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.
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.
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).
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.
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.
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.
So, instead of a financial crisis, we get a bunch more Enron’s
Yay?
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.
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.
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.
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.
“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.
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.
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.
See whether this analogy makes sense:
If your company owns a company car, its value to the company is what the company does with it. You pay collision insurance so if it suddenly loses value you can get it running again or replace it, and you’d rather pay a predictable fee than have the occasional big expense.
You depreciate the car over the time you intend to keep it, and you set aside money to buy a new one when this one is fully depreciated. If the price of a new car goes up then you need to set aside more money. You don’t need mark-to-market in your accounting. You do need to anticipate the price of a new car when you need to buy one. You don’t at all care about what you can sell the old car far, not unless you’re going out of business and selling all the assets.
But if your company is an auto dealership, it’s absurd to buy sales insurance. “I ought to be able to sell all these SUVs at a 22% profit, so I’m taking out insurance and I’ll cash in on each car that doesn’t sell.” No.
And you don’t depreciate your unsold merchandise the way you’d depreciate a company car. The value of each car to you is what you can sell it for. You might plan to keep a company car for 5 years and depreciate it 20% a year. But inventory that’s sat in the lot for 4 years is not worth — to you — 20% what you paid for it. No way.
So if your company car is an SUV that does the job you want it to do, it doesn’t matter to you whether SUVs are selling or not. When you’re ready to buy a new car you might choose a Prius or whatever makes sense. But if you have a lot full of SUVs that you can only sell for 20% what you paid for them, you have a *problem*.
If your company wants a bank loan, the bank doesn’t care much about how you value your company car, except they might notice when you’ll face the expense of buying a replacement. But if your auto dealership wants a loan, it matters *a whole lot* how much of your capital is tied up in merchandise you can’t sell. Mark-to-market is the only right approach then.
It makes no sense to treat the two situations the same.
In a way it seems fair that everybody should use the same kind of accounting. But that doesn’t work.
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. – Andrew
Indeed. Regarding the arguments that M2M benefited institutions during the market expansion, I reply that if correct, then M2M apparently distorts the true value of assets altogether: (1) to the upside during market expansion; (2) to the downside during contraction.
If credit-granting institutions go out of business, unfortunately so does the credit market, because these institutions are the market.
Suppose we took $700 billion to start new banks. The new banks don’t have any of the problems the old banks do, all they have is a combined $700 billion. They could do business. People who wanted a solvent bank could put their assets in the new banks where they were safe, and the new banks would have that many more assets to work with.
An old bank that wanted to compete could find ways to show that it was solvent, then it would be like a new bank. If it can’t do that, too bad.
Why should we let a corrupt bankrupt oligopoly keep running our economy?
David J, when you’re renting a home that’s deeply infested by termites, and the utilities are shut down because they’re unsafe, and it’s mortgaged for far more than it’s worth, you’d do better to build a new house than buy the one you’re in.
I doubt we have nearly enough money to bail out the corrupt businesses. It looks like a massive undertaking to even decide just how many trillions they owe.
J Thomas,
I’ve come to conclude that the ratio of heat-to-light being generated across the net about this subject should be taken as a cautionary note in this.
My new working assumption is that M2M is not widely understood – certainly not by me at least – and that therefore more light need be shed on M2M for a more productive discussion to occur.
David J, I like your proposal for dealing with the insolvent financial institutions.
What bothers me is that we have given the Bush administration $350 billion, with another $350 billion unless Congress votes to stop it, and we are trusting them to do the right thing in detail.
If their friends are running utterly insolvent banks, why wouldn’t they bail out their friends and put them back in business? And if their not-so-close-friends are almost solvent but not quite, why not take them for everything they’re worth?
They have four months to loot the economy before a new administration comes in. Won’t they make the most of it?
I particularly note RMWarnick’s statement about that:
http://yglesias.thinkprogress.org/archives/2008/10/after_legislating.php#comment-688446
Not that M2M only applies to leveraged assets but if there is no leverage then, aside from operational bankruptcy, there is no need to sell those assets or otherwise adjust their value in order to meet external obligations. This is a practical, not necessarily a GAAP or legal analysis.
M2M isn’t going to cause a market to “over-correct” but to correct more quickly and thus leave less chance for business circumstances to change and allow a company to recover. It is a less-forgiving mechanism meant to protect investors and not investees. However, the effects cascade to the degree that entities are inter-connected and those other parties also have less time to react.
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