While well intended, mark to market accounting in times of stress only serves to exacerbate market dislocations and confuse investors. For instance, check out FGIC’s earnings release today.
From the release:
“In accordance with SFAS No. 157, which the Company adopted effective January 1, 2008, FGIC updated its mark-to-market methodology to take into account the market’s perception of FGIC’s non-performance risk. The adjusted methodology, which resulted in a reduction in the valuation of FGIC’s derivative liabilities, incorporated spreads of FGIC’s credit default swaps. In accordance with SFAS No. 157, the Company recorded a benefit of $1.56 billion in the fair value of credit protection contracts provided by FGIC that are considered credit derivatives, which more than offset the mark-to-market losses of $1.40 billion related to such credit derivatives and resulted in a net unrealized gain of $157.0 million in the fair value of such credit derivatives for the first quarter of 2008.
The first quarter 2008 mark-to-market loss of $1.40 billion consisted of approximately $228 million related to estimated credit impairments and $1.18 billion related to the widening of credit spreads in the structured credit markets. The estimated credit impairment of $228 million represents management’s estimate of future claim payments on certain ABS CDOs and other derivative transactions.”
Got it?
All the numbers being thrown around, billions, yet what did the business actually do?
What mark-to-market has done in many cases is reduce earning for companies from actual earnings based on the functions of the business to “anticipated results”. The credit spreads referenced are what the market feels about the insurance issue by the company. If the market feels good, the spreads contract, if they feel bad they expand.
This caused the “earnings” of FGIC to rise and fall based on these “feelings”. They do not have any actual effect on the actual eps. Yet they are now becoming more powerful than the actual operations, especially for businesses like banks and insurance companies that hold large pools of products. Without selling anything and actually realizing a loss or a gain, they will see wild swings in earnings based on market perception of these products.
It is like Anheuser-Busch (BUD) posting a “loss” for the quarter because the market thinks the selling price of beer will fall casing profits to be affected negatively. What should happen is that the market votes on the stock price by buying or selling and then we wait and see what actually happens. What mark-to-market has done is take that speculation and transferred it from the price of the stock to the earnings of the company. Not right…
The good news is for those with stones, when these spreads contract and the huge write-downs become write-ups, boom go earnings…..
Oh, FGIC, actually had a loss of $279 million based on “reserves for estimated credit losses”. That is what operations actually did irrespective of posted results and write-ups and write-downs.
Disclosure (“none” means no position):None
3 replies on “Why Mark-to-Market Sucks”
I like to think that marked-to-market can be a valuable opportunity creator. I could go into long detail about it but Cullen covered it fairly well the other day in Berkshires market-to-market derivatives. Fine, with me if berk has a bunch of markdowns on them, I’ll just pick up shares cheaper in the chaos. Does anyone honestly expect Buffet to make a deal where he thinks for a minute he will loose money on it. He may not get as much as he thought but he wont loose money on it. Bottom line is mark-to-market creates confusion and that usually leads to opportunity to those that take the time to get past that confusion.
ryan,
i totally agree but, the purpose of accounting ought not to be to create confusion and opportunity…
it ought to be to create transparency and ease of use for potential investors…
Googled ‘fair value sucks’ and brought up this post, which was posted well ahead of the fall 2008debacle. Very nice work, Tom, and I see that even Congress is starting to take note!
I have long been fighting against my CFA brethren on this issue because, as you note, transparency (and comparability) is ill-served by this destructive rule. If investors want a theoretical ‘if sold today’ value, let it be a footnote to the financial statements, because financial statements should reflect ACTUAL value and ACTUAL losses (and experience-based estimates of losses), not ‘fair value’ and phony losses (or market-based estimates of fear premiums).
Keep up the good work!
Dave Hodge