoughtless evil results only a clueless bureaucrat can contrive. Though not blamed for starting the recession, nonetheless “Mark-to-Market” is universally acknowledged to have chronically aggravated the collapse. The effective date alone should give one a clue – November 15, 2007.
The ABCs of mark to market.
The basics of mark-to-market follow below (and if you know all of this feel free to skip to the second part of the article):
In the wake of the Enron scandals, financial regulators deemed that companies should carry assets on their books not at the prices that they “arbitrarily” choose, but at the price which someone, i.e. the market, is willing to pay for that asset at that moment. At first glance, the idea seems a common sense approach to make a company’s balance sheet transparent and reflective of reality. After all, if you have a share of stock, say GE, you wouldn’t carry it on your balance sheet at whatever price your analysis says it is worth, but rather at the current bid price.
However, the need to implement mark-to-market didn’t arise because companies allegedly used improper valuations for liquid and easily priced assets such as cash or securities or commodities. The issue arose out of a need to force companies to value exotic and less liquid securities for which a quote is not easily found. A method that potentially values an illiquid security as near worthless.
The basic premise is that for any security, regardless how arcane or complicated, there has to be at least two parties: the seller – the institution that concocted it; and the buyer – the institution that actually purchases it. Without either of the two there is no market. So, for the far out securities engineered in the past fifteen years or so, the market consists of institutions that package these concoctions and the other institutions that buy them. ( A quick word about this. It is not necessarily a valid model. For example your house might right now not have anyone interested in bidding for it probably because you have no interest in selling. In the strict interpretation of mark to market that would mean that your house has no value. )
Mark-to-market valuation then works by getting a consensus of what the buying institutions think that the security offered is worth and expressing said consensus in the form of a bid. This is a key point, the valuation for these securities is based not on what someone thinks that it worth but on the exit price, the price that it is sold.
As you can imagine, the number of institutions who have the expertise to buy and sell these securities is very finite and, as such, very incestuous. Both of these characteristics became extremely evident in the past eight months. There are very, very few (I only know of maybe one and it survived this debacle with a AAA rating) such institutions that do only selling. Most of them are, at the very least, sellers in one security and buyers in a different one
Relatively few participants
Because the number of institutions involved is relatively small (think of how many entities buy commodities such as wheat or oil -in fact mark to market originated in the very liquid commodities markets- and compare it to the number of major players in say credit swaps), the welfare of one or a handful of participants will affect the market and the price of the securities. Further, because the number of buyers has diminished, the sellers will also be adversely affected and they in turn will curtail their own buying. This, as you can imagine, will drive the price of the “market” lower.
On the back of this less populated market, institutions are dealt yet another blow because the mark-to-market regulations kick in and holders have to mark their inventory to the lower current price. If prices drop low enough, then the institutions are required to raise the amount of capital that they hold in reserve (think liquidity or credit crunch). When that happens they will probably have to sell more of the exotic securities at extremely devalued prices. If this cycle repeats often enough, some of the participating institutions will no longer be able to sell the securities at the lower prices and either abandon the market, go bankrupt, or survive only at the mercy of taxpayer bailouts. That, of course, puts the kibosh on that entire market.
A small percentage of assets precipitated an avalanche
Here is what the world didn’t expect. Because the institutions that make markets in these exotic securities also dominate all areas of the financial universe, and because of the tremendous amount of leverage involved, it took only a relatively small percentage of the products on which the exotic securities are based to go sour and the entire economy was dealt a body blow.
OK, so here is the rub: in the above description, we see how in a tight market, the wellbeing of a few key traders will cause the price of the traded product to drop. The product itself may be in much better financial health than the participants who are trading it and yet, because of the nature of the market and the nature of mark-to-market, the price of the product will be very negatively impacted.
How to fix that? That’s the three and a half trillion-dollar question, ain’t it?
1) Issue specific pricing
One way to do it is to have different mark-to-market standards for assets that actually perform or are based on assets that are performing. Another words make the valuation entity specific rather then market based. That’s an idea that makes a lot of sense and it would be relatively easy to implement. Any institution that wants to get the benefits of lower reserve requirements would have to come forward and show that they hold securities that are based on assets which can be reasonably calculated as being performing assets. Straight forward and quick to implement.
There is no excuse to not value performing assets not on market price, if there is no market, but rather on valuation and performance ratios. Think on the lines of mutually agreed upon cash flow or some sort of modified price earnings ratios or maybe book-value valuation for illiquid securities.
The Gordian knot
The problem is that there is a tremendous amount of securities that are based on assets that are chopped-up, repackaged and then repackaged all over again. Their origins are very hard to determine and therefore difficult to say if an underlying asset is performing or not. To further put the Gordian knot to shame many of these repackaged securities are flung all over the world and we aren’t done yet. To try and limit their risks or maximize their profits, many institutions created new securities based on the probable behavior of the underlying securities. (When the underlying securities behave in improbable ways ,such as now, it’s when financial Armageddon looms.) And finally to get better terms some institutions paid other institutions with better credit ratings to guarantee their products. This is the basis of the “evil” CDSs (Credit Default Swaps). So if a major AAA rated bank guarantees the debt of a lesser bank and the lesser bank runs into trouble the AAA bank guaranteed the debt. In theory and in practice this worked just fine. The problems start when the snowball turns into a huge avalanche the credit of the banks which “loaned” it’s rating to guarantee the debt of the lesser bank was itself negatively impacted.
2) Arbitrary Valuation Points!
To begin to straighten this out would take us until the next recession, but the thing is that we don’t have to wait that long. A faster way, especially for the really hard to value issues would be to simply pick a price and assign it to that asset class. Heck, find the lowest valuation point of the past year for whatever higher class of securities one can find a bid and then assign incrementally lower values for issues that have lower ratings. Or just take an average of the prices for the past seven months, it really doesn’t matter.
That’s it !Start with that!
Then either allow these things to go on an exhange ( more on that below) or find a way to issue a put option on the price. At the very least investors would have a starting point from which to begin evaluating the institutions holding the assets. Try it with one institution first and I am convinced that its stock price would be a lot higher than now and the cost would be a less then buying all the assets fit to print . If the markets respond favorably apply this to the rest.
3) The permanent solution!
Why not let the experts do it. And who are the experts? The experts are those who created these things in the first place. It’s time to get over the demonizing of financial engineers and understand that they have done nothing other than come up with products that enabled the issuance of mortgages, as prescribed by fiscal and monetary policies set by the government. Did they do it for altruistic reasons? Hell no! When your job is to make money you try to do it as well as you can and yeah they went over board. But how can we blame a single financial engineer for any of these when Barney Frank , Chris Dodd or Jamie Gorelick are yet to be indicted?If any one deserves any blame for this mess it would certainly be those who advocated the easy credit for homeowners and certainly the Bush administration who let them get away with it. Yeah, I know the mantra “they tried to fix Fannnie Mae but, but,but democrats”. I will not dignify that nonsense with a rebuttal. Bush claimed to be a cowboy, is that what cowboys do?
Place the blame where it belongs, on the politicians, the community activists, and the bureaucrats.
The reality is that the only ones who have an idea how much these securities are worth are the people who created them and we need their help to get out of this.
The only way to get an honest, objective and fully transparent answer from them as to what they are worth is to make them disclose it in public for the entire world to see; on a public exchange now! Why wait? if we assign them a value point we would know in no time if the world thinks they are priced right.
The only way to get anything close to a real price for these securities is to allow the world to bid for them.
We own many of these things so lets get the best price
To encourage participation, we should reward participating institutions with a temporary suspension or easing of reserve requirements on these securities. If you are skeptical, take comfort in knowing that Warren Buffet himself stated that of all the assets that the banks own, the ones he would most like to buy are the “distressed” ones – if they are priced properly. For Buffet, proper pricing means that he wants to get these assets at dirt-cheap prices.
Keep in mind, however, that you and I own a big piece of these assets so why would we want to sell them to old Buffet and his ilk at deeply distressed prices? Wouldn’t it be much better that we get the right price for these on an exchange? At the very least, we’d know what they are worth. And you know what? The exchange may even be a huge success and start up an entirely new industry that would help lower the cost of capital without having to rely on the government to print money.
4) The least that we can do
Finally the very lest that can be done is to admit that we have no idea what these assets are worth and simply, lower the regulatory reserve requirements for these assets. What the heck is the down side that Citicorp goes to $1? I would have to say that on the risk reward scale at these prices lowering the reserve requirements would probably not cause the markets to drop. It will however give financial institutions the room needed to breath and wait for either an exchange to be set up or a for the market to stabilize and figure out how to price them.
The administration would rather spend our money
These are things that can and should be done immediately and yet the administration prefers to spend trillions of dollars giving the government an ever-increasing share in our nation’s banking system.
We were told that the Obama team would hit the ground running, we were told that Geitner was God’s gift to the financial crisis. Heck we even allowed him to go “Scott Free” on a potential felony charge because he would save us all!
So far the only thing that is administration has done is take more of our money than anyone in history and they have nothing to show for! To paraphrase Cramer, Obama is the biggest destroyer of wealth in the history of the planet!h