The Credit Catastrophe a Mark-to-Market Accounting disaster.

[JohnWxy]

http://en.wikipedia.org/wiki/Mark_to_market

Financial Accounting Standards Board (FASB) Statement No. 157 “Fair Value Measurements”,<2> established some new rules related to valuation of assets and liabilities:
FAS Statement 157 includes the following:

A new definition of fair value;

A fair value hierarchy used to classify the source of information used in fair value measurements (i.e. market based or non-market based);

New disclosures of assets and liabilities measured at fair value; and

A modification of the long-standing accounting presumption that a measurement date-specific transaction price of an asset or liability equals its same measurement date-specific fair value.

FAS 157 defines "fair value" as: “The price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.”
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Although FAS 157 does not require fair value to be used on any new classes of assets, it does apply to assets and liabilities that are carried at fair value in accordance with other applicable rules. The accounting rules for which assets and liabilities are held at fair value are complex. Mutual funds and securities firms have carried their assets and some liabilities at fair value for decades in accordance with securities regulations and other accounting guidance. For commercial banks and other types of financial services firms, some asset classes are required to be carried at fair value, such as derivatives and marketable equity securities. For other types of assets, such as loan receivables and debt securities, it depends on whether the assets are held for trading (active buying and selling) or for investment. All trading assets are carried at fair value. Loans and debt securities that are held for investment or to maturity are carried at amortized cost, unless they are deemed to be impaired (in which case, a loss is recognized). However, if they are available for sale or held for sale, they are required to be carried at fair value or the lower of cost or fair value, respectively. (FAS 65 and FAS 114 cover the accounting for loans, and FAS 115 covers the accounting for securities.) Notwithstanding the above, companies are permitted to account for almost any financial instrument at fair value, which they might elect to do in lieu of hedge accounting (see FAS 159, "The Fair Value Option").

So banks have been valuing their Mortgage Backed Securities at their Fair Market value - periodically updated to the most current market conditions. but as the housing market began to deteriorate defaults started increasing and house prices stopped going upward and started drifting downward.

Former FDIC Chair William Isaac placed much of the blame for the subprime mortgage crisis on the Securities and Exchange Commission and its fair-value accounting rules, especially the requirement for banks to "mark-to-market" their assets, particularly the mortgage backed securities.<6>

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Because the market for these assets is distressed, it is difficult to sell many MBS at other than fire-sale prices, which may be below the actual value that the mortgage cash flow related to the MBS would merit. As initially interpreted by companies and their auditors, the typically lower sale value was used as the market value rather than the cash flow value. Many large financial institutions recognized significant losses during 2007 and 2008 as a result of marking-down MBS asset prices to market value.

The write down of these assets is what has put so many banks in weak balance sheet positions.

[Joanne98]

1. But if we repeal M to M will they just create more crime waves?

Doesn't M to M keep them honest?

[JohnWxy]

2. Yes, MTM was introduced to preclude 'creative' valuations of assets and probably won't go away.

I really wanted to point this out as a reason for rejecting the idea of a "Bad Bank" where the Government buys toxic assets (something the banks would love). I think this means capital infusion to acquire an equity stake in the banks is the only way to go here. Also, this gives us the opportunity to gain something on the upside later (hopefully).

The introduction of CDSs has really complicated the situation enormously since CDSs are also Marked to Market and get this, as credit risk increases for CDS of a certain class that means that any entity holding CDSs of the same class will have to increase the liability side of the equation for the existing CDS thus reducing the value of that CDS on their books (because the potential liability (due to increased probability of default of underlying asset (e.g. a CDO)) rises relative to the value of the stream of fixed payments being received (by the seller of the CDS) for the default protection). THat is, the value of the agreed to stream of payments to obtain default protection doesn't change even though the risk of default (and therefore the likelihood of payment by the seller of the CDS) increases.

This too has contributed (enormously) to the negative balance sheets the banks now have.

Apparently a "fix" to these accounting difficulties is something called 'hedge accounting'. But this seems enormously complex and sounds like it would require a super-computer to keep all your positions' shifting market values current (and hopefully accurate).


The whole thing is, when they securitized mortgages (e.g. Collaterized Debt Obligations) it forced banks and investors to confront the issue of the changing market values of these tradable securities.

Wikipedia is a great source of info on these topics. Here's their entry on Credit Default Swaps : http://en.wikipedia.org/wiki/Credit_default_swap

[notesdev]

4. Yes

One's position on mark-to-market is to me, a key indicator of clear understanding of what the problem is and how to fix it.

The problem is a complete and total lack of honesty. Nobody is going to give money to scam artists, and the entire financial sector after their recent performance must be viewed as such unless proven otherwise.

Would you buy a stock, even one that looks cheap, when there are off-the-books (aka 'off-balance-sheet') liabilities of an unknown amount that no one wants to quantify honestly? When the banks behave as if the honest presentation of these liabilities will put them so far in a hole that even the US government can't bail them out?

For lack of actual reliable truthful information... one has to assume the worst about these hidden liabilities, that they were hidden for reasons so strong that admitting the truth of the matter is not even a possibility open for discussion.

[notesdev]

3. They wouldn't have been so vulnerable

if 30:1 leverage wasn't the industry standard in the bubble. A few percent correction in the price of an asset class shouldn't be a game-breaker... unless you have a 30x multiplier, in which case a 3.33% correction is all it takes to wipe you out entirely.

What kind of bank puts itself in such a precarious financial position? Who would trust their money with a bank that can't manage its own properly, whether that be as a stockholder, bondholder, or depositor?

[JohnWxy]

6. Yes, when Hank Paulson and the rest of the Wall Street Banks directors

told SEC to loosen up the reserve requirements (2004) that was what really put them over the edge. This is more leverage (and risk) than you get gambling on commodity futures!

Because they bought CDSs on their riskier CDOs they thought they had virtually NO RISK. Only thing was everybody else, including those who sold them the CDSs were playing the same game. So when time came to "call" your CDS you found out your "insurer" was about to go bust himself because he too didn't hold enough reserves for his liabilities! Now this also is due to the idiot use of a formula that estimated default risk not by looking at the risk of the mortgages combined in a given CDO but using a comparison of prices paid for CDOs of similar class. In other words default risk was based solely on the markets view of the risk as reflected in the price paid for similar CDOs. Risk assessment based on what the latest market prices were for similar class CDOs! Essentialy the "speculators" model - for estimated default risk!!!

THe same thing as 1929 - everybody was gambling like they couldn't lose and using enormous amounts of leverage (same as being on margin with commodities or stocks).

Their greed was only surpassed by their hubris and gullibility (regarding the valuation formula). Certainly one of the humankinds greatest weakenesses is the stubborn belief that you can get something for nothing (or get away with operating at 30:1 Debt to Equity and think you are not gambling).

[notesdev]

9. Sort of like

AIG being the local insurer in New Walleans when Hurricane Greenspan hit.

[HamdenRice]

5. It's a tough issue, but I think I agree: Mark to Market is wrong and caused unnecessary problems

Here's basically one thing that happened. Let's say Bank has two kinds of mortgage backed securities: (1) Bear Stearns Mortgage Shitstorm Series A and (2) Lehman Goldplated Series C. Both were initially triple A rated.

Both are $10,000 face value mortgage backed securities trust certificates, paying 5%, or $500 per year. The Bank's assets are $20,000.

Now when BS Shitstorm Series A defaulted, and stopped paying $500 per year in interest, the mortgage backed securities market froze up. No one would buy EITHER BS Shitstorm Series A or Lehman Goldplated Series C. So the market value of BS might be $1,500 and the market value of Lehman Goldplated might be $3,000.

So Bank's assets are $4,500, and if their liabilities were based on having assets of $20,000 rather than $4,500, then the bank goes under.

But if Lehman Goldplated Series C is continuing to pay $500 per year and the mortgage portfolio is still good, according to "discount to present value" method of valuation, it's still worth near $10,000. The Bank's asset value might actually be $11,500 instead of $4,500.

M2M forced the banks to price "panic" into the value of their assets, which created more panic, which further depressed assets, which ... you get the picture.

[JohnWxy]

7. Since the Government operating under the Republican myth that the market will police itself, was

absent from the picture and there was no regulator - there was nobody monitoring the trading in these derivative instruments or looking at the systems level effects of asset valuation of these CDOs and CDSs at the latest market price. - a prescription for volatility and speculative madness. As soon as there is a little roughness in the market, everybody started looking around at everybody else and in a very soon everybody starts running for the exits. Obviously, almost everybody loses under that scenario.

But Milton Friedman said a free unregulated economy was our salvation. Alan Greenspan said "What, me worry?" and Phil Gramm said: “There is this idea afloat that if you had more regulation you would have fewer mistakes,” he said. “I don’t see any evidence in our history or anybody else’s to substantiate it.” He added, “The markets have worked better than you might have thought.”


Phil Gramm was the free marketeer who snuck the http://www.motherjones.com/politics/2008/05/foreclosure-phil">Commodity Futures Modernization Act in as a rider to the Omnibus Spending Bill 2000. This is the legislation which made CDSs legal and UNREGULATED.

[notesdev]

8. If no one will buy it

then its market price is by definition zero. Just because they dress up a pile of bullshit and pretend it's an asset, doesn't mean it is.