Mark-to-Market: A Rule That Begs to Be Broken

Interesting Read.



The Investment U e-Letter: Issue #954
Thursday, March 12, 2009

Mark-to-Market: A Rule That Begs to Be Broken
by Louis Basenese, Advisory Panelist
Senior Analyst, The Oxford Club

In this issue:

More fallout from Enron.
Where mark-to-market fails.
How this impacts your investments.


Dear Investment U Reader,

Today a House Financial Services subcommittee will examine the hot-button accounting issue of mark-to-market, formally known as FASB 157.

The SEC's already asserted its stubbornness. An anonymous source told Reuters this week, and I'm editorializing slightly, "There ain't no way we're suspending mark to market!"

But there are a lot of good reasons why they need to do exactly that. Unfortunately, the SEC doesn't have a great history of proactive regulation. Here's why we better hope our elected representatives see the situation differently.

Mark-to-Make Believe

Proponents of mark-to-market contend, and rightfully so, that the rule increases transparency. It requires banks to "mark" or price assets based on the current market price. In other words, it forces banks to tell us what their assets would sell for in the current environment.

On paper, that's a great principle. Who wouldn't want to know what their investments are worth on a daily basis? If you're like me, you probably mark your stocks to market every day - checking their prices after the closing bell.

However, doing the same for mortgage-backed securities - the assets at the center of this debate - is not as simple as punching in a symbol on Yahoo! Finance. You see, while stocks trade daily and by the hundreds of thousands of shares, these mortgage-backed securities might not trade for weeks or months at a time.

And when thousands of these investments exist, and only one trades in a month, can we really say a market exists? Not at all. So under the current conditions, mark-to-market is more like mark-to-make believe. Especially since the prices banks are forced to use are completely out of whack with reality.

Let me provide some examples to illustrate what I mean...

When FASB 157 Misses the Mark

In the fourth quarter, The Bank of New York Mellon (NYSE: BK) was forced to write down a $5 billion portfolio of Alt-A mortgages by $1.24 billion or (25%). Yet, based on the performance of the underlying loans - the principal and interest payments the bank was receiving - they only expected to lose about $208 million.

Granted the bank's estimates of losses could be wrong. But the difference between the two methods - net realizable value and mark-to-market - is gargantuan. And it proves mark-to-market fails to do its job when virtually no market exists for these assets.

For good measure, here's another example of its shortcomings...

The Federal Home Loan Bank of Atlanta (http://www.google.com/finance?cid=87557) holds three private mortgage-backed securities. But, it has no intention of selling any of them. Again, based on the actual performance of the loans, the bank estimates it will lose $44,000, beginning in 2025.

That's not a typo. It will be another 16 years before any losses are incurred on these loans. Yet because of mark-to-market accounting, the bank was forced to write off a loss of $87.3 million - a figure almost 2,000 times greater than the actual losses.

Good in Principle, Bad in Practice

One could argue that over time - as a market returns for these assets - the huge price differences would correct themselves. That's true. But banks can't simply wait it out.

The write-downs required by mark-to-market put many banks out of compliance with capital requirements - the amount of cash and easily liquidated assets they need to hold to offset their liabilities (i.e. - loans to others). And the only way to become compliant again is to raise capital by either issuing more stock or selling off assets.

Bottom line - the current application of mark-to-market forces banks to raise billions upon billions in real capital to offset losses that are never going to occur. And that makes absolutely no sense.

As for questioning the authority of the Financial Accounting Standards Board, their track record warrants it. Remember, their rules on special purpose entities allowed Enron to pull-off its accounting shenanigans and later required revisions to adjust for the deficiencies.

Mark-to-market rules were supposed to fix problems from Enron. Unfortunately, they created a large batch of new problems.

Mark-to-market is simply another one of FASB's rules that's good in principle, bad in practice, in desperate need of a revision.

Good investing,

Louis Basenese

Today's Investment U Crib Sheet

Another regulatory item of note for market watchers this week was talk from the SEC that they might re-instate the "uptick rule." The uptick rule was originally created by the SEC in 1938 to limit the amount of influence large institutions had to purposefully push the price of a stock down.

Specifically...

The Uptick Rule requires that in order to sell a security short, the price must be higher than the preceding sale. This had the impact of limiting the influence of "shorts" - those selling a security short to profit from the difference.

Amongst the other benefits, it was reported that the uptick rule reduced volatility and decreased manipulation.

The SEC eliminated the uptick rule in 2007, based on market tests they did during a bull market. No one had seen the effects of a bear market without the uptick rule since 1938.

As we know, extreme bull and bear markets are ruled by emotion, and little financial discipline. Rules like the uptick rule were designed to reduce the effect of this irrationality on the market.

Bringing the uptick rule back will be as welcome as adjusting the mark-to-market accounting rule.

If you're looking for another way to profit from the market's mispricing, take a look at real estate investment trusts (REITs). It was one of the sectors hit hardest from the mark-to-market rule. Hundreds of REITs have seen share prices plummet. But we've found a few that haven't been affected at all. In fact, you can Get Paid, the Next Time you go to the Doctor because of it.

http://www.oxfonline.com/HealthPlan/HC309.html?pub=OXF&code=EOXFK319

Recipe for Disaster: The Formula That Killed Wall Street

A year ago, it was hardly unthinkable that a math wizard like David X. Li might someday earn a Nobel Prize. After all, financial economists—even Wall Street quants—have received the Nobel in economics before, and Li's work on measuring risk has had more impact, more quickly, than previous Nobel Prize-winning contributions to the field. Today, though, as dazed bankers, politicians, regulators, and investors survey the wreckage of the biggest financial meltdown since the Great Depression, Li is probably thankful he still has a job in finance at all. Not that his achievement should be dismissed. He took a notoriously tough nut—determining correlation, or how seemingly disparate events are related—and cracked it wide open with a simple and elegant mathematical formula, one that would become ubiquitous in finance worldwide.

For five years, Li's formula, known as a Gaussian copula function, looked like an unambiguously positive breakthrough, a piece of financial technology that allowed hugely complex risks to be modeled with more ease and accuracy than ever before. With his brilliant spark of mathematical legerdemain, Li made it possible for traders to sell vast quantities of new securities, expanding financial markets to unimaginable levels.

His method was adopted by everybody from bond investors and Wall Street banks to ratings agencies and regulators. And it became so deeply entrenched—and was making people so much money—that warnings about its limitations were largely ignored.

Then the model fell apart. Cracks started appearing early on, when financial markets began behaving in ways that users of Li's formula hadn't expected. The cracks became full-fledged canyons in 2008—when ruptures in the financial system's foundation swallowed up trillions of dollars and put the survival of the global banking system in serious peril.

David X. Li, it's safe to say, won't be getting that Nobel anytime soon. One result of the collapse has been the end of financial economics as something to be celebrated rather than feared. And Li's Gaussian copula formula will go down in history as instrumental in causing the unfathomable losses that brought the world financial system to its knees.

How could one formula pack such a devastating punch? The answer lies in the bond market, the multitrillion-dollar system that allows pension funds, insurance companies, and hedge funds to lend trillions of dollars to companies, countries, and home buyers.

A bond, of course, is just an IOU, a promise to pay back money with interest by certain dates. If a company—say, IBM—borrows money by issuing a bond, investors will look very closely over its accounts to make sure it has the wherewithal to repay them. The higher the perceived risk—and there's always some risk—the higher the interest rate the bond must carry.

Bond investors are very comfortable with the concept of probability. If there's a 1 percent chance of default but they get an extra two percentage points in interest, they're ahead of the game overall—like a casino, which is happy to lose big sums every so often in return for profits most of the time.

Bond investors also invest in pools of hundreds or even thousands of mortgages. The potential sums involved are staggering: Americans now owe more than $11 trillion on their homes. But mortgage pools are messier than most bonds. There's no guaranteed interest rate, since the amount of money homeowners collectively pay back every month is a function of how many have refinanced and how many have defaulted. There's certainly no fixed maturity date: Money shows up in irregular chunks as people pay down their mortgages at unpredictable times—for instance, when they decide to sell their house. And most problematic, there's no easy way to assign a single probability to the chance of default.

Wall Street solved many of these problems through a process called tranching, which divides a pool and allows for the creation of safe bonds with a risk-free triple-A credit rating. Investors in the first tranche, or slice, are first in line to be paid off. Those next in line might get only a double-A credit rating on their tranche of bonds but will be able to charge a higher interest rate for bearing the slightly higher chance of default. And so on.