I keep reading about how the problem with the banking system isn’t all the crappy securities and loans it’s loaded up with. It’s not that they took on too much excessive risk, lending against assets whose value is plunging. It’s not that they funded asinine private equity deals, stupid commercial construction deals, and dumb home purchases. It’s that they have to mark their securities book to market.
If only they didn’t have to mark to these “artificial” prices, everything would be fine. Eureka, the banking crisis would be solved! Even Bob McTeer, the former Dallas Fed president, is chatting about this on CNBC this morning (Of course, if I heard correctly, he also said he bought Citigroup at $15 figuring it couldn’t go any lower — a sure sign of financial savvy considering it traded below a buck yesterday). Steve Forbes is weighing in with a similar viewpoint in the Wall Street Journal today.
My take? The problem isn’t that there is no market for these bad securities. The problem isn’t that the prices are “artificially” low. The problem is that these institutions don’t want to acknowledge that today’s prices are the REAL prices. I fail to see how an accounting maneuver would magically make all the underlying markets to which these securities are tied improve.
Look, in the early days of the housing market downturn, sales volume dried up and inventories of homes for sale surged. Yet mysteriously, reported median prices didn’t decline. I don’t know how many people asked me: If the market is so bad, why aren’t prices falling, huh? I answered that fewer and fewer buyers were paying inflated prices, holding up the median, but that the huge build up in supply and dramatic fall off in the sales pace meant that the TRUE market value of U.S. homes was declining. It just wasn’t being acknowledged by most sellers yet. The image that came to mind? Those old Road Runner cartoons, where the coyote runs over the cliff but doesn’t start plunging until he looks down.
I believe something similar is happening today. Volume is drying up and the inventory of securities for sale is piling up. But sellers don’t want to admit reality. Neither does the government for that matter. Why do you think all these vulture funds are raising gobs of cash, but not deploying most of it? Because the sellers are hanging on to the garbage securities, hoping against hope that they won’t have to sell at the true market prices, and the government is too busy trying to figure out ways to prop up the price of the garbage. I understand why this is occurring: They’re afraid of mass insolvencies. So they’re trying to figure out how to do something akin to the early 1980s use of Regulatory Accounting Prinicples (RAP), which papered over insolvencies in the Savings & Loan industry.
Of course, papering over the problem didn’t mean it went away (The unofficial nickname for RAP used to be Creative Regulatory Accounting Principles — and you can figure out what the acronym is there). Meanwhile, many of the S&Ls granted forbearance and permitted to try to grow their way out of insolvency increasingly gambled on new ventures, especially commercial real estate. They eventually blew up anyway — at a much BIGGER cost to U.S. taxpayers.
Will this time be different? If M2M is suspended, allowing the industry to mark its paper at higher values based on forecasts of future cash flow, will it “work?” I have my doubts. I suspect many institutions (if allowed to suspend M2M) will keep using optimistic model forecasts, based on underestimations of the depth and breadth of the economic downturn and the slump in both residential and commercial real estate. They’ll end up kicking the can down the road, and ultimately need to be resolved anyway. In other words, they’ll be just like those homeowners who said three years ago: “I’m not going to GIVE this house away. I think it really IS worth a half-million bucks and that the market is wrong” — and who are now being forced to sell for $250,000.
{ 9 comments… read them below or add one }
In your article Upside Down and Out of Luck today you spoke about people both walking away from their home mortgages as well as the highest occupancy rate in rental housing in years. Where are all those people living? Are we seeing an increase in emmigration?
I agree with your analysis, Mike. That’s why I don’t trust corporate America, even though I’m a capitalist. But I want honest capitalism. I know how corporate America spins the numbers. Here we go again with another bubble. The gullible will be coming out in droves investing their money based on bogus numbers. If you can time the market on the gullible coming out in droves, then I guess you can make money. I myself am disgusted with everything. Also am disgusted with the Obama administration and their change mantra (which I didn’t believe to begin with). But they profess to be anti-lobbyists, and Barney Frank and the rest of them are in bed with the banks. Anyone who invests based on these games played by DC and the banks better not come to me whining when they lose their money. I don’t want to hear it. I believe in mark to market. I think the banks “banked” on not being able to value these phony assets, and that is why they are saying there is no market for them so they can inflate their balance sheets on arbitrary, overinflated values created by them. I’m staying out of the market.
The MTM that the banks want to suspend is SFAS 157, which was introduced in 2006 with an effective date for financial statements after 11-15-07. The FASB & SEC encountered objections and delayed the enforcement until 11-15-08. Before SFAS 157, assets that were held for trading were marked-to-market. SFAS 157 wants all assets and liabilities to be marked-to-market.
Part of what helped gain support for SFAS 157 is a clever use of the English language. If the FASB and the SEC had called it “Value Based on Trade Prices Measures” and the subset “marked-to-trades-in-an-irrational-market”, no one would have taken it seriously. Instead SFAS 157 and 159 used the phrase “Fair Value” over 1,400 times to assure us that this method is fair and they tell us the new rules will help provide transparency.
Please remember that the FDR administration suspended a similar Mark-to-Market system in 1938. The SEC provided details on the 1938 suspension on page 44 of their 12-30-08 report to Congress in their “Study on Mark-to-Market Accounting”. The report is at http://www.sec.gov/news/studies/2008/marktomarket123008.pdf
In my opinion, some of the basic flaws in the MTM accounting measures are:
1. Currently bankers make loans based on projected cash flow. The banker and the borrower negotiate the terms including interest payments, principal payments and maturity. It would seem that the completed negotiation is the market for the loan.
Now, consider the MTM alternative. The banker prepares for the loan negotiation by collecting trade price data for similar loans. This might be from the Merrill sale of mortgages or sales by the Lehman bankruptcy Trustee or from FDIC sales of assets to PennyMac. The banker uses the data to determine the terms of the new loan.
2. MTM provides wide swings in earnings and losses. At best these swings are misleading. For example, if a bank holds a municipal with a 5-year maturity, the bank could mark the value up or down each reporting period to reflect changes in trade prices of similar municipal bonds. If the 5-year bond was purchased at par then the net result, of all the mark-ups and mark-downs, at the end of five years, is zero.
With disrupted markets, the trade prices can fluctuate over a wide range. Very few assets have escaped recent wide market price fluctuations. Assets that the banks might invest in, such as jumbo mortgages or credit card debt, or student loans have recently had wide trading price fluctuations. The SFAS 157 change from cash-flow valuation to trade-price valuation has destroyed billions of dollars of equity. (See the 11-15/16-08 WSJ article on Fannie & Freddie. The chart shows the equity difference between the GAAP accounting in effect 9-30-08 and “Fair Value” accounting in effect for financial statements after November 15, 2008. The difference is roughly $70 billion less equity under the new accounting measures.) For performing assets that the banks intend to hold to maturity, MTM is useless and misleading.
3. MTM destroys predictability. The financial companies cannot mark-to-market until they have figures for the trade prices at the end of the reporting period. (Level 1 and Level 2 under SFAS 157) This means huge surprises when the companies report their earnings. They can predict their cash flow, but not the end-of-quarter trade prices and resulting MTM valuation changes.
4. Under the new MTM rules, a financial institution can have a positive cash flow and a huge phantom loss from MTM adjustments. The lending patterns have been changed and many financial institutions have had to dilute their equity.
5. SFAS 157 wants all assets and liabilities to be marked-to-market. This means that a TARP contribution creates a phantom loss and reduces equity. (The TARP contribution improves the credit-worthiness, which increases the market value of the Company’s liabilities. Under SFAS 157 this translates to a loss, since the Company would have to pay more to buy-back their own liabilities. The loss reduces the equity.) This is counter-intuitive.
The SEC and the FASB have introduced and actively defended SFAS 157 and 159. The Statements themselves, the amendments and the SEC’s 12-30-08 letter to Congress total over 400 pages. It appears that they had good intentions, but the volume of amendments and explanations indicate that there were unintended consequences. Why not confine MTM to the financial statement notes where it doesn’t affect capital.
An interesting side question is who benefited from this recent accounting change?
1. Some of the regulators are hiring while the banks are laying workers off. Think about the FDIC as one example. We are witnessing major employment shifts and major power shifts in our country at this time.
2. Articles have mentioned short sellers benefiting. (In addition to regular short-sellers and naked-short-sellers, also think about SKF, SRS and similar issues on the NYSE.)
3. Public firms are getting seriously hurt and some private and foreign firms are benefiting. (Think of the Lehman assets that were sold at distressed prices to Barclays and the Japanese securities company and the Merrill mortgage assets sold to a private TX hedge fund and the recent private offer for IndyMac assets, or the Nevada bank assets that went from the FDIC to PennyMac or the recent purchases by Wilber Ross etc.) Private and foreign firms are benefiting from the U.S. public companies’ MTM challenges. Many of the private firms do not have capital requirements or MTM requirements. In talking about profits, a PennyMac executive was recently quoted as commenting on his firm’s recent experience buying assets from the government. He said, “In fact, it’s off-the-charts-good.” (See page 5A of the 3-4-09 Sarasota Herald Tribune.)
“Those who do not learn from history are destined to repeat it.”
Recent References and examples:
Public comments on MTM in the latest SEC study are here http://www.sec.gov/comments/4-573/4-573.shtml
Some of the writers presented real-life examples of their current holdings and the effect of MTM. These include:
Richard A. Dorfman, President & CEO of FHLBank Atlanta at http://www.sec.gov/comments/4-573/4573-180.pdf
Norman Smith, Corporate VP, MassMutual Financial Group
http://www.sec.gov/comments/4-573/4573-155.pdf
K Brick, SVP & CFO, U.S. Central Federal Credit Union
http://www.sec.gov/comments/4-573/4573-152.pdf
Jon, What a great post! You hit the nail on the head. Mike, I hope that you digested the info.
In short, I am not selling my house that is worth less than what I paid for it at “market value” just to stop the loss. I know in 5 years we will be fine and in 10 we will be better. (I also don’t take a bunch of phantom equity out of the house when the market goes up for the same reason). The regulators need to find a way to value assets at the prospective value of when they are desired to be sold… Some of these assets are raw land that is designed to be retained until market conditions present an economic reason to build out or sell… why would you ding the bank for making a decision to purchase an asset that is designed to drive future profits and in many cases will?
It is like assuming that my home is worth 35% less than it was worth in 2006 because 1 or 2 homes in our neighborhood “HAD” to sell because they made bad decisions..> Does that mean that all of the other homes in my neighborhood are now worth that even if it is under the cost of reconstruction? and that no one else wants to sell their homes for those prices???
Not sure I have the answer on how to properly regulate it but the current structure is crazy! and overly devalues assets… even extending out the “average asset value over a period of a year” or the normal holding period for the asset class would be a better way to value.
The pre-2007 method was to show any hold-to-maturity assets at face. This means that a banker could make a $1 million jumbo-mortgage and if it was performing, it was held at the remaining balance.
I would suggest that MTM estimates should be kept in the footnotes.
Mike, I appreciated your article, but as an utter novice, I have to ask; how do they value these toxic assets right now? I mean, in simple terms. Is that mortgage valued as a loss of
the entire current mortgage amount
the lifetime expected amount
the current value of the house
the current mortgage minus the existing equity
The only method that seems accurate to me is to take either the house price or the current mortgage minus equity, then subtract the current average sale price + the foreclosure costs for the bank, and that would be the loss amount for the bank. i.e. The house cost 100k, they’ve paid 10k on the principle, that takes up to 90k, the current sale price is 50k, that takes us to 40k loss, plus 7500 for forclosure & resale cost gives us a loss of 47.5.
I know that’s very basic, but I seem to be hearing all sorts of answers on the loss amounts and I feel very confused by it. Thanks for taking the time!!
Cat
Jon’s analysis was thoughtful, detailed and to the point. The original m2m note from Mike I thought to miss the point. It does not really matter what we think, feel or believe. The facts are that FASB is working very quickly to publish “more flexible” rules associated with fair value accounting. Most likely to be published before end of q2. These changes will have a material impact on the financial performance of large sections of the financial services industry and perhaps even clear the log jam of toxic assets as now owners and private equity can negotiate on on equal footing. I’d like to hear arguments from Mike et al as to why these new facts do not create a catalyst for an sizable upward move in the equity market?
Jonathan,
Does the economy actually do better because of repealing mark to market or does it just give the appearance of doing better? I think the latter. I do not agree with your assessment, but that’s what this country is all about; we can disagree. I agree with Mike’s assessment.
Information for Caterina:
If you pull up FDIC.gov you can look at old reports for the banks (or pull up the reports for the Holding Companies on the Federal Reserve web site). What you will find is a system of MTM for performing assets held for trading. For performing assets that are to be held-to-maturity, the method starts at cost. The FFEIC/Call reports show impairments for assets that are not performing as anticipated and haircuts for volatile or risky assets. These methods have been in use for a number of years.
The FASB & the SEC want all assets and liabilities to be marked-to-market. This means that if the current secondary market for student loans is 75% of face, then a bank that writes a new student loan today would have to immediately write it down to 75% of face. (SFAS 159 tries to give some relief to this situation by letting financial institutions select the valuation method, but it appears that the FASB did not convince the financial institution examiners.)
Information for Lyn:
IMO there are a number of reasons that MTM, as defined by SFAS 157, should be repealed.
1. Stock investors hate uncertainty and confusion. SFAS 157 was amended at least 3 times by the FASB and once by the SEC rule 2008-234, plus approx. 100 pages of additional information were issued in SFAS 159 and over 200 pages of information are in the SEC’s 12-30-08 letter to Congress. Dealing with SFAS 157 issues has added a few pages to each public bank filing.
2. How can anyone predict earnings or losses when the MTM figures are not available until the end of the reporting period? Investing is challenging enough without the wild swings caused by SFAS 157.
3. TARP gave money to a number of banks, then the SEC tightened the accounting rules with SFAS 157 and the Federal Government announced another tightening on capital requirements today.
4. Congress wants the banks to lend more, but how can banks afford to do that if they have to write down every loan as they make it?
5. As far as I can tell, the IRS does not recognize SFAS 157. The IRS uses IRC 2031, IRC 2032 and Revenue Ruling 59-60. This means that the SFAS 157 income and losses are phantom.
6. SFAS 157 promotes the use of “Exit price”. So, if you buy an asset. What could you immediately sell it for?
7. With the SEC pushing SFAS 157 on public companies, private companies benefit. When you see an article about banks selling assets, or the FDIC selling assets, note who the buyers are. When you read about TALF, note that the potential buyers are not public companies. Congress is supposedly worried about another Madeoff situation, but the Government is willing to lend low-interest money to private hedge funds and sell them assets from the banks.
In summary, the new SFAS 157 provisions provide confusion, additional expense and useless information to sort out in the financial statements. The banks are being pushed into tightening their lending standards, which is a contributing factor in our declining economy. Steve Forbes calls it a “death-spiral”. As the article in the Nov 15/16, 2008 WSJ shows, under the old GAAP rules Fannie & Freddie needed approximately $70 billion less than under SFAS 157 (a/k/a “Fair Value Measures”). Seems to me that we have better uses for each $70 billion, rather than dump it somewhere to compensate for a dubious accounting change. But that’s just my opinion.