We have all heard of “mark to market” accounting. In short, you value an asset based on its market value. But, what if there is no market?
This is what is happening with the current situation. Banks and lenders are basing values of assets, not on the performance of them, but on the “perceived value”. This is causing huge write-downs of the assets, that then forces the institutions to raise capital. How? A forced selling of these performing assets. Since everyone else is on the same boat, no one wants to buy them. If there are no buyers, there is no market. When I took Economics 100, a market was defined as a “place where buyer and sellers of good or services meet”. Unless that definition changed in the last 21 years, we should not force holders or these instruments to “mark to no market”.
When the market knows a seller has to dump an asset, the last thing it will get for that asset is a fair price. Now, the question is, are the assets really performing?
Since this all centers around mortgages, lets look. According to the FDIC, 98% of all real estate loans are current as of 12/31. Now, admittedly there has been some deterioration of this metric since then but it is nowhere near the level that would cause the pricing of mortgage backed assets today.
It is not a question of performance but of complexity. How can you value a CDO that you cannot understand the revenue stream from. When in doubt, in times like this, investors flee.
Thus we have the current environment. So, what happens? Intense pain the followed by a surge in the opposite direction. Think of it this way.
You live in a home and have a job. The value of your home has fallen and thus your “net worth” along with it. Has this “net worth” decline had any real effect on your day to day life? Is your EPS (income) affected by it? No. But, if you are a bank, you have to account for the decline in your home as a “loss” in your EPS. Now, assuming you are the bank, because the value of your home has fallen, and perhaps you have a home equity loan on it you have a problem. The holder of your home equity loan tells you that you have to liquidate assets in order to keep a “ratio” of assets to liabilities that they want.
Now you have a problem. You have to sell something and fast to raise $$ or reduce debt. It is a fire sale. Since you cannot sell more “shares” of yourself (like the bank can) to raise cash, you have to sell the home to the first bidder to reduce debt and raise cash. Problem, everyone looking at the home knows you have to do this. How low are those offers going to be below the fair value of the home? Way below….
As you start getting offers in for the home the banks sees them and now we have a problem because the money you will raise from the sale is much less than what everyone previously thought you would get. Your “net worth” or EPS if you were a bank would fall further because your new net worth would be based on this artificially low new estimate. Now you may have to sell the car also to meet their “asset levels”.
Now, out of the blue Grandpa comes in and gives you the money you need to restore your “asset levels” with the bank. Now, all of a sudden the home sale is not necessary and you can value your house at a fair market value and your net worth rises.
But, did anything actually happen? No. It was a mystical market driven event that turned into a very real problem for you. Were you late on a payment? No. Did you lose your job or revenue stream? No. Did you actually have to sell them home? No. Was the “quality” of the loans you had out less based on your payment results? No. But your “net worth” fell and rose and thus the above actions took place.
Had the value of you, the loan payer, been based on your performance on the loan, none of the above would have happened.
When the forced dumping by irresponsible holders of these mortgage assets stops, the value of what is left will rise, rapidly. When is does, the holders of what is left will then do the reverse of what they are going now. They will announce “write-ups” of the assets and EPS will surge and many of the institutions.
Thus is the current financial institutions situation.
3 replies on “"Mark to No Market"”
But the guy who has a job and bought the house did not leverage himself upto 30 times the equity and was not getting the margin calls on the borrowed money. The problem here is of huge leverage that was used by these banks, I don’t think it makes any sense to compare it to common man as he cannot leverage up to 30 times.
anon,
the banks are not leveraged that high
by law they cannot be
i was trying to make a simple analogy
This is one of the great disservice being done by the accounting profession. By forcing companies to price using illiquid markets, they are exacerbating the problems with the financials. As someone who is long a monoline insurer, you can easily see how a lot of the marks don’t make any sense. It’s even worse for the banks because they face margin calls (whereas monolines don’t–but their rating may be under threat though)…
We are going to see some big mark-to-market gains in the future. Unfortunately the shareholders will suffer (because firms are forced to raise capital at low prices when mark-to-market writedown is high)…