Thursday, April 02, 2009

Mark to Make Believe and Other Talking Points

In case you missed it, the news today is that FASB (the Financial Accounting Standards Board) has relaxed mark-to-market accounting rules regarding how banks price illiquid "toxic" assets on their books. As the Associated Press summary explains, "The decision will allow the assets to be valued at what they would go for in an “orderly” sale, as opposed to a forced or distressed sale." As a former trader, I'm a firm believer in marking to market - maybe that's partly because I always traded assets which had liquid marks, and because I worked for a firm with real risk management policies.

You've probably heard hundreds of times the mantra, which I subscribe to, that "something is only worth what someone else will pay for it." There may be cases where you have the luxury of holding an asset - where you think you can ignore the market's currently ascribed valuations, because you don't need to sell the asset currently - but this argument is being used by the banks today, when it could not be less relevant. The "I can hold it to maturity" argument applies only when you're NOT massively overlevered and have the luxury of adequate capital, and when the final value of the security in question is clear (which is almost never): neither of which is the case for our investment banks holding massive quantities of mortgage backed securities which are likely to face impairment at some point.

I traded merger arbtrage for several years. We marked our (equity) positions at closing value every night (note: I would assume everyone did this, we weren't special or super conservative) - not at the value they'd have if the merger deals closed, even though we did NOT have to liquidate the positions at any time. The point was that IF we wanted to unwind our positions, they aren't worth whatever our model thinks they're worth - they are worth what the buyer in the marketplace thinks they're worth - plain and simple.

Another simple example of this is when people quote ASKING prices for items like homes or concert tickets. If I list my Jonas Brothers tickets on StubHub for $10k each, that's an ASKING price - it doesn't create any valuation. What matters is how much the buyer will pay me for the ticket. When I recently pulled a bunch of my prized baseball cards from my dad's attic, I wanted to figure out how much they were worth. Instead of consulting the 1980's bible of price guides - Beckett - I pulled each card up in EBAY - the cards are only worth what someone is willing to PAY for them.

Dan Greenhaus of Miller Tabak reiterates points many have made regarding abandoning mark-to-market accounting today, on Barry Ritholtz's blog: emphasis mine

I cannot fathom why investors would cheer less transparency and more involvement by management in the pricing of assets that they own. I have garbage pail kids cards from 1987 that I still think are worth $20 each. Does that make it so?

By allowing institutions to carry assets and loans at higher values, the government is effectively undermining its own program to purchase assets. If I am a bank and I believe asset X is worth 80 cents if held to maturity but the market is pricing it at 40 cents, FAS 157e gives me even more room to carry said asset at 80 cents which reduces the necessity of selling it in the meantime.

To be clear, mark to market accounting hasn’t caused this issue. It has exposed it. The cause of this issue is the overleveraging by banking institutions as they invested not in the vast array of entirely liquid markets that would facilitate their exit from any position necessary in a moment’s notice but rather an opaque and infrequently traded market that generated an extraordinary amount of fees and relied on economic assumptions that have proven to not only be wrong, but have proven to be almost diametrically opposed to what is actually occurring.

Final point on the subject - State Street doesn't mark to market its assets, but they detailed in their earnings report what the current valuation of the questionable assets would be if they needed to sell them. Take a look at their chart, and see if it made any difference when they reported earnings on January 20th. (hint: the stock dropped from $40 to $15 in a day). General Electric is in the same boat - they don't mark to market, but it doesn't matter - more transparency in asset pricing will never be the problem.

Now for some other brief talking points:

Northern Trusts's Paul Kasriel, via Clusterstock, explains the difference between Bernie Madoff's Ponzi scheme and Social Security:

"Both depend, or in the case of Madoff, depended, on being able to get new contributors into the scheme in order to pay off the previous contributors. The Social Security Administration has the power of the law to force new contributors into its scheme. Madoff did not have the power of the law to force new contributors into his scheme, therefore, he has been accused of breaking the law. Just another example of how it's good to be the king."

The 90% bonus tax bill may not happen, but the House has passed another bill restricting compensation at firms receiving taxpayer money.

"The bill adopted by the House on Wednesday would bar companies that received a capital infusion from the federal government from paying any bonus or other compensation that is “unreasonable or excessive” as defined by the Treasury, until they had repaid their bailout money to the government. The companies would also be barred from paying any bonus that was not “directly based on performance-based measures.”"

I find this problematic because it leaves the door open for all sorts of disasters in the future - after all, how can the House determine qualitative traits like "unreasonable" and "excessive?" Although they probably didn't want to put a quantitative cap like "$500k" on compensation, at least that would have been something that employees knew about up front. I don't really want to get into this debate here and now, but if, as a trader, my positions make a $100MM profit for the bank, what is unreasonable compensation for me? $3MM? $5MM? $15MM?

Chris Whalen, of Institutional Risk Analyst, writes on Barry Ritholtz's blog about what appears to be outright, unimitigated fraud at AIG:

"As with the phony reinsurance contracts that AIG and other insurers wrote for decades, when AIG wrote hundreds of billions of dollars in CDS contracts, neither AIG nor the counterparties believed that the CDS would ever be paid. Indeed, one source with personal knowledge of the matter suggests that there may be emails and actual side letters between AIG and its counterparties that could prove conclusively that AIG never intended to pay out on any of its CDS contracts.

The significance of this for the US bailout of AIG is profound. If our surmise is correct, the position of Feb Chairman Ben Bernanke and Treasury Secretary Tim Geithner that the AIG credit default contracts are “valid legal contracts” is ridiculous and reveals a level of ignorance by the Fed and Treasury about the true goings on inside AIG and the reinsurance industry that is truly staggering."

I'm up in Boston today, and I sat down on my dad's couch to actually read the physical hard copy of the New York Times - something I almost never do when I'm at home in NYC. Amidst the sea of absurd financial shenanigans, I came across an article that struck a chord with me, and I encourage you to read it. "Cadillac Man's" recounting of his 13 years living on the streets of New York is not an account of a decade of hell - but rather a wistful memory of his former life, and perhaps a desire to resume it.

"FOR nearly 13 years between 1994 and 2007, I wandered the streets of New York, a nomad in the town where I was born in 1949. To say that I was homeless is true and yet not the whole truth. I had a mobile home of sorts — my wagon — the most recent, a grocery cart I liberated from the Costco in Long Island City. In it, I carried everything I needed: bedding, clothes, a camp stove, beach chairs, an umbrella, pots and pans, a first-aid kit and 20 or so paperbacks.

Every morning, I’d get up and say to myself: Where to today? And I’d turn my wagon either right or left and just keep going in that direction. Eventually I rolled my way through all the boroughs except Staten Island, stopping to live for a while in one place or another."

It's the concluding paragraph that I find most interesting:

"If we find a place in Astoria, I’ll be under the viaduct every day. In the meantime, my old wagon is still there, where I had a friend anchor it into the sidewalk with cement so nobody knocks it over.

Will I ever take my wagon for a spin again? Or is it a monument to my old life? I know what I hope."

What is Cadillac Man's hope? That he'll never have to return to the grind of pushing his wagon? Or that he'll get a chance to return to the nomadic freedom it provided him? I hate for this to sound like a high school book report, but I nevertheless found the article intriguing.


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