Thursday, April 2, 2009

The Financial Crisis For Dummies:
FAS 157, Mark to Market

Ever heard of Mark to Market? Here is a little primer on what it is. It is an accounting term and it has played a big role in this current mess.

Assume you own a house, you bought it in 2004 at 600k. In 2006 a comparable house down the street sold for 750k. Today it would probably sell for 450k. You took a loan for 550k, question: ARE YOU BANKRUPT?
1/ no, since you don't want to sell now and you can wait for the market to come back
2/ yes, since on a mark to market basis, you are under-water.
Tough to decide right?

This is pretty much what is going on with the banks. They are holding onto long term highly illiquid assets (called Level 3 assets) and those assets nose-dived and there is no market for them. The balance sheets of the banks are highly impaired on a MTM basis. But many people point out that MTM is used because it is the only way we know to price things in a fair and transparent way, but that in extreme market breakdowns these numbers are temporary and should not force institutions into insolvency by the very definition of holding onto L3 assets that will vary in price over time. If an L3 asset hits a bottom price it should not trigger bankruptcy.

So congress just made sure we suspend MTM, you can now carry the assets at model or historical cost. In other words, we are in a breakdown mode and the rules are being suspended. Short term it means the earnings of the banks will be bullshit, marked to what management thinks it is worth. Just like you think of your assets with what your house "should be worth".


Andrew Meyer said...

It's lovely. As property values went up, people MTM and used it as justification for bonuses and salaries. Now that they're going down... well it's not fair to MTM.

In fact, the Treasury is setting up auctions to create an artificially high price where banks can move those same assets off their books... with our money.


Marcf said...

yeah... it is a tricky one.

The positive way to see it is that in a collapsing market MTM is its own positive feedback loop. It is in fact like a debt trap in depression. If MTM is low you trigger regulatory steps in banking to sell assets to raise capital further depressing assets. So as you try to float you balance sheet you depress it further.

To be fair, this is part of shock and awe, the combination of QE and no MTM is aimed at stabilizing the markets by getting out of the death spiral. It is all about animal spirits or "market psychology" at this point. If enough people believe the numbers are going up then the numbers going up.

The PPIP is indeed another problem. They probably are artificially propping the numbers, but that may not create a market, you are correct and who knows what the real price is.
I honestly believe this is aimed at stopping the flood of bad earnings and giving the banks some reprieve. This is congress's little gift to Bank of America.

Anonymous said...

Real price is simple.

real price WAS what you paid for it.

real price IS what you can get for it.

sometimes painful, but always simple.

Marcf said...

Anon, point is well taken but I think of it a little differently
1/"real" just means today's price. Not yesterday's, not tomorrow's
2/ MTM paints you as insolvent even if you don't want to sell today. Many institutions hold on level 3 assets, (by definition of L3).
3/ not so much real rather than ONLY price we know for sure. Which is why accounting uses it.

View the problem in time, the price of L3 assets will fluctuate. Between 80 and 120 over the time period. At 110 you get great returns, at 82 you are bankrupt. THE POINT here is if at any time MTM hits 82 (say no liquidity) should you be forced to liquidate when you can wait? That's harsh and not suited to L3 asset holding.
Anti MTM says MTM fed a negative feedback loop that was getting out of hand. This temporary suspension of MTM for banks is part of bernankes shock and awe. It will give them a bit of a breather.

All that being said I am more of your inclination.
1/ all the stuff above assumes that the prices are fluctuating and that the "real" price, is higher. Most of the toxic securities are mortgage related (CDO, synthetic CDO) and it is quite obvious that the residential mess is far from over. I don't believe housing prices have found a bottom yet. The price is not fluctuating, it is cratering. MTM may reflect long term real.
2/ in the example above I use 82 as the threshold for bankrupt. In reality banks use leverage to buy such assets, some 30 to 1. So 97 is where you break the bank litterally. The levels of debt MUST be RE-regulated to include securitization flow. This is not directly related to MTM. MTM just shows the problem in dramatic fashion. OMG THE BANKS are insolvent!
3/ This is a cameo operation so that earnings don't look like shit in this upcoming earnings season. In fact they may look great! So the markets will see good numbers, about as real as a report from soviet Russia, but as long as many idiots believe it, it will be enough to protect the nascent rally. Remember, price stability would be nice and the key in avoiding deflation. This is all part of dr strangelove's shock and awe. I can see through the walls, they are litteraly made of paper.
4/lack of transparency is never good. I wanted to know more about the public private stuff, maybe invest! Now I know the numbers will be bullshit and I don't get such a warm and fuzzy about "the deal". I don't like no transparency. I want to pay market prices or better, not what some jackass exec thinks it's worth.

It's not an easy one.

Celal Birader said...

Presumably these 'assets' generate some kind of inward cash flow, don't they ? So what is wrong with using discounted cash flow to arrive at values for this junk ? Wouldn't you tend to believe that kind of valuation more than anything else ?

FBA said...

Mark to Market is linked to what you are pricing :
Mark to market price for a stock is last price, mark to market price for debt is...discounted value, or spread. (debt yield-risk free debt yield at equivalent maturity)

If you have a floating rate, paying Libor USD every 6 month,
to get the price right now, you need something that is quite difficult to obtain : you need the forward rates, to build the curve.
Whatever the method you're using, since no one know exactly what spread everyone is talking on, or what curve they use to get the mtm, mtm is just a bet like another.

Interest Rate swap; OIS vs fixed.
When initiating, you're assuming that at the term date, OIS==fixed.
g.e :
On 3/1/2009, 1M€ until 3/5/2009 paying OIS, receiving 1.2789
1.2789 is fixed because the coupterparty forecast that the value of OIS on 3/5 will be 1.2789.

That is : MTM is not relevant, has never been and will never be. It is just existing, and it's better than nothing.

Because when it comes to debt or any income based security (notes, tranches, fixed income), the MTM is not what you would get paid for it, but what you could get paid for it IF your assumptions on the curve rate and many other little things are right.

And that's where it hurts.
If the security is liquid, the a bid price is a good and fair value.
But, when it's not, it means that no one wants to buy. If no one wants to buy then, in "real economy", the value is null.

But on the market, you will then assume something like "lets think that someone wants to buy, and that the yield curve will benefit from a regain of the usd vs eur, that the G20 will find a solution, less than 35 entities in my basket will run into default...".

Treasury bond, whatever the country the name, have always been used as :
Benchmark; they set the spread; so they set the shared perception of the risk
Collateral; they are used as "as good as real money"
And issued through auction mecanism.
the big difference is today, everyone know it (more or less).

Modified duration. The most essential thing to keep in mind.
But it is only one element, that is the market risk.

The second element, is the real problem today : do you trust your counterparty enough to get paid ?
And that's the credit risk.

For the first, well, you may know. It's more or less predictible.Everyone is using the same forecast, and the market is validating it's own forecasted value : you think that tomorrow will be 2, so you do everything today considering this, making that 2 happening as a consequence.

Second is quite difficult, because you never know.

So the MTM is something like :
Present Value + (1+[-0.1;+0.1] +

So they are all doing the same :
Seeking for similarity (what is my buddy doing with it ????)
Averaging (5 said it could be 82; 5 said it could be 86, 1 say it is 75 and another said 95; I guess it is something like 84, because we never consider extreme values in models, so why would I try to understand ?).

Add sorry for my english.

Marcf said...

Celal: yes Discounted Cash Flow (DCF) analysis is a great *intrisic* measure. But the *market* does not always base pricing on this measure. Also DCF makes assumptions about the future, how do you validate those assumptions? in a market! back to square one!

As a side note. The difference between intrisic DCF and historical cost was very clear to me while at Red Hat and JBoss. DCF analysis clearly showed the cash generated by the asset and one would argue that DCF was a better way to account for the price of a share. However most of the market was still using P/E ratios and on this basis, due to revenue recognition and accounting, RHT looked VERY expensive.

FBA: You are right, and part of what I try to show in the post is that "MTM" is flawed but the alternatives (including DCF to some extent) are based on future hypothesis that can turn out false. For example in CDO and other fixed income derivatives there were many hypothesis as to the quality of the cash flow (10 sygma events before we blow up) and quality of the collateral (housing always goes up) that seemed very wrongheaded in putting a forward price on assets. So forward looking models are wrong. Backward looking models (historical cost) are wrong and SPOT MODELS (Market) are wrong. Clearly, as you say, in highly illiquid securities spot models will give non-sensical values.

All I am doing here is trying to sensitize the "dummy reader" that knowing what "things cost" is a very difficult excercise that is highly subjective and context dependent. For example L3 assets should NOT trigger bankruptcy if lower barrier is hit. They should if that lower barrier is permanent. Knowing the difference is a subjective excercise. There is no right and wrong, just a system we must protect and evolve.