My Mark-to-Market Nightmare

I couldn't sleep at all last night. It started with a dream-nay, a nightmare-that I had taken a three-week vacation in a remote part of the world where cell phone reception was happily non existent. There were zero bars.

It was a good vacation. I came home refreshed, full of vim and vigor, and ready to re-join the rat race. All that changed when my accountant called with bad news. He said I was broke-flat broke. I thought he was kidding.

"How can that be?" I asked.  "I have my portfolio of Treasury bills and notes and a few mortgage-backed securities to fall back on if necessary."

"Yes, but you've been gone three weeks, which is an eternity these days.  During that time, your Treasuries declined in market value because interest rates increased, and your mortgage-backed securities became illiquid as trading in them virtually stopped. I had to mark them all down to market, which, in the case of the MBSs, was virtually zero. Sorry about that, but that's not the worst of it. Writing down the market value of your securities reduced their value by more than your net worth. So, you're now broke.  You've gone from a high-net-worth individual to a no-net-worth individual."

"Wait a minute! I don't have to sell these securities now. I can wait until their prices recover. I can even hold them to maturity if I have to. There's no credit risk. The Treasuries were issued by the federal government, which could print money to pay them off if it had to, and the MBS's were issued by Fannie Mae and Freddie Mac, which are quasi-government. They are obviously too big and important for the government to let them fail."

"I'm afraid a lot happened during your vacation. Fannie and Freddie are government now; they, too, got marked to market and taken over by the government. So did AIG, the huge world-wide insurance company."

"Well, there you are. All my securities are now government securities, and, if necessary, I can hold them all to maturity. There's no need, no rationale, to mark them to market. Besides how low could they go anyway?"

"Your Treasuries are pretty short term, which is in your favor, but a flight into Treasuries still reduced their yield. Your Mortgage-backed securities took the biggest hit. Since the market for them has virtually dried up, I've had to mark them all the way down."

"All the way down?"

"Yes, all the way down."

"Well, I guess I could always sell my house."

"I've already taken the liberty of putting a for-sale sign out front."

"Thanks a lot. I'm glad I have a thoughtful accountant like you.  I don't know what I would do without you."

"Thanks. I do my best. I'm actually trying to get appointed to FASB, which is the Financial Accounting Standards Board.  That's the outfit that makes up these accounting rules. It would be quite an honor for me. It is the most powerful organization in the country. Even their bosses at the SEC and Treasury are afraid to mess with them."

"Do they have the power to change their rules or modify them a bit to help the country get through this housing crisis?"

"Yes, of course. Or, the SEC could direct them to do it. In its big bailout bill, Congress reaffirmed the SEC's authority to do that in order to remove any doubt.  I don't know why they are defying Congress."

"Do you think it will get done eventually?"

"I doubt it. Accountants take pride in their professionalism, and it just wouldn't look right for them to modify an accounting rule just to save the financial sector and the economy."

"Speaking of that, I read on the plane that the Federal Reserve, probably the most conservative institution in America, if not the world, has been pulling out all the stops-taking unprecedented steps-to get the country through this national emergency. And I understand the Treasury has also taken extraordinary, unprecedented steps to save the economy. Am I right?"

"You are right."

"And I believe there is a provision in the Emergency Powers Act, or some such law, that gives the President the right to suspend even the Bill of Rights in a national emergency. Am I right about that too?

"I believe so."

"So the Bill of Rights may be suspended in a national emergency, but not mark to market accounting?"

"It would appear so."

About that time I woke up in a cold sweat and said a little prayer:

"Lord, please don't ever mark me to market, especially on one of my down days."

Comments (13)

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  1. lord alfredo spoonmaster jackson jr., esq. says:

    honestly, Bob. I cannot understand your obsession over this MtM business. You need a new hobby in your life. Perhaps, expand your fishing practices beyond fly and take up deep sea fishing.

    All you policy wonks/academic/economists who don’t manage money in the real world seem to love getting rid of MtM like it really means something. The rest of us who run real money actually have to know what the value of an instrument is — including liquidity risks.

    If bank regulators want to change the reserve requirements, that’s fine. But stop arguing for the manipulation of real asset values. Idiots (garrett von wagoner, firsthand funds landis, jacobs asset mgmt) who bought crappy .com common stock paper didn’t have their mutual funds marked to some imaginary value based on earnings in 2011 when all .com stocks would clearly be worth more. Why do banks who own convoluted mortgage paper, the whatever-non-AAA tranches of MBS/CDO structured paper? Are these people special becuz they got FDIC oversight and mutual funds don’t? whatever…

  2. lord alfredo spoonmaster jackson jr., esq. says:

    and btw, i say this w/ love, as i do hold in high regard… forgive my draconian critique, if it runs a little too harsh…

  3. James Miller says:

    Hi Dr. McTeer!

    Great illustration about the MtM problems.

    I have one little nitpick: isn’t it “FASB” instead of “FSAB”? I’m not an accountant by any means; I just remember people phonetically saying ‘fazbee’ whenever they were talking about GAAP.

    Thanks for taking the time to write these posts.

  4. Bob McTeer says:

    Jim:

    Is that you?? Of course you are right about FASB. We are fixing it. Good to hear from you.

    Spoonmaster?

    You may be right too. I do need to get a life. I don’t necessarily want to change information available to investors. But you can have transparancy without having to write regulatory capital down dollar for dollar with the hit on illiquid securities, especially if the owner can hold them to maturity. Another problem with MBSs is that a couple of bad mortgages behind a very large bond shouldn’t require writing down the whole thing. Don’t worry. Nobody seems to be listening anyway.

    Bob

  5. spoonmaster says:

    i feel your pain, bob.

    i bought a ton of .com stocks when they imploded and my boss complained bitterly that they were all, “illiquid POS”. but they were also ridiculously undervalued and most were only trading at cash value in the bank or less. liquidity eventually came back and they market revalued good companies higher and the bad ones went bankrupt.

    trying to adjust prices to some artificial level just cuz you think you can guarantee the holding period, doesn’t really make sense to me. but i see your concern.

    reality is that these complex mortgage tranches will probably stay illiquid, cuz they are too complex for most average funds to value…. even if the underlying fundamentals improve, liquidity may not.

    take care bob & i enjoy the blog.

  6. Jack B. McPherson says:

    Bob: Although I am not an economist, it seems to me that Mark to Market (MTM) is an arbitrary standard which displaces the old maxim of Fair Market Value (FMV) which is defined as: “the price at which property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or to sell and both having knowledge of the relevant facts” MTM rests on the assumption that a buyer is not willing to offer par (or even a discounted present money value including risk factors) for a security which has appreciable value albeit it may not be liquidated or redeemed until a deferred maturity date. MTM presumes that these securities are here and now valueless because of the complexity, especially in the case of Mortgage Backed Securities, in evaluating the viability of the underlying indentures. However, this concept may not be shared by a seller and buyer who are observing FMV considerations while negotiating and closing a deal in the market place. MTM encroaches upon free market principles which, I gather, was adopted to prevent banking and financial institutions from using FMV on their balance sheets by arbitrarily and peremptorily forcing them to list these assets at an artificially low (or zero) value by imposing an arbitrary standard which suppresses rather than encourages traditional market dynamics. This disregards the duty imposed on everyone in the market place to perform due diligence in making a decision on what an asset is worth to him or to her as the foundation upon which to freely offer or accept the sale and purchase of securities and , in essence, freezes assets and constrains free market dynamics. Thanks for all of the informative insights and analyses.

  7. JustOne says:

    Just because no one is listening, does not make the comments less worthy. They didn’t listen to the Man from Galilee either.

    A car is not worthless because it is out of gas and can not be driven to an auction. A 10 carat flawless diamond is not worthless at midnight in the Diamond District of Manhattan just because all the buyers are asleep. A house is not worthless just because no offers come in the first day of the listing.

    All markets have timing as an element. MtM ASSUMES markets are continuously repricing an asset and that the process is fair and open (not manipulated). For some assets those may be a better assumption than for other assets. Obviously the assumption has broken down for many of the asset classes that are used by banks for reserve capital.

    Keep up the voice of reason, even if few are listening. Hopefully in time, the right will out.

  8. Timothy Kershaw says:

    I could not have said it better.

  9. Timothy Kershaw says:

    I see more churches talking about the collapsing financial markets and talking about how Christians can protect themselves from financial ruin by paying down debt. While I think this is great, the problem is actually been created by laws that have been passed. I normally would not go to our nations Christians asking for help but it seems we need the moral leaders of this country to step up and protect the average American from total financial ruin.
    The following story below is written with a conspiracy theory approach, as it is more compelling for a writer like me to create a set of situations with an underlying bad guy or guys. The real goal is to point to the danger of certain rules put in place all at once that create a systemic risk for all financial markets.
    My hunch is that most of these rules were up in place with the best of intentions. The problem arose as smart short traders saw the weakness these rule changes created in company balance sheets as the problem spun out of control. So please when you read his don’t look for a bad guy on the short side. Instead realize the weakness that all of these rules in place at once have created. Until they are changed FINANCIAL MARKET ARE AT RISK OF falling like a rock. There will be no bottom.
    I wish you all he best and am praying the Lord gives all of you he wisdom to react quickly to these problems. Throwing money at this problem only creates a temporary backstop. Asset values under the current situation will continue to erode. NOW QUESTION ABOUT IT.
    Well here is the story of what is taking place.
    An Attack on Financial and Asset Liquidity

    The very nature of the phrase ‘financial liquidity’ implies movement or albeit life itself. It is an intelligent multidirectional flow with a purpose in mind. Imagine 5 people in a room who represent the entire population of the world. Person ‘A’ is a farmer. Person ‘B’ is manufacturer (tractors and anything else needed). Person ‘C’ produces raw materials (steel and wood). Person ‘D’ is a Home Builder; Person ‘E’ is a banker. Very simple world, but it works. Liquidity implies that person A can buy a tractor from Person B, based on the fact that his beans have always sold for $10 a bushel. So the bank finances the deal for the farmer to buy a tractor, based on the value of his upcoming crop. The bank then sells the note to the steel worker. With these new funds, the bank can now loan money to the home builder to build new homes. You get the picture. Our little world has both financial and asset liquidity. Assets are flowing and alive.
    In this scenario, Mark to Market (MTM) works well because there is actually a market. The term ‘Market’ implies a buyer and a seller. There is always someone who is ready, willing, and able to sell; and someone who is ready, willing and able to purchase. The purchase may be done with cash, financing, or even asset trades. The agreed upon price becomes the market price. So in order to have a market, one can see you MUST have liquidity. One can now also see that both terms (Market and Liquidity) imply a level of trust about what is being traded and the transaction of payment in funds or assets. In our little world, the market value of anything can be quickly found. One $50 steel beam can be construed to be worth 5 bushels of beans, or $50, if beans sell just sold for $10 a bushel to someone else. But what if everyone stops trusting each other, and finally stopped trading with each other because something had caused the underlying value of the assets backing all their livelihoods to crash. This scenario would seem impossible to happen naturally in our little world. In fact, I state it is impossible, without determined and planned destructive intervention. What would happen to the price of beans if no one was willing to trade with the farmer? The beans have a MTM value of $0. The farmer now defaults on his tractor loan, which destroys the bond the steel manufacturer is holding. This scenario runs its course and EVERYONE is destroyed.
    In order to destroy this little world, one does not have to bomb or kill anyone. Just destroy LIQUIDITY. Now let’s apply this to the present situation within the USA. How could this ever be accomplished?

    I. Destroy the Value of Equities(Stocks)
    a. Implement the “Shorting to the Down Tick” rule without any limitations on losses. This by itself would be restricted by the number of outstanding shares. So one could calculate a bell curve and formulate legitimate statistics upon which shorting would naturally occur due to the finite number of shares available to trade.
    b. In order to overcome the limitations on point ‘a’, allow the unrestricted short selling of phantom shares which would destroy the natural paradigm of shorting a company with a finite number of shares. In this scenario, a stock could be driven to $0 if the short seller has the financial power.
    c. Do not enforce the rules of ‘covering’ your short sales. This adds unbelievable power and unlimited funds for points ’a’ and ‘b’. It also means all the funds gained from shorting are kept and not used to buy the stock used as the collateral in the short sale transaction.
    II. Create a financial instrument that insures the bonds floated by any company(CDS)
    a. This must be traded in a totally non-transparent and unregulated manner.
    b. Anyone must be able to buy them, even if you are totally uninvolved in the bond transaction. This includes your enemies.
    c. Make this instrument more powerful than the bond itself by adding fail safe checkpoints which can be tied to several scenarios, credit ratings being one example, which force early repayment of a portion or the entire bond.
    i. The checkpoints are regulated by an outside agency with the ability to downgrade a company’s credit rating

    without question.
    ii. These outside agencies actually hold the bonded companies hostage to some extent.
    III. Create powerful offshore predatory hedge funds intent on carrying out points I and II.
    a. With the implementation of point I and point II, perfectly healthy companies will soon be destroyed, due to their relative stock values being driven down to unfathomable levels, their bonds being called because the rating agencies downgraded their credit thus activating a checkpoint fail safe within the CDS, thus destroying their cash, thus bankruptcy.
    b. Other companies that were dependent on the underlying asset values of the newly bankrupt company now must write down their corresponding asset values. But these companies are also under the point I and point II attack.
    c. Launch the attacks described in points I and II on financial institutions in a predetermined and planned out manner. In other words, start your attacks aiming at ‘vulnerable’ institutions that will crumble quickly and then use the momentum caused by the financial failure to pole vault to the next more difficult institutions.
    d. Mask your real attack, liquidity, by getting everyone to focus on any single event.
    IV. Aim your attacks simultaneously at commercial paper institutions.
    a. Even a small degree of failures within the flow of commercial paper will greatly influence liquidity.
    b. Cause modern day panic ‘Runs’ banks due to the spread of false rumors about another bank failure, which is really just another victim of point III.
    c. When appropriate, launch a massive attack at a major world wide institution. If coordinated properly in Point
    III, this will be much easier.
    V. Enforce Mark to Market Accounting (MTM).
    a. Due to point III, and the declining liquidity caused by point IV, asset values will decline in an accelerated manner
    b. Declining asset values will cause complete mistrust between banks, thus causing LIBR to sky rocket. This LIBR effect will cause major devastation to every Equity on the market, since no banks can borrow to buy commercial paper and no businesses can sell it.
    c. The result will be that there is NO market, hence No value to any asset.
    d. LIQUIDITY stops because no one knows what the underlying value of any asset used as collateral really is.
    e. Fear and distrust. No trades, no market, no liquidity, no LIFE.

    I have left out much in an effort to simplify a more condensed explanation of what has transpired, IMO. The actions used to counter attack the above situation must all be based on the following points
    1. Restoring Liquidity First Federal Reserve and Treasury are doing this. It is only a stop gap
    2. Stopping the manner in which we are being attacked/ shorting to the down tick, transparency in CDS and Mark to Market rules modified
    We need to move immediately to Mark to Model or back to Cost Accounting model
    3. This will restore confidence in the financial markers and it will also stop banks from having to write down asset values every time they make a loan.
    4. Restoring confidence by announcing your plan

    We need Christians across the country to take a stand to stabilize the collapse of world financial markets. We are running out of time!!
    I sent this letter to the Senate Banking committee and President Obama. My hunch is he may not fully understand.
    If the SEC would at least test out a suspension of the Mark to Market Accouting Rule and use a Cost Basis Accounting instead and at the same time suspend the shorting to the down tick, AND RETURN TO THE UPTICK RULE president Obama may be spared total embarrassment from a crash he will be blamed for!
    Your help to bring back the uptick rule for stock shortselling and totally change to structure of mark to market accounting is critical. CDS transparancy is also key.
    Feel free to forward to your Congress and Senators and every American you know. We have little time left as the rules in place will lead to a crash of massive proportion. All one has to do is look at stock values since these rules were put in place in October 2007 for shorting stock to the down tick (last used in the GREAT DEPRESSION AND STOPPED IN 1933) and January 2008 for Mark to Market Accounting and see the cause and effect. Do a two year chart on any stock you wish. It will be very eye opening!!!!!!!!!!!!!!!!!!!!!!!!

    Timothy Kershaw

  10. KC Kid says:

    Sometimes an analogy helps.——————– If you were to “Mark to Market-ize” (M2M-ize) the cruise control on your car you would need to reverse the action it now takes when your car slows down or speeds up. ——– As the car slows down instead of pushing the accelerator pedal down to speed the car back up, as a normal cruise control would do, the M2M-ized version would instead let up on the pedal. ——— Thus the car would slow down even more causing the M2M-ized cruise control to lift the pedal up even more. ——— This cycle would be repeated until the engine eventually was at idle and the car stopped moving or was moving at minimum speed (assuming a flat road). Of course the reverse is also true. ——— So when this type of seeming logical yet improper feedback is introduced into the banking system it tends to help produce (destabilizing) boom and bust cycles. Of course if you are an active trader that’s great but if you are a retired long-term investor it’s pretty scary. ——— If M2M is to be kept, which I’m not in favor of, we need to find some way to help stabilize the system. ——- That’s why the counterintuitive recommendation from some of inverting the capital raise requirements makes sense from a dynamic system analyst’s perspective. —— Right now anything that causes capital raise requirements, which M2M does in a down economy, will tend to cause banks to let up on the lending pedal. —— That in turn reduces the velocity of money and economic activity (MV=PQ) thereby causing more defaults driving the market marks down even further. And, the cycle repeats itself until the economy comes to a standstill or is finally reversed with gigantic sums of new money. This process is particularly troubling because the banking system is naturally leveraged which amplifies the effect.

  11. [...] subcommittee members and later asked that it be entered into the record. Here is a link to "My Nightmare." « Previous [...]

  12. mktcycler says:

    Bob,
    You also need to underscore to Congress how MtM is affecting bond and bank debt covenants. MtM-related writedowns are causing such covenants to be violated, forcing companies to renogiate debt in an environment when credit has frozen. MtM is the new poster child for the law of unintended consequences. MtM should be a footnote item, not something that flows through the income statement and balance sheet. The rule as it exists today should be suspended, not just tweaked.

  13. Steve Booren says:

    Bob – I stumbled across your blog searching for facts about the suspension of the Mark to Market rules… I have a hypothesis that we can easily track major market moves based on legislation by our government. Yes, legislation matters.. and what they are doing is terrifying…

    Have you ever seen any research, a chart, etc. looking at the market (S&P 500) versus major tax or legislative decsions? For example:
    – consider the 70′s – 80′s… high taxes (70%) = no incentive, no market growth.
    – ERTA 82 (8/13/1981) – tax rates go from 70% to 50% = presto, incentives to work, market goes up for 18 years…
    – TRA 86 takes away passive loss deductablity on real estate, and presto, commercial real estate tanks along with the lenders (S&L’s)…. could that be part of the 87 Crash???
    – 1999 Preparing for Y2K overstimulates the economy, leads to the March ’00 collapse.
    – 9/11/2000 – Attacked by Islamic Terrorists
    – 3/2001 – Attached by White Collar Terrorists and the collapse of Worldcom, Global Crossing, Qwest, Enron, oh and then those trusted CPAs Arthur Anderson…
    – the decade of the 2000′s – Can anyone trust the accounting ??? Maybe that is why the market is lower today than 10 yrs ago…
    – 3/30/2009 – Mark to Market “suspension” – Presto, the market climbs again, maybe freeing from a self-inflicted accounting rule…

    I wonder if anyone has put together a graphic or looked at this more thoroughly ???

    Welcome your thoughts –
    steve.booren@lpl.com