Having read through a recent line item breakdown of the bill, I am filled with fear and doubt at some of the liberties our federal government is taking. However, I must admit there are portions of the bill which do show some insight into the way our financial system works, and I believe will have a beneficial impact on our current crisis. One ray of light in the new Economic Stabilization bill that may add back some sanity to our system is granting the SEC the power to suspend a practice known as “mark-to-market” accounting.

Not to delve too deeply into the arcane of financial jargon, put simply mark-to-market is a method of bookkeeping that has been pushed to the forefront of modern business. This method requires that an assets and liabilities on a company’s balance sheet be “marked-to-market”, or rather, recorded at the current value any one item could be bought and sold for at present. At face value this seems intuitive – why say you have something worth X million dollars when you could only sell it right now for Y million dollars? Not telling people you have $Y million of that asset is deceptive, no? That is the argument of the Financial Accounting Standards Board, the independent body which governs how companies keep their books (through what is known as Generally Accepted Accounting Principles). The FASB, as America’s acronymophilia requires we refer to it as, has been pushing this practice for years and incorporating it more and more into GAAP. The problem is the answer to my previous question above is “no”, and the depth of our curious crisis is the “why”.

The concept becomes tricky when you begin to examine these bundles of loans which are floating around the system as mortgage-backed securities and collateralized mortgage obligations (MBS and CMOs, oh yeah baby yeah). So much risk surrounds these that, effectively, a liquid market no longer exists. As such, these investments are effectively worthless. Associated marks to market have dramatically impacted the “on paper” financial strength of many of the institutions which serve as the backbone for the American economy (I don’t think I need to name names). Of course, the actual value of these securities is not zero. If not traded, and their value SHOULD be equivalent to the cash flows generated by the underlying mortgages. Even if foreclosures reach great depression levels, the value of these cash flows will not be zero. In fact, there are probably a number of these bundles which will still pay most of the principle and interest promised. It is impossible, however, to know which these are.

So how do you value these? Classically, you record them at what you bought them. If, when all is said and done they don’t produce the intended cash, then you take the loss. Uncertainty is mitigated “on paper” until such a time when certainty exists, and everyone lives happily-ever-after-not-spontaneously-going-bottom-up.

Section 132 of the new bill gives the Securities and Exchange Commission the power to do this. Effectively, the SEC can tell the FASB “F U” (yum, alphabet soup), and set things back to the way they used to be. Marking to market it self isn’t a bad concept and can at sometimes have a stabilizing effect on transparency and the markets. In a specific situation however - such as our current liquidity crisis - it can be devastating (akin to building a house out of brick but using an accelerant as the mortar: sure in most circumstances it holds up a lot better than a wooden building, but set it on fire and burns a lot faster too). Usually, I am not in favor of giving a government sanctioned entity authority over a private entity like this. Then again, the FASB pretty much answers no one, so it makes me smile to know that someone is willing to spank them when they do wrong.


Hariolor said...

As I am sure Mr Tony will be sure to agree: the downside of the current arrangement that so recently tanked in congress is that the $700bil was being used, essentially, as a benchmark sum to artificially "mark-to-market" any bad debts so entrusted to the government's authority.

Furthermore, the risk surrounding the assets is now realized by the markets, and keeping them on the books at purchase prices is, at best, a gross overstatement of capital, and at worst could lead to bigger scares down the road as they start to go pop with greater frequency.

Then again, that's all pie-in-the-sky (PITS?) since the market already knows that there are trillions of sick assets out there, and that knowledge has been built into market expectations.

As we are witnessing, proclaiming that the toxic securities will be permitted to remain in the market at any value will drive markets down to the point where they finally reach expectations. And right now, everyone expects a crash...

Tony Cannizzaro said...

The point missed is that these assets aren't trading anymore, and the current rules require these items to be recorded at market liquidation value. As a liquid market does not exist, that effectively has forced all these institutions to record the value of these assets as nearly zero. The assets, if held to maturity and allowed to realize the underlaying cashflows are not worth zero - they are worth far more than zero. When a liquid market exists, we can approximate what the actual value may be, and so it is fair to use market prices as the paradigm of measing value. If that market dries up, however, you cannot merely say these assets are worthless. It is more accurate from a standpoint of maintain market transparency (and measuring actual solvency of an institution) to maintain the value of the assets on the book at the last "good" measurement, and then revalue the assets when either their true value is realized (maturity is reach) or an actual liquid market capable of efficiently capturing value once again exists.