How Not to Solve the Credit Crisis

So, let's say there is a confab of all of the great veterinarians of the globe, and they determine that, henceforth, dogs' tails shall be reclassified as legs. Look, it was a fair vote, the right folks agreed, the parties came together in a spirit of bipartisanship, and they got it done for the good of the country (or for dogs).

I ask you, in light of this important yet entirely invented decision, how many legs would a healthy, fully limbed dog have?

Bully for you if you said "four." Because just calling a tail a leg doesn't actually make it a leg.

It is no surprise to most people that (a) the global financial system is a bit of a mess, and (b) our elected and non-elected leaders in many countries around the globe are throwing any strategy they can think of at the problem. One idea that some are pressing the Securities and Exchange Commission to adopt is for it to suspend mark-to-market accounting, essentially overriding the Financial Accounting Standards Board (FASB), which is tasked with setting accounting standards in this country.

It's not just a bad idea. It's a bad idea that sets a bad precedent.

Mark-to-market accounting forces companies to value the securities on their books at the going market rate. In normal times, this gives investors an accurate view of what a company's assets are worth.

Many people are pointing to mark-to-market accounting (also known as "fair value" accounting) as being part of the problem in keeping the American financial system in turmoil. Banks, insurance companies, and other financial institutions have statutory capital requirements, which are being harmed since the market for so many securities is essentially glued shut. If the last sale of some esoteric, asset-backed security for government of Iceland general obligation bonds trade today at $0.05 on the dollar, then every financial institution holding that security must value it on their balance sheets at $0.05, even if they're pretty sure that the Icelanders are going to catch enough cod to pay their bonds in full.

So the proposal to suspend mark-to-market pricing would allow these firms to value such assets using some other method -- generally speaking, a test for impairment, which would be based on models created by the companies themselves.

But "company-derived models" are the same nonsense that helped convince banks like Wachovia (NYSE: WB  ) that they could buy billions of dollars worth of garbage home loans and keep them at full value on their balance sheets as foreclosures rose, especially among the very type of loans they held by the billions. AIG (NYSE: AIG  ) didn't implode because of mark-to-market accounting, nor did Fannie Mae (NYSE: FNM  ) , Freddie Mac (NYSE: FRE  ) , Merrill Lynch (NYSE: MER  ) , or any other financial company that possesses toxic assets on its balance sheet. The problem is, as the name suggests, that these securities must be valued at the price they could fetch on the open market. Even if the holder intends to keep these securities, it must value them at market. At a time of market turmoil such as we exist in today, that leads to these values being marked down. Way down.

That matters because banks have to maintain a certain level of capital adequacy, and marked-down securities lower their statutory capital levels, leading to the need for them to raise funds, which is expensive, or in severe cases, rendering them insolvent, which is, er, expensiver. In the past few months, we've had plenty of the severe cases. In all likelihood, there will be more.

Bad medicine
But suspending fair value accounting because the answer is inconvenient is akin to firing the weatherman because it's raining. Fair value accounting didn't cause the problems in the financial system. Rather, it pointed them out and highlighted the impact of a decade's worth of poor risk control. Fair value exposed the problem; suspending it to allow banks to use alternate methods has the effect of reducing the amount of useful information for investors by obscuring the value of large portions of banks' balance sheets.

Sure, it might feel better, and giving banks the ability to use models rather than fair value might keep a few out of insolvency. But there's a problem. Investing isn't Calvinball. An environment where the rules are changed in order to consistently make things look as positive as possible does not instill confidence. FASB is an independent body, prone to errors, certainly. I doubt, for example, that when FASB promulgated fair value accounting, that the risk of a credit market freeze was a central consideration. But political interference into FASB's role as standard setter is bad policy.

A better solution would be to attack the problem of capital adequacy at banks on the banking regulatory side. It is possible for banking regulators to relax their capital adequacy requirements for banks that have assets they intend to hold to maturity, so that they're not pushed into technical insolvency by virtue of the trading prices of their assets. Regulators could make some determination about whether to use straight fair value accounting or alternate standards to determine the appropriate mark for a bank's asset level. I doubt that anyone is saying that the only valuation level for bank assets is fair value -- in fact, alternative standards already exist.

But let's not kid ourselves that reducing the usefulness of the information for investors is somehow the panacea to making the credit crisis unwind itself. That makes as much sense as rounding pi.

Bill Mann said something really pithy one time, but no one was paying attention. He holds none of the companies mentioned in this article. He loves both pi and pie. The Motley Fool is investors writing for investors.


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  • Report this Comment On October 22, 2008, at 4:40 PM, Pushkinator wrote:

    Bill,

    I always like your articles. You have caused a shift in my thinking on this matter. The one concern I have about mark-to-market is that the Wall Streeters have such a short-time frame that they freak out at these mark-downs and push the stocks in a downward spiral. The Wall Streeters equate mark-downs with decreased quality, which may be true some of the time, but is not always true.

    I would compare it to our own stock holdings. Those stocks have a significant lower price today than they had a year ago, but I am not going to take the position that those stocks are now bad, just because they have lost value. Unfortunately, the Wall Streeters do take that position and it would appear to make these instruments even more toxic.

    I guess I have to just hope my long-term horizon helps me to get over this short-term trough.

  • Report this Comment On October 22, 2008, at 4:45 PM, Tinka82 wrote:

    Bravo, Bill!!

    Company derived valuation is so prone to overvaluation and misleading results, it's appalling that thinking people would actually consider this a reasonable suggestion.

    Part of the problems were caused by improper valuation methods of the real estate within the portfolios, and then improper pressure and relationships between the issuing companies and their bond ratings.

    Market value is market value. Considering the circumstances, most of these securities are experiencing a distressed market, and the values are reflecting this in the sale prices. To fudge the numbers only results in the purchasers of these bonds getting fleeced and the lenders claiming them as assets being undercapitalized.

  • Report this Comment On October 22, 2008, at 4:52 PM, efhouse wrote:

    Mark-to-market is supposed to show the "fair value" of an asset. But, as you pointed out above, if the market for an asset is stuck, but nothing has changed about the asset itself, mark-to-market does not show you the FAIR VALUE of the asset. So the information that the valuation is now giving you is more that the market is broken, rather than the correct value of the company holding the asset.

  • Report this Comment On October 22, 2008, at 5:28 PM, Tinka82 wrote:

    Efhouse,

    Here are the levels of mark to market valuation from the American Institute of Certified Public Accountants:

    How does mark-to-market work? SFAS 157 provides a hierarchy of three levels of input data for determining the fair value of an asset or liability.

    Level 1 is quoted prices for identical items in active, liquid and visible markets such as stock exchanges.

    Level 2 is observable information for similar items in active or inactive markets, such as two similarly situated buildings in a downtown real estate market.

    Level 3 are unobservable inputs to be used in situations where markets don’t exist or are illiquid such as the present credit crisis. At this point fair market valuation becomes highly subjective.

    Fair is what the market will bear and pay. This is how your home, car, etc. are generally valued. Would you pay more than typical going rate? Would you like to pay based on the Level 3 valuation method?? It's a big part of what got us into this mess. Level 3 valuations are highly suspect.

  • Report this Comment On October 22, 2008, at 5:50 PM, whsw wrote:

    As a former trader and manager of institutional portfolios consisting of all manner of derivatives, I too shuddered at the notion of abandoning the marking-to-market methodology of recognizing income (losses) In so many cases I had to convince my superiors atop Mt. Olympus that my positions would come into the black as they either approached maturity or some anticipated event would take place. I know all of the explanations because my traders used them often enough on me. Sometimes they worked out and some times they didn't, such was the game we played.

    But, there are more dimensions than the obvious. Abandoning m-t-m would be foolish yet, having it in place in its present form does not reveal the entire picture either. One quarter and you're down but in another, you're up without doing anything more than letting the positions sit on the books. I, for one, would be in favor of a two number income recognition method. One number would be the true operating income, fully recognized and in the 'bank' so to speak. The other income (loss) number would be the m-t-m of the unrealized g/l. That number should be a number weighed against the estimated of the value of the position. Factors such as liquidity, especially for longer dated exotic derivatives and changes in valuation criteria should be noted, perhaps by a qualified audit report. In the case of highly tailored securities, as much of this 'toxic' waste is, a clearing house should be established that would help quantify the true value of the positions.

    As m-t-m might seem to be offering transparency, having it in place may also mislead.

    By the way, accounting/auditing firms and rating agencies are highly suspect here as well. Talk about being asleep at the wheel.

  • Report this Comment On October 22, 2008, at 5:52 PM, MotleyGrandCru wrote:

    Bill, Could not agree with you more...here are a couple other ways to view the issue:

    Let's say I'm a homeowner in an area with a glut of empty houses on the market; what's the fair value of my house today if I try to sell it in this illiquid market? Is it A) the market price in boom times, B) the price in "normal" times or C) the price in today's market? If I'm the seller I know which way I'd like to answer the question, if I had the power to set prices.

    Or perhaps I'm a farmer who decided to plant corn and now, for reasons beyond my control, the price per bushel has dropped by 30% in just one month; do you think anyone is going to give me anything but the the market price?

    Would it be fair to the person buying the house or for the food or ethanol company purchasing the corn to pay an "adjusted" price which the seller somehow determines through some opaque calculation?

    ...Not in a economy which would keep at least some of its free market benefits!

    Of course in the two examples the home seller and the farmer don't have any choice but to sell at the market price. The financial institutions with the "toxic" debt failed to perform adequate risk management. Why reward them beyond the generous steps already taken by the Federal government by allowing them to cook the books?

  • Report this Comment On October 22, 2008, at 6:16 PM, MKArch wrote:

    http://www.bankstocks.com/ArticleViewer.aspx?ArticleID=5438&...

    Bill,

    I don't know if you ran across this MTM article by Vernon Hill or not but it sounds to me like you both start from opposite ends of the argument to arrive at about the same conclusion.

    Mike

  • Report this Comment On October 22, 2008, at 6:53 PM, mlaursen wrote:

    I'm far from being an accountant, so forgive me if my question is naive. Could the volatility of mark-to-market be toned down by allowing the valuation to be an average over some time period: three months, a year, five years?

  • Report this Comment On October 23, 2008, at 8:55 AM, jharsh wrote:

    Calling a tail a leg doesn't actually make it a leg, but that's what mark-to-market does.

    Your Icelandic bonds are worth a lot more than $0.05 on the dollar if you're not desperate to unload them right now. MotleyGrandCru's house may not be worth much TO HIM right now, but to his mortgage company it's worth should be based on the likelihood that he'll keep paying his mortgage, not it's current, temporary, low value.

    And the current mark-to-market rules aren't some great tradition of accounting that have worked for centuries, they're less than a year old. Remind me; when did the current crisis start?

  • Report this Comment On October 23, 2008, at 10:01 AM, TMFOtter wrote:

    jharsh-

    By my reckoning the crisis started in 2002 when housing prices decoupled from the rate of growth of income. Maybe you're asking a different question, but I think mine's probably the right question.

    As I stipulated, there are other ways to get at the capital adequacy problem, and banks are welcome, under SEC regs, to make multiple presentations. I agree that the price and the value are likely decoupled in many instances. Some things that have a speculative value may actually have a cash-flow value of zero.

    Best- Bill Mann

  • Report this Comment On October 23, 2008, at 11:22 AM, zinser wrote:

    Great article Bill. Any arguement that can somehow work in Calvinball makes for a good read.

    If you own those $.05 icelandic bonds you may think they're worth more in the future - just like beaten down shares that are being purchased now. But until the market buys and sells at a higher price it's a guess, an educated one at best.

  • Report this Comment On October 23, 2008, at 1:21 PM, mlaursen wrote:

    I thought the economic theory is that market price is a justifiable measure of a good's value only if there is some minimum volume of trading in that good. Do the mark-to-market rules have any concept that there must be a certain level of trading in a particular asset at a particular price before that price can be considered accurate?

  • Report this Comment On October 23, 2008, at 10:59 PM, bruiserND wrote:

    Sorry Bill you're wrong in the case of the physical GNMA securities in question that have been marked down to their knees .

    These various speed pools are very different which affects the varied income streams.

    Suspend 'mark to market' on the aforementioned , let the securities 'breathe' for a couple of months , then evaluate them for redistribution to long term buy and hold hands and out of the hands of those who created synthetics against an income stream that is volatile and tainted.

    Not all GNMA pools are created equal despite what FNMA & FRE insinuated nor those swap dealers who pawned them off as just like long term treasuries when seeking 'yield to commission'.

    Had Greenspan & Co issued long bonds all along to satisfy demand at the long end of the curve none of this would have happened.

    20 years from now , business school students will reflect back on what a marble mouth bluff and political hack Greenspan was .

    Let' em breathe , suspend Sarbanes Oxley 'mark to market ' on GNMA's now. It's the right thing to do regardless of political ideology.

  • Report this Comment On October 24, 2008, at 4:37 PM, buckerine wrote:

    The problem with mark to market is that the Tier 3 assets, the assets without a market, are subject to the company models that eveyone is complaining about. Until they is an accepted and mandated method of calcaulating the value of these assets we will continue to have these assets overvalued.

  • Report this Comment On October 24, 2008, at 8:03 PM, dougmoskowitz wrote:

    Should we revalue balance sheet debt based on MTM? If interest rates go up, should a company be required to write-up their commercial loans because if they were forced to re-finance refinance they would have to pay more? Even if they were not a willing re-financer and had no intention or reason to do so?

    This ridiculous suggestion points out the inherent flaw with MTM. While I agree with the intention of MTM, its range of outcomes deem it unreliable when considering factors such as an orderly liquidation, forced sale, forced liquidation, general market volatility, etc.

    Basically, it is a copout...a fast and easy way to establish a today's value without doing any work. It has lowered the complexity of valuation to something perhaps congress can understand, but it has little to do with presenting reliable information to a balance sheet reader.

    The question of "would you pay the going rate" is not always relevant. A fair market value requires a willing buyer and a willing seller entering into an arms length transaction. It is not reasonable for a holder of an asset who is not a willing or forced seller to be subjected to valuation that is established by volatility or an irrelevant buyer. Was the market truly worth 300 more points yesterday? Only if you were a willing seller today.

    Consider the basic scenario of being a bondholder that has the capacity and intention of holding a bond until maturity. Who cares what the market says its worth?

    Just because the market has the power to set a price for something right now, it is questionable whether that translates into what something is worth in the manner that MTM requires on a balance sheet.

  • Report this Comment On October 25, 2008, at 8:06 AM, lquadland10 wrote:

    can you tell me why they don't do mark to market in commercial real estate just housing. What about other assets. How can we value the banks if we don't know that?

  • Report this Comment On October 25, 2008, at 10:28 PM, underdone wrote:

    Bill you are obviously not an accountant.

    Mark to market does not apply to all companies or all assets. Indeed it would be absurd to apply it to all assets. It conflicts with the going concern concept and only applies to assets that are traded. Companies such as Fannie Mae and Freddie Mac do not trade their mortgage assets they hold them to maturity which is essentially when they are paid off either by refinancing or over time.

    The problem with mark to market is not in how it is applied but that there are parties within the market that are attempting to apply mark to market principles to companies and or assets that they do not apply to. Imagine applying mark to market to motor vehicles or specialised plant. Motor vehicles would have to be writen down by 50% when driven out of the showroom and specialised plant would have to be writen down to scrap value when delivered. Virtually all companies would be bankrupt. Can you not see the conflict with the going concern concept.

    It is about time that people attempting to exploit mark to market principles to talk down the value of companies actually read the accounting rules and principles and how and when they are applied.

    Also in respect of banks, capital adequacy is determined in part by adding back the provisions. e.g. if a bank has $2000 lending against which there are $1200 provisions and $1000 borrowing, the original capital of $1000 would be reduced to -$200 but the capital adequacy would be -$200 plus $1200 or the original capital amount of $1000 divided by $2000 i.e. 50%. And so long as there was no defaults and repossesions there would be no actual loss incurred or reduction in the capital adequacy. In other words the bank would still be solvent.

    These two areas are clearly being misinterpreted by the market at the moment giving rise to some incredible undervaluations of stocks.

  • Report this Comment On October 26, 2008, at 8:03 AM, bbednarz wrote:

    Banks do not lose money - they give you 3 o 4 % on your saving accounts or CD's, while charging you 22% for your credit cards.

    Wall Street gets paid whe you buy a stock - Wall Street gets paid when you sell a stock (FEES).

    ......

    Theft - Fraud or the politicians favorites Smoke & Mirrors. We all understand theft, andwe all understand fraud....So when treasury "secret"ary Henry Paulson said we are too naive to understand the complexities of banking -.- to me it means more of the same "SMOKE & MIRRORS" no valid explaination ..... F R A U D

  • Report this Comment On October 27, 2008, at 4:44 PM, TMFOtter wrote:

    Dear underdone-

    I thank you for your comments, they are well taken. I'm having a hard time finding in the article where I claimed that fair value accounting applied to *all* assets. There are a multitude of ways in which assets can be carried on a balance sheet -- some of these decisions are based not on the asset itself but rather on the intention of the company in terms of holding or disposing the asset. I know this, and it's not the point of the article. For those assets to which fair value accounting applies -- and remember, the companies *themselves* elected to adopt fair value -- having the SEC mandate a switch away is a bad precedent that lowers information quality to investors.

    Best regards-

    Bill Mann

  • Report this Comment On January 28, 2009, at 4:45 AM, mcdiv wrote:

    "Separate and distinct things not to be confused, as every thoughtful investor knows, are real worth and market price." - John Burr Williams, The Theory of Investment Value

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