Mark-to-market: the good, the bad, and the ugly

Last week Thursday, the Financial Accounting Standards Board vowed to pressure and voted on the relaxation of the mark-to-market accounting of securities.  And this was welcomed by the markets, when indexes ended on a positive note (which may have been a combined effect of the end of the G20 summit and this piece of news).  The past months have seen financial institutions who had huge exposure to the legacy assets write off a big part of their value and would likely continue doing so.  Having the rule around also made it easier for investors not only to speculate the ‘real’ value of these assets but also take advantage of that negative sentiment, some by selling and some by shorting, which continuously pummeled the stock market.  Without a market for the toxic assets to help value them accurately, banks could find themselves selling some of these assets at a much lower price and bearing assets with inappropriately depressed values.  Although about 20% up since March 9 lows, this cannot be taken to mean that hope has come back to Wall Street.  The rally of the past several weeks could only be seen as a bear market rally, which many analysts believe could be back to testing the lows.  The relaxation of the MTM accounting may have simply added to that rally.


THE GOOD

With that said, I believe this rule change creates some benefits for the banks who are owners of the securities affected by this change.  As if not hurt enough, having MTM for much longer does not really leave banks much breathing room. By relaxing it, banks gain some space to recover from the heavy losses they have suffered.  While the rally has already provided some of this, removing the rule that has proven harsh over the past several months perhaps serves a better rescue aid for the banks.

The lack of the market has also contributed to the overall problem.  With nothing more than the belief that the assets are indeed worthless, financial institutions run the risk of disposing of them at horrible prices and horrible losses – even if they don’t truly reflect their real values. Giving the people who know more about the assets the ability to price them without having to follow the market is a way that real values are to be reported.  What is becoming a conventional wisdom that all assets are worthless, bankers are able to defy that and defend what MIGHT be the true value behind them.

Having the ability to not follow what the still-negative market dictates, relaxing MTM also allows institutions to reflect better numbers on their balance sheet, thereby restoring at least a bit of confidence that has been long lost.  The better value that will be reflected could help lift the prices not only of the distressed assets but also their stock price.  Firms such as Citigroup and Bank of America have become dollar stocks (and at some point even broke under that); the confidence gained from the departure of MTM may serve as a catalyst for faster recovery for these firms.

To complement the better balance sheet is a better earnings report.  If the financial institutions are not required to mark to market, reports of a better outlook might just be well ahead of us. There is no need to have significantly huge write offs which correspond to a similarly significant reduction in earnings.  “The earnings will go up in the single-digit area, something in the order of 7% to 8%,” Robert Willens, a former managing director at Lehman Brothers said in a report from TheStreet. If the negative sentiment has caused a downward spiral on the markets, this newly found confidence aims to do the same spiral, albeit following a different direction.

I’m not sure what else I missed with regard to the benefits of this change in accounting rule.  A couple of weeks ago, I called for the same thing that the FASB finally did last week.  But in hindsight, the removal of the mark to market may not have only a good side.  There are potentially a bad and ugly side, too.


THE BAD

From the many potential bad things that can come out of this rule change, the devil might be the fact that people involved in this ‘re-pricing’ gains the ability to value the assets according to their own perceptions about their real value. Above, I mentioned that without mark to market, institutions are able to reflect better numbers and reduce their losses from the write offs they have become accustomed to do from the past several months.  But then again, if there are no strict standards to follow, other than the market, when it comes to valuation, who are we kidding? Better numbers? Lower losses? Maybe. But that is no assurance that what we will hear from these firms in the coming quarters is an accurate reflection of their performance.  Somehow I now view this change as some form of reporting distortion. Of course, banks will not be reporting figures as if there was nothing wrong in the first place (or at least I hope not).  The only trouble here is the possible misuse of that discretion to value.

Furthermore, if many analysts/experts are not able to specify the true value of many of these assets, I doubt the public will do a better job in doing that.  Many individual investors cannot afford to hire their financial advisors and perhaps rely on their research.  Once banks report better numbers and better outlook, the people might decide to get involved while having the wrong ideas in mind.  Of course, at the moment the wisest may be to stay away from these institutions while the balance sheets have not been fixed, but without a doubt there lies the possibility of the public being misled by the reported numbers.

Other bads of this mark to market issue have been discussed by Baseline Scenario:

  1. Investors and regulators are not idiots (somehow supporting and on some level refuting my last point above)
  2. This is an unsafe choice, as it deviates from the conservatism principle in accounting
  3. Mark-to-market is a “red herring to begin with”


Then we come to this part: THE UGLY

The administration has vowed to do whatever it can to solve this financial crisis.  Based on that, both the Treasury and the Fed have already introduced a lot of programs begining with the TALF last year then the TARP, this and that, this and that, and the latest PPIP.  And the last program is where I see the ugly.

There has already been a big discussion on the loopholes of the public-private investment program or PPIP, as famously known. Through this program, private investors will be guided by the government by matching their investments dollar for dollar along with a 6:1 leveraging, backed by the government.  With the aim of price discovery, or simply price improvement, the PPIP will follow an auction-type of buying toxic assets to try to help bring up the prices from their distressed level.  Since the plan was released, there has already been so many analyses about how this program is a win-win-lose situation, apparently the taxpayers being the losers.

With the bidding process that is about to ensue, and the government paying as much as $92 for a $100 asset while the private investor only shoulders the remaining $8, we run the risk of overpaying for these assets.  A bit of a relief if in the end the assets really are worth a lot.  Save the idea of private investors earnings a lot, the taxpayers also could take some benefit from this although miniscule.  If the assets, in the end, are worth nothing, then the government faces the threat of throwing so much good money after bad.   Now, enter mark-to-market, or the absence of it.  Providing the ability to lift the prices from distressed levels sounds good but if that is paired with the bidding process of the PPIP, there just might be a bigger chance that everyone will be overpaying for things, which might end up being worthless in the end.

I don’t believe there will be investors who will pay for the assets’ maturity value.  Having MTM back PPIP will only get banks to value assets, say, 20-30% higher while everyone pays $60-75, instead of $40-50 (yes, these numbers are pulled out of thin air).  The bigger purchase price only translates to a bigger subsidy by the government, or need I say taxpayers.  Again, the spooky part is finding out in the end that the assets are not really worth anything.  With the discretion to improve valuations, firms could simply price their worst type of assets higher than their true value.  The two implications: 1, investors could own the worst type of worthless assets and 2, both parties (investors and taxpayers) could overpay and lose so much.

In the end, we can only hope that there is indeed much value to be had. Or it could turn really ugly.

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