More on Marking To Market

Last week I wrote this post regarding the hazards of applying 'mark to market' to every balance sheet in sight. In the post, I asked,

"Why should a firm be forced to keep its balance sheet on a 'breakup' valuation basis? If the firm doesn't plan to sell itself or liquidate, why must every scrap of every asset be current-valued?

What about industry sectors in which substantial investment is required in assets whose value will grow with time, such as cable, mining, or technology? Or commercial banks which legitimately desire to be portfolio lenders to the housing sector, and, thus, are not affected by performing loans whose values are temporarily depressed due to market or credit conditions?"

I guess I'm in good company, because in yesterday's Wall Street Journal, Holman Jenkins echoed my post and sentiments in a column entitled "Mark to Meltdown?"

Jenkins wrote,

"Overstating the importance of accounting rules is, indeed, the essential error that leads to excessive twiddling with accounting rules. Whether a company values its assets at historic cost or market value or a value derived by some other formula, investors still have to make their own forecasts and judgments. A thermometer is equally useful whether it says water freezes at 0 degrees or 32 degrees -- though it still doesn't tell what the temperature will be next week.

But loose as well is a fear that exaggerated writedowns in the current credit crunch are rapidly chewing through the banking system's capital cushion. Banks will be forced to dump assets at fire-sale prices, leading to yet more writedowns and more fire sales. At best, banks will have to keep shopping cheap equity to foreign potentates to keep themselves afloat. At worst, massive regulatory insolvency lies ahead.

This horror show, we hasten to add, has proven more theoretical than actual, but it plays a key role in the meltdown scenarios of NYU economist Nouriel Roubini, which he recently retailed for a congressional hearing. And it's hard to doubt that fears of accounting-prompted distress sales are partly behind the melodramatic yields now available in the corporate and municipal bond markets."

Which is pretty much what I further opined in my earlier post,

"It's one thing to force market valuations on assets which are purposefully traded frequently, such as bond or equity funds. But forcing firms which own significant amounts of assets that are not intended to be liquid seems silly, especially if the 'market' for those assets temporarily dissolves, creating an apparent value of zero."

We therefore have the Law of Unintended Consequences extracting perverse, severe penalties from today's credit markets. Somewhat arbitrary accounting rules are now governing the behavior of financial service firms to issue margin calls and trigger the unwinding of highly-leveraged positions in credit instruments, which is causing further, temporary cratering of values of otherwise-performing assets.

As Mr. Jenkins informs us,

"Mark to market was a gift to the world from SEC Chief Richard Breeden in the early '90s. With the help of accounting mavens, he argued that requiring banks and other companies to account for financial assets at current market prices, as if the institutions were being sized up for liquidation, would provide a rough-tough discipline for the edification of investors, regulators and managers.

A rose would smell as sweet if it were called skunk cabbage -- so we always maintain when somebody predicts either dire or utopian results from a mere accounting change. Still, many questioned Mr. Breeden's initiative at the time, among them Fed Chairman Alan Greenspan and Bank of America's Richard M. Rosenberg. Particularly notable were their warnings that the new rule, when combined with risk-based capital standards, might lead banks to hold fewer loans on their own books, packaging more of them as complex securities for sale to investors.

Overlooked, too, was a phenomenon we perhaps understand better today -- the propensity of the speculators who provide much of the market's day-to-day liquidity to go on strike during moments when their services are most needed. "Mark to market" then becomes something else, because markets no longer exist for many of these abstruse securities. Banks are left oxymoronically trying to estimate what market prices would be if markets existed."

Which, again, echoes something I've written about many times in the past year- the tendencies of younger trading mavens to fail to understand that sometimes markets simply cease to exist, in the classical sense of the definition. If you hold such instruments with borrowed money, you are in a bind. If you are forced to mark such positions to market in the face of a non-existent 'market,' you are also in a bind.

Mr. Jenkins closes his piece with this passage,

"But the best argument was articulated by the late Citibanker Walter Wriston, and it applies equally to most of the accounting innovations with which the world has been oversupplied in recent decades: "Consistency of accounting treatment is always more useful to managers and investors than the latest fad of accounting aficionados." "

Just so. And perhaps we should allow for context, too. As I asked at the end of my prior, linked post, why isn't this a subject on which FASB should rule? Have they been attending to it since, oh, last June, when the effects of this accounting policy began to send credit markets in a downward valuation spiral of 'devalue-sell-devalue-sell-devalue-sell-writedown-close?'

I think the much, much larger issue now is to consider, for the entire financial services sector, the contexts in which mark-to-market makes little sense, and should be suspended, versus when it is appropriate.

As I began to suggest in my earlier post, businesses and companies in the business of trading and investing with the constant expectation of selling and buying securities should probably mark their assets to market daily. If that causes them to use less leverage or avoid exotic structured finance instruments, so be it.

Financial service businesses intending to hold assets, whether they be whole loans, exotics, or what have you, beyond a pre-determined duration, should probably be able to value those assets on the basis of performance, rather than immediate market value.

As I wrote here in September of last year,

"Could it be that, rather than a uni-directional march toward market pricing and underwriting, credit markets are, in reality, about to swing between extremes? Moving from all-bank balance sheet valuation and warehousing, to heavily market-priced and securitized, and now back toward the original pole of bank-sourced and distributed credit instruments?

It's not something I've read anyone else hypothesizing. Even I just assumed that banks had pretty much become a mere origination platform for credit.

Now, with this latest credit market debacle, the first since really heavily asset securitization of mortgages and corporate loans have kicked in, we are learning that there are market conditions under which non-banks may not be viable for very long, if they originate and/or hold volatile fixed income assets.

It's an interesting phenomenon. Who would have guessed that there was life in the old commercial bank model, yet?"

More than anything else, it seems that commercial banks began behaving like investment banks, and have effectively eliminated an institution which used to anchor the US economy- the bank that judges credits based upon the prospect of actually holding them to maturity.