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Mark-to-Make Believe: Living on a Prayer

Marking MtM to Market

Proponents of MtM argue that basing values on current prices provides an accurate picture of a firm’s financial position. In particular, it is superior to the alternative – historical cost accounting – where assets and liabilities are valued at the price at the time the transaction was entered into.

Recent research indicates that MtM accounting may, in fact, distort the price of assets. Under historical accounting, if the market value of a bank’s loans increase above historical cost, then there is an incentive for management (who are judged on current profits) to sell the loans. This allows the profit to be realised irrespective of whether the market values the asset accurately. The sale is in the interest of the managers but not necessarily of the shareholders that may be better off if the loans were not sold (especially if the market value is below the “true” economic value of the asset). Under MtM accounting, in theory, the loans do not have to be sold as marking the assets to market value enables the gain to be realised.

In a falling market, this process can work perversely resulting sometimes in the uneconomic sale of long-term, illiquid assets. In a MtM environment, if observed market prices are falling and even if they are low (below perceived value) firms may try to sell assets to try avoid recording losses. If all firms behave in this way, the resultant selling may drive prices down. This penalises shareholders that would have benefitted from the assets being held as in the absence of default they would receive face value rather than the (lower) market price.

The research highlights that MtM accounting is pro-cyclical and creates volatility of asset values through complex positive and negative feedback loops. Under normal market conditions where asset markets are liquid, MtM accounting works benignly. In volatile markets, where behaviour becomes linked by a common factor such as disclosure required by MtM accounting, co-ordinated actions of market participants can easily lead to sharp movements in asset prices. The process distorts market prices and ultimately the firm’s financial position and value.

The effects of MtM accounting illustrate a fundamental economic principle where eliminating one market imperfection (poor information) magnifies other imperfection (illiquid markets).

In the current crisis, MtM accounting has exacerbated uncertainty. Banks have constantly misjudged values of assets. This uncertainty has been destabilising to market confidence.

The new accounting framework has actually been an impediment to dealing with the problem. In a pre-MtM environment, banks may have responded to the deterioration in asset quality by writing exposures to conservative values to remove uncertainty. This would then have allowed them to re-capitalise to an adequate level to restore confidence. In a MtM environment, there is less flexibility. Firms have been forced to mark assets to unreliable market prices causing them to progressively follow the market down. This has resulted in a “drip feed” of losses and a succession of capital raising measure that have increased uncertainty.

Robert Kaplan, Robert Merton and Scott Richard writing in the Financial Times (17 August 2009) asserted that: “Financial assets, even complex pools of assets, trade continuously in markets.” This would have been news to those in the real world that struggle daily to get meaningful prices for many securities and assets.

The learned Professors, without a hint of irony or humour, went on to advocate the use of models for valuation: “Mutual funds in the US now use models, rather than the last traded price, to provide estimates of the fair values of their assets that trade in overseas markets. … In this way, the funds ensure that their shareholders do not trade at biased net asset values calculated from stale prices. Banks can similarly use models to update the prices that would be paid for various assets. Trading desks in financial institutions have models that allow them to predict prices to within 5 per cent of what would be offered for even their complex asset pools.”

Sadly, many of the lessons of the current financial crisis for MtM accounting seem to be lost on some.

Marking Time

The emerging problems of MtM accounting have led to proposals for change. Accountants were stung by the criticism of the standards. One structured finance accountant noted that: "It's the market that needs to change, not the accounting."

Officials and commentators have called for the accounting standards to be suspended with firms being allowed to revert to historic values adjusted for expected impairment. It seemed that MtM was acceptable when there were “gains”. However, everybody should be allowed to revert to historical or “adjusted” model prices when there were “losses”.

Paul Craig Roberts, a former Reagan administration official, wrote that the mark-to-market rule "is imploding the U.S. financial system by requiring financial institutions to value subprime mortgages at their current market values." He proposed that financial institutions be allowed to “keep the troubled instruments at book value, or 85-90 percent of book value, until a market forms that can sort out values, and allow financial institutions to write down the subprime mortgages and other troubled instruments over time."

Steve Forbes from Forbes suggested a 12-month “moratorium” of MtM in "exotic financial instruments (primarily packages of subprime mortgages)." In Forbes’ opinion: "It's preposterous to try to guess what these new instruments are worth in a time of panic." Going even further, the publisher and erstwhile presidential candidate, in a Wall Street Journal op-ed piece wrote: “Mark-to-market accounting is the principal reason why our financial system is in a meltdown.”

The International Institute of Finance (“IIF”) proposed resorting to historical price to facilitate “stable valuations” that “increase market confidence”. The IIF proposal was dismissed by Goldman Sachs as “Alice in Wonderland” accounting. The IIF, following hasty informal consultations with market participants, central banks, regulators and accountants, clarified their position:

1. MtM accounting will remain as it fosters transparency, discipline and accountability. 2. There is already latitude to use model approaches where observable market inputs are not available. 3. There is a need for clarification of pricing inputs in illiquid markets and the rules may need “refinement”. 4. New “techniques” or allowing “greater flexibility” risks that however well-framed the proposals the intentions of those advocating changes could be “misunderstood by investors at this stage”.

Another alternative approach was suggested by a group of French accountants . The Gallic thesis was that “market prices [had been] squeezed by a “crisis discount”. They proposed adjusting the valuation using an “upgraded fair value” model for serious crises where the “market” price was measured consistent with their intrinsic values. The proposal recommended that the accounting regulator in the country concerned would arbitrate that the “crisis discount” was abnormally high. Once this determination was made banks would be able to discontinue mark-to-market measurements of credit assets and switch to a fair value measurement. The “fair value” would be based on a “mark-to-model” approach using parameters set by the regulator. The proposal was reflective of French strengths as identified by Napoleon III: “We do not make reforms in France; we make revolution.”

In March 2008, the SEC has clarified the application of SFAS 157. The SEC indicated that it is appropriate to use actual market prices, or observable inputs, even when the market is illiquid, unless those prices are the result of a forced liquidation or distress sale.

Under political pressure, the U.S. SEC and the FASB were forced to further clarify FAS 157 in September 2008. The SEC also conducted a study into mark-to-market accounting - a condition of the Emergency Economic Stabilisation Act passed by the U.S. Congress in October 2008.

The FASB and the IASB altered the accounting standards so that firms were not obligated to use market prices in distressed markets. The changes allowed the reporting firm to use its judgement about whether individual market transactions are forced liquidations or distressed sales. If it determined the market price is not reflective of ‘true’ value or if no observable inputs are available, then the reporting entity could use its own assumptions about future cashflows and risk-adjusted discount rates.

The revised position introduces significant uncertainty about how MtM is to be applied. It is difficult to determine objectively whether prices are “distressed”.

Proponents of the alternatives to MTM seems to have decided that in the final analysis it better to just manipulate the values and pretend that there are no losses using an arbitrary model with assumed inputs in preference to “inconvenient truths” about market prices and the extent of the losses. As Mr. Hazard aka hedge fund manager Jon Shayne sings on You Tube:

“It’s easier to patch and mend and temporize away; Immediate cost is tough, we favor gradual decay.”

In July 2009, the IASB proposed a further change in MtM principles. Under the approach, reporting firms would need to value a financial investment as a long-term holding or as a trading position. Under the proposed rules, if the investment produces predictable cash flow like a bond, then it would be valued in accounts using an accounting mechanism that smooths out market fluctuations. If the investment’s cash flow is unpredictable, like derivatives, then it would be valued at current market levels.

The proposals were an attempt to resolve the increasingly intense disputes about MtM accounting. The problem was that it now introduces subjectivity in how instruments should be classified.

The amusing thing about the ‘radical’ proposals was that it was a return to exactly what the rules were before the entire MtM system was implemented. Firms valued hold to maturity instruments at book value (accrual accounting) adjusted for impairments and trading instruments at market. Value.

In the words of Giuseppe di Lampedusa, author of “The Leopard”, the great Sicilian novel: “everything must change so that everything can stay the same.”

Mark-to-Make Believe

MtM accounting has theoretical advantages. The famed humorist Yogi Berra once opined that: “In theory there is no difference between theory and practice. In practice there is.”

MtM and fair value accounting allowed banks to maximize short term returns by recognising profits up-front. Longer term risks of illiquid assets were hidden by the process. When the hidden risks emerged, central banks and regulators were left to solve the problems using public funds. If accounting is a mechanism for communicating financial information, then in the global financial crisis, MtM accounting has been a means for mis-communication.

In a speech in September 2008 to the Institute of Chartered Accountants of Scotland , Sir David Tweedie, head of the IASB, spoke of accountants with “all the backbone of a chocolate éclair.” He spoke of an era of “creeping crumble” when “… auditors [were picked off] by investment bankers, selling a scheme that perhaps was just within the law to a client, persuading two major auditing firms to accept it whereupon it became accepted practice and QCs would tell a third auditor that he could not qualify [the company's financial report] as the scheme was now part of ‘true and fair’.”

Sir David’s outlined his vision of the role: “The accountant is an artist, but he has to portray his subject faithfully…..If the reporting accountant lacks integrity; if raw economic facts are unpalatable and smoothing devices are sought; if he fails to support fellow professionals who have carefully documented their view of the principle, researched the literature and sought advice and made an honest judgment; if regulators demand one answer and one alone, not those within a range; or if the profession constantly seeks answers for all questions - the reporting accountant will paint by numbers and deserve the rule-based standards he has requested. This will be the profession of the search engine, not one of reasoned judgment."

George Clemenceau, the former French Prime Minister, once noted that: “La guerre! C’est une chose trop grave pour la confier à des militaires.[War is too important a matter to be left to the military.]” Accounting may be simply too important to be left to accountants.

© 2010 Satyajit Das All Rights reserved.

Satyajit Das is a risk consultant and author of the just released Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives -Revised Edition (2010

Mark-to-Make Believe – Still Toxic after all these Years!

In 2007, as the credit crisis commenced, paradoxically, nobody actually defaulted. Outside of sub-prime delinquencies, corporate defaults were at a record low. Instead, investors in high quality (AAA or AA) rated securities, that are unlikely to suffer real losses if held to maturity, faced paper - mark-to-market (“MtM”) - losses.

In modern financial markets, market values drive asset values, profits and losses, risk calculations and the value of collateral supporting loans. Accounting standards, both in the U.S.A. and internationally, are now based on theoretically sound market values that are problematic in practice. The standards emerged from the past financial crisis where the use of “historic cost” accounting meant that losses on loans remained undisclosed because they continued to be carried at face value. The standards also reflect the fact that many modern financial instruments (such as derivatives) can only be accounted for in MtM framework.

MtM accounting itself is flawed. There are difficulties in establishing real values of many instruments. It creates volatility in earnings attributable to inefficiencies in markets rather than real changes in financial position.

Alan Greenspan once noted that: “It has been my experience that competency in mathematics, both in numerical manipulations and in understanding its conceptual foundations, enhances a person's ability to handle the more ambiguous and qualitative relationships that dominate our day-to-day financial decision-making.” He may be the only one qualified to understand modern financial statements.

MtM accounting falls well short of its objective - the provision of accurate, reasonably objective and meaningful information about financial position. In the present crisis, it has heightened uncertainty and confusion about the position of banks and investors.

MtM accounting requires financial instruments to be valued at current market prices. This assumes a market and a price. As Michael Milken (the progenitor of “junk bonds” at Drexel Burnham Lambert) once noted: “Liquidity is an illusion. It is always there when you don’t need it and rarely there when you do.”

In volatile times, liquidity becomes concentrated in government bonds, large well known stocks and listed derivatives. For anything that is not liquid, MtM means mark-to-model. This assumes universally accepted pricing methodologies with verifiable inputs. Valuation for all but the simplest instruments today requires a higher degree in a quantitative discipline, a super computer and a vivid imagination. For complex structured securities and exotic derivatives, the only available price is from the bank that originally sold the security to the investor. Prices available from the purveyor of the instrument (a concept known as mark-to-myself) strain reasonable concepts of independence and objectivity.

A current market price of 85% for a AAA security does not actually mean that you will lose 15% of the face value. It is only an estimate of likely losses. It may reflect the opportunity loss of being able to invest in the same or similar security at the time of valuation. In volatile markets, excessive uncertainty or risk aversion means that values deviate significantly from actually cash values.

MtM prices may be prone to manipulation. An often neglected element of the Enron scandal was the company’s ability to convince its auditors and the U.S. Securities and Exchange Commission (“SEC’) to allow MtM accounting to be used in the natural gas industry allowing the company to record current earnings based on the future value of long term contracts.

In dealings with hedge funds and structured investment vehicles (“SIVs”), banks have an incentive to mark positions at high prices thereby preventing complex and illiquid securities being sold at a discount and pushing down prices in the market. If these securities actually traded then the lower market price would have to be used to value positions increasing losses and margin calls on already cash strapped investors.

A lower price can be used to force margin calls and selling that may allow a dealer to buy the assets cheaply. Long Term Capital Management (“LTCM”) believed that the dealers brought about their downfall by moving the market values against their positions. In the current credit crisis, at one time markets resorted to barter – you exchange what you want to sell for something else – to avoid recording low prices for securities.

MtM prices, no matter how dubious, drive real investment and credit decisions. Holders of AAA rated securities may be forced to sell securities showing losses because MtM losses reach “stop loss” levels. Where investors have borrowed against these securities, the falling MtM value supporting the borrowing means finding money to top up the collateral or selling the securities thus realizing the loss. In the case of SIVs, the MtM losses trigger breaches of tests that require selling securities to liquidate the structure.

MtM values are used to establish current portfolio values and allow investors to invest or withdraw funds. Errors in pricing lead to transfers in wealth between incoming and outgoing investors; for example, a low value punishes a redeeming investor but rewards the new investor. In 2007, difficulties in establishing MtM values caused some funds to suspend redemptions. Sound investments may be sold off to prevent further losses or realize earnings to cover other losses even where the market does not fairly value the asset penalizing investors.

In the global financial crisis, with the capital markets virtually frozen, the extent of losses on bank inventories of hard-to-value products and commitments (structured debt and leveraged loans) was difficult to establish.

Financial Accounting Standard Board (“FASB”) Standard 157 (“FAS157”), which became effective for fiscal years after November 2007, is designed to provide “clarity” to the issue of fair valuation of assets and liabilities.

The centerpiece of FAS157 is the three level hierarchy of valuation (better referred to as the “three levels of enlightenment”).

The Fair Value Hierarchy prioritizes the valuation inputs used to determine fair value into:

Level 1 – this requires observable inputs that reflect quoted prices for identical assets or liabilities in active markets and assumes that the entity can access the markets at the measurement date (known as Mark-To-Market). In practice, this means a liquid asset or instrument that is actively traded; for example, where two-way prices are readily available.

Level 2 – this requires inputs other than quoted market prices included within Level 1 that are observable either directly or indirectly (known as Mark-To-Model). In practice, this means instruments that cannot be priced based on trade prices but are valued using observable inputs; for example, comparable assets or instruments or using interest rates/ curves, volatility, correlation, credit spreads etc that can be put through an accepted model to establish values.

Level 3 – this relates to unobservable inputs reflecting the reporting entity's own assumptions used in pricing an asset or liability (known as Mark-To-Make Believe or Mark-to-Myself). In practice, this means that the asset or liability cannot be priced using observable inputs and requires the use of modeling techniques and substantially subjective assumptions.

FAS157 valuations should be based on the exit price (the price at which it would be sold) regardless of whether the entity plans to hold or sell the asset. FAS157 emphasises that fair value is market-based rather than entity-specific.

FAS157's fair value hierarchy ranks the quality and reliability of information used to determine fair values - market prices are regarded as reliable valuation inputs, whereas model values that include unobservable inputs are regarded less reliable. The lowest level of significant input drives placement in the hierarchy and the level within the hierarchy drives financial statement disclosures.

The objectives of FAS157 are laudable and unobjectionable. Unfortunately, the standard provides significant discretion to companies in determining the values of assets and liabilities, although detailed disclosure is required. It also may create significant uncertainty in the values of assets and liabilities and financial condition of the reporting entity. This is especially true of Level 3 assets. It is also relevant to the valuation of Level 2 assets.

The problem is compounded by the fact that many major global financial institutions have increased their holdings of Level 3 assets in recent years. Major areas of valuation concern include:

1. Structured finance securities such securitised mortgages including subprime mortgages, securitised credit card obligations, asset backed commercial paper and collateralised debt obligations (“CDOs”).

2. Leveraged and private equity loans.

3. Distressed debt.

4. Principal investments by financial institutions in private equity, unlisted securities or physical assets for which there are no true market.

5. Complex derivative contracts including exotic options.

Level 3 assets of the leading 20 U.S. banks as at 31 March 2009 were reported to be $657.5 billion (as reported by the Congressional Oversight Panel in its Oversight Report dated 11 August 2009 “The Continued Risk Of Troubled Assets”). This represented a 14.3 % increase in Level 3 assets compared to three months prior (December 31, 2008). Bank of America, PNC Financial, and Bank of New York Mellon had twice as many assets (in terms of dollars) classified as Level 3 in the first quarter of 2009 compared to year-end 2008. Morgan Stanley had more than ten percent of their total assets categorized as Level 3.

The panel noted that: “The risks troubled assets continue to pose for the banking system depend on how many troubled assets there are. But no one appears to know for certain….It is impossible to ever arrive at an exact dollar amount of troubled assets, but even the challenges of making a reliable estimate are formidable.”

The key issue is that a relatively small change in the values of these Level 3 assets has the potential to reduce the capital base of the entity significantly.

The valuation of Level 2 assets may be more problematic than generally assumed especially under condition of market stress. This reflects the impact of model risk and lack of disclosure of the instruments treated as Level 2. Importantly, if market conditions deteriorate then some of these assets classified as Level 2 may need to be reassessed and treated as Level 3 assets.

It is not clear where in the Fair Value Hierarchy specific instruments are currently being valued. The correlation between disclosed bank write-offs and Level 3 assets is imperfect. This may be because individual institutions are classifying assets within the three level hierarchy using different criteria. It may also mean that there is actually no correlation between the classification and “real” losses. The lack of correlation may also reflect behavior, such as new chief executives wishing to write-off assets to be able to “blame” previous management.

Level 3 securities and derivatives cannot be valued using observable prices in liquid public markets. Market values must be based on models and estimates. Where losses are reduced (substantially) by MtM “hedging” gains, the exact nature of the hedges is not disclosed. Some banks and hedge funds have indicated that some losses resulted from hedges that did not function as intended. The hedge counterparty is undisclosed. As the gains are unrealized, if the counterparty (a thinly capitalized hedge fund) is unable to perform, then the hedge gains would be illusory. The lack of disclosure around the value of the hedges, their nature and hedge counterparties makes it difficult to gauge whether they are truly effective in reducing losses.

There are other oddities in current MtM accounting, such as the fair valuation of an entity’s own liabilities. FAS157 and Statement 159 (“Fair Value Option for Financial Assets and Financial Liabilities” issued in February 2007 by the FASB) allows the entity's own credit risk to be used in establishing the value of its liabilities.

Changes in the entity's credit standing are therefore reflected as changes in fair value. This results in gains for credit downgrades and losses for credit upgrades. For example, if a bank has $100 million of bonds that are subject to mark-to-market accounting and the market price drops to $80 (80%) then, it records a “gain”. As credit spreads increased, U.S. banks have taken substantial profits to earnings from revaluing their own liabilities. These MtM profits on liabilities have helped banks offset recent write-downs. But the revaluation of a bank’s liabilities is problematic. The face value of the liability must still be repaid. The gain from a higher credit spread is unlikely to result in cash profits. It is only if the entity can re-purchase its debt that the “theoretical” gain can be realised.

The Federal Reserve, Federal Deposit Insurance Corp., Office of the Comptroller of the Currency and Office of Thrift Supervision objected to Statement 159 prior to its passage. They argued that would the MtM of a bank’s liabilities in this way would “have the contrary effect” of increasing a bank’s net worth at the same time its “financial condition is deteriorating.”

The revaluation of a bank’s liabilities may also create volatility of earnings. Major financial institutions have recently been forced to issue substantial amounts of debt to finance “involuntary asset growth” as assets returned onto their balance sheets. This debt has been issued at relatively high credit spreads reflecting current debt market conditions. This means that if the market conditions improve, these institutions may record the mark-to-market losses on their liabilities even as their credit condition improves.

The International Accounting Standards Board (“IASB”) is understood to be considering the issue. Under proposals being considered, gains on falls in the value of an issuer’s own debt my no longer be allowed to be recognised. This would remove one of the most controversial elements of MtM accounting.

© 2010 Satyajit Das All Rights reserved.

Satyajit Das is a risk consultant and author of Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives - Revised Edition (2010, FT-Prentice Hall).