Thursday, February 25, 2010

Reality Bites: Mark to Wishful Thinking Fails Again

Thanks to Karl Denninger for pointing readers toward this story from Bloomberg's Jonathan Weil.

"Next time you see some company complain its “mark-to-market” losses aren’t real, remember this name: the Federal Home Loan Bank of Seattle. It used to claim that, too. And it couldn’t have been more wrong. 

About a year ago, the government-chartered lender blamed accounting rules after it wrote down its portfolio of mortgage- backed securities by $304.2 million to reflect how much their fair-market values had fallen. While those declines counted against its earnings and regulatory capital, the bank said they were “well beyond any expected economic loss.” 

The bank’s executives said they expected to lose a mere $12 million of principal over the life of the securities. That estimate proved far too hopeful, though. 

The bank, one of 12 regional Federal Home Loan Banks that supply low-cost loans to about 8,000 member banks and finance companies, now says it expects about $311.2 million of credit losses on its portfolio."

As Homer Simpson would say... DOH!  In case it wasn't clear: a year ago the market value of their portfolio fell by $304MM, but the bank claimed those were just temporary dislocations - panic in the market - and that actual losses would be $12MM.  Now, reality has struck, and they have increased their loss estimates to $311MM.  It seems that economists declaring the recession over and recovery imminent do not actually make recovery imminent.

But there's more:

"The bank became a poster child for everything supposedly wrong with mark-to-market accounting. At a March 12, 2009, congressional hearing, U.S. Representative Ed Perlmutter of Colorado cited the disparity between the bank’s writedown and its much smaller anticipated loss as “an example that really was disturbing.

The congressman leading the hearing, Paul Kanjorski of Pennsylvania, pointed to a similar instance at the Federal Home Loan Bank of Atlanta. The bank reported an $87.3 million writedown on its mortgage-backed securities for the 2008 third quarter; however, it said it expected its actual losses would be only $44,000.
While that’s roughly equivalent to the losses from a modest studio condo foreclosure, Kanjorski didn’t question the tiny number, saying: “I find that accounting result to be absurd.”

“It fails to reflect the economic reality,” he said. “We must correct the rules to prevent such gross distortions.” Kanjorski, Perlmutter and other lawmakers told Bob Herz, the chairman of the FASB, that it needed to change its rules immediately so banks could show stronger earnings. The board, which fancies itself as an independent standard setter, complied a few weeks later.

The rest of the story: Last year when the Atlanta bank released its financial results for the third quarter, it said it had raised the credit-loss estimate to $263.1 million. (Here’s the math in case you missed it: $263.1 million > $44,000.)"

Double DOH!  In case that part wasn't clear -  Congress was dismayed that banks were unjustly showing decreased earnings - after all, the banks clearly had very low estimates of losses compared to the panicking market which placed fire sale values on the portfolios.   We needed to act to prevent such "gross distortions!!!"  That crazy Mr. Market was harming the banks' earnings unnecessarily!  Yet again, it seems that the banks were wrong:  FHLB of Atlanta's $44,000 loss estimate was raised to $263,000,000.  I mean - what can you even say about that?  Insane. 

In any case, Congress managed to push through a change in the rules:

"The FASB rule change gave companies a new way to avoid counting paper losses from toxic debt securities in their earnings. Before 2009, whenever companies recorded writedowns on impaired securities that they labeled as held-to-maturity or available-for-sale, they had to run the full amounts through net income for any losses deemed to be “other than temporary.”
Now they get to separate the impairments into two parts: estimated future credit losses and everything else. The first kind reduces earnings and regulatory capital. The other doesn’t."

later, from Weil

"what happened here is that a few members of Congress bum-rushed the FASB into action based on a premise that was false, in a misguided effort to boost public confidence in the financial system through smoke and mirrors. It’s an open question if the board’s standard-setting process can regain its credibility someday. Undoing this disaster of a rule change would be a good start."

A peripheral lesson to be learned here is that rosy projections, hopes, and anticipations do not equate to a rosy reality. 



Anonymous said...

KD, when's the next Vegas trip? Looking forward to the writeup.

Anonymous said...

if you're too heavy ... blame the scale!!!

James said...

The entire US is one giant socialized mess. Anyone who thinks Greece is any different than the US is mistaken.
What hasnt been nationalized? Housing, Banks, autos.
Any big ticket item has to be financed no one has the cash to buy anything without borrowing money.

Economics of Contempt said...

Strangely, I've found that the argument over mark-to-market has become one of the most controversial and bitterly contested issues in the financial industry. (When I retired for the first time in 2006, most people in the industry didn't even know what MTM accounting was.) Now people fight over MTM like they used to fight over short-selling. And just like devout anti-shorts, who were clearly scarred by some early experience with short-sellers, the devout anti-MTM people were clearly scarred by the financial crisis.

I find the whole debate rather amusing, because people never seem to specify what product they're talking about. When someone asks me what I think about MTM, me reply is always: "As applied to what market?" Agency MBS? Mezz CDOs? Interest rate swaps? The usefulness of MTM is dependent on the specific product/market. I think most reasonable people would agree that in clearly illiquid markets, requiring MTM can cause unwarranted and potentially harmful accounting distortions. But that's not the same as denouncing MTM in general.

My position on MTM has always been: Where MTM can be used reliably, it should be used. The real issue, then, is where you draw the line between "sufficiently liquid/reliable" and "too illiquid/unreliable." I tend to err on the side of using MTM accounting, which I gather you do as well. Unfortunately, most people never seem to get past the "MTM: Good or Evil?" stage.

(P.S. The anti-MTM movement really needs to find their Patrick Byrne. Especially since Byrne will no doubt be in prison one day, and we won't get to enjoy all the free entertainment he provides.)

Kid Dynamite said...

EOC - yes, i tend to favor mark to market whenever possible, but i realize that my views are skewed because i'm a former trader of largely equities, which were super liquid and easily markable, and HAD to be marked to market daily. I do understand the argument that in super illiquid situations, one off marks that must be marked to can cause a lot of potential damage.

my favorite "marks" related story is one I've written about before:

"There is a fantastic segment about the valuation of the CDO portfolio, where the managers get marks from multiple Wall Street dealers. While most counterparties valued the assets at 98 cents on the dollar, Goldman Sachs provided a valuation of 50. At first it seems that GS is the bad guy, accused by a former BSC exec of trying to mark the portfolio lower in order to profit on a short position GS had. However, Goldman's Gary Cohn explained the real story:

"He (Cohn) then shared an anecdote about a conversation he'd had with Nino Fanlo, one of the founding partners of KKR Financial Holdings, a specialty finance company started by KKR, the private equity shop. After Goldman sent out the marks in the 50¢ to 55¢ range, Fanlo called Cohn and told him, "You're way off market. Everyone else is at 80, 85." Cohn then offered to sell Fanlo $10 billion of the paper at his 55¢ price and encouraged him to sell that in the market to all the other broker-dealers at the higher prices they claimed to be marking the paper at. In other words, Cohn was offering Fanlo a windfall: buy at 55 and sell at 80. "You can sell them to every one of those dealers," Cohn told Fanlo. "Sell 80, sell 77, sell 76, sell 75. Sell them all the way down to 60. And I'll sell them to you at my mark, at 55, because I was trying to get out. So if you can do that, you can make yourself $5 billion right now."

Cohn had been trying to sell the securities at 55 for a period of time and people would just hang up on him. A few days later, Fanlo called Cohn back. "He came back and said, 'I think your mark might be right,'" Cohn said. "And that mark went down to 30."

Cohn said the market changed dramatically through the course of the year. "We marked our books where we thought we could transact because some of this stuff wasn't transacting," says Cohn. "We sold stuff at 98 and marked it at 55 a month later. People didn't like that. Our clients didn't like that. They were pissed."

JCH said...

I think many bloggers and commentators wildly exaggerate the extent of the MtM rule change, but maybe I'm wrong about that.

So in the case in Seattle, there was apparently a reliable market reference, and there can be no complaint.

But to crater the world economy when there is no reasonable market price was prodigiously stupid. As previously written, the rule was horrendously schemed, and I do think it exacerbated the worsening of the credit crisis.

Whether it is truly better now is beyond my pay grade.

Anonymous said...


The previous accounting standards wasn't the reason why the economy is going to crater, no; radical lending had taken care of that all by itself. Changing the way one counts or takes the loss merely kicks the can down the road a little bit, as everyone will see soon enough the losses were real then and are real now.

I suppose delaying the day of reckoning simply provides time for those that concocted such schemes and got rich off these charades ample time to run and hide, when the mob comes knocking;)

JCH said...

I did not say it caused it. I said in unnecessarily exacerbated it.