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Mark-to-Market: A Rule That Begs to Be Broken
by Louis Basenese, Advisory Panelist
Senior Analyst, The Oxford Club
Thursday, March 12, 2009: Issue #954
Today a House Financial Services subcommittee will examine the hot-button accounting issue of mark-to-market, formally known as FASB 157.
The SEC’s already asserted its stubbornness. An anonymous source told Reuters this week, and I’m editorializing slightly, “There ain’t no way we’re suspending mark-to-market!”
But there are a lot of good reasons why they need to do exactly that. Unfortunately, the SEC doesn’t have a great history of proactive regulation. Here’s why we better hope our elected representatives see the situation differently.
Mark-to-Market – Increasing Transparency?
Proponents of mark-to-market contend, and rightfully so, that the rule increases transparency. It requires banks to “mark” or price assets based on the current market price. In other words, it forces banks to tell us what their assets would sell for in the current environment.
On paper, that’s a great principle. Who wouldn’t want to know what their investments are worth on a daily basis? If you’re like me, you probably mark your stocks to market every day – checking their prices after the closing bell.
However, doing the same for mortgage-backed securities – the assets at the center of this debate – is not as simple as punching in a symbol on Yahoo! Finance. You see, while stocks trade daily and by the hundreds of thousands of shares, these mortgage-backed securities might not trade for weeks or months at a time.
And when thousands of these investments exist, and only one trades in a month, can we really say a market exists? Not at all. So under the current conditions, mark-to-market is more like mark-to-make believe. Especially since the prices banks are forced to use are completely out of whack with reality.
Let me provide some examples to illustrate what I mean…
When FASB 157 Misses the Mark
In the fourth quarter, The Bank of New York Mellon (NYSE: BK) was forced to write down a $5 billion portfolio of Alt-A mortgages by $1.24 billion or (25%). Yet, based on the performance of the underlying loans – the principal and interest payments the bank was receiving – they only expected to lose about $208 million.
Granted the bank’s estimates of losses could be wrong. But the difference between the two methods – net realizable value and mark-to-market – is gargantuan. And it proves mark-to-market fails to do its job when virtually no market exists for these assets.
For good measure, here’s another example of its shortcomings…
The Federal Home Loan Bank of Atlanta holds three private mortgage-backed securities. But, it has no intention of selling any of them. Again, based on the actual performance of the loans, the bank estimates it will lose $44,000, beginning in 2025.
That’s not a typo. It will be another 16 years before any losses are incurred on these loans. Yet because of mark-to-market accounting, the bank was forced to write off a loss of $87.3 million – a figure almost 2,000 times greater than the actual losses.
One could argue that over time – as a market returns for these assets – the huge price differences would correct themselves. That’s true. But banks can’t simply wait it out.
Due to Mark-to-Market, Banks Out of Compliance
The write-downs required by mark-to-market put many banks out of compliance with capital requirements – the amount of cash and easily liquidated assets they need to hold to offset their liabilities (i.e. – loans to others). And the only way to become compliant again is to raise capital by either issuing more stock or selling off assets.
Bottom line – the current application of mark-to-market forces banks to raise billions upon billions in real capital to offset losses that are never going to occur. And that makes absolutely no sense.
As for questioning the authority of the Financial Accounting Standards Board, their track record warrants it. Remember, their rules on special purpose entities allowed Enron to pull-off its accounting shenanigans and later required revisions to adjust for the deficiencies.
- Mark-to-market rules were supposed to fix problems from Enron. Unfortunately, they created a large batch of new problems.
- Mark-to-market is simply another one of FASB’s rules that’s good in principle, bad in practice, in desperate need of a revision.
Good investing,
Louis Basenese
Today’s Investment U Crib Sheet
Another regulatory item of note for market watchers this week was talk from the SEC that they might re-instate the “uptick rule.” The uptick rule was originally created by the SEC in 1938 to limit the amount of influence large institutions had to purposefully push the price of a stock down.
Specifically…
The Uptick Rule requires that in order to sell a security short, the price must be higher than the preceding sale. This had the impact of limiting the influence of “shorts” – those selling a security short to profit from the difference.
Amongst the other benefits, it was reported that the uptick rule reduced volatility and decreased manipulation.
The SEC eliminated the uptick rule in 2007, based on market tests they did during a bull market. No one had seen the effects of a bear market without the uptick rule since 1938.
As we know, extreme bull and bear markets are ruled by emotion, and little financial discipline. Rules like the uptick rule were designed to reduce the effect of this irrationality on the market.
Bringing the uptick rule back will be as welcome as adjusting the mark-to-market accounting rule.
If you’re looking for another way to profit from the market’s mispricing, take a look at real estate investment trusts (REITs). It was one of the sectors hit hardest from the mark-to-market rule. Hundreds of REITs have seen share prices plummet. But we’ve found a few that haven’t been affected at all. In fact, you can Get Paid, the Next Time you go to the Doctor because of it.
- TD Ameritrade Gains Uptick from SEC Rule
- Banks Pushing the Limit?
- What is Toxic Debt and How Much is There?
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19 Responses to “Mark-to-Market: A Rule That Begs to Be Broken”
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A former Wall Street consultant and analyst, Louis helped direct over $1 billion in institutional capital before joining forces with The Oxford Club.
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March 12th, 2009 at 9:44 am
Lou
Excellent succinct explanation. I also watched your short video on the subject. My question, in light of the potential that M2M might be lifted, you mentioned that solid banks might be a good buy for a 5 year vision. You also suggested that an ETF with said banks might be good. do you have any such ETF’s in mind specifically?
Regards and thanks for all the great information.
John Fitzpatrick
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March 12th, 2009 at 9:48 am
very good
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March 12th, 2009 at 9:54 am
Mark to market rules only apply if a bank is putting securities they own into a trading account. If they buy securites with the intention of holding them to maturity, they don’t have to mark to market. If banks are trading securities in a market that is very illiquid, they should be very cautious about exposing their capital to a lot of risk. I believe mark to market rules are necessary and that banks should be held accountable for the mistakes they made.
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March 12th, 2009 at 9:58 am
Banks are ruining out of real money.
the world economy is about 500 trillion dollars at a 40 to 1 leverage. That is one real dollar to every 40 imaginary ones (loan investment stock dollars)
As the economy of US EU ASIA and others slow down, less real money will be produced and therefore there is no logic on how to suport a 500 trillion world economy. Mark to market could help maintain an equilibrium between real money (Cash deposits on a bank)and the imaginary world of lending.
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March 12th, 2009 at 10:14 am
Right on! Why didn’t the “genius” economists and lawyer congressmen and the banking regulators, etc., realize this mark-to-market rule was at the root of the economic downfall ? ? ? They have been dancing all around the root problem to keep the economy falling to get Obama elected….so he, the “great one” along with his Prince Reid and Princess Pelosi could get their big spending bills through Congress. Our Government is a disgrace!
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March 12th, 2009 at 10:57 am
Transparency yes, Mark to Market, NO. I believe this rule single handedly created the housing bubble, and then popped it. When things went up you could up value the entire portfolio. When they went down, you had to down value everything. It did not do what it was designed to do. We were warned this would happen, no one listened. Let’s hope they get it right this time.
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March 12th, 2009 at 12:17 pm
The real problem is the banks securitizing the mortgages in order to get more money to lend, thus leveraging themselves many times over. That increases the risk, but puts the risk on the backs of the investors who buy these ‘Mortgage-Backed-Securties’. Probably most of these risks were put in the retirement plans of workers, who will never realize what happened to their retirements! A good deal for banks & brokers!
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March 12th, 2009 at 12:30 pm
Outstanding explanation on “mark to market” from Louis. Unfortunately, barring a miracle, I think it too much to hope that our Congress and the likes of Barney Frank and Nancy Pelosi are capable of such reasoning. Suspending “mark to market” would have an immediate and positive effect on the balance sheets of most banks and financial institutions thus eliminating the need for more TARP monies and federal bailouts. Maybe then we really could balance the budget. What a thought!
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March 12th, 2009 at 12:34 pm
Great post Louis. But it’s not just banking that’s saddled with this M2M albatross. Venture capital and other private equity investments are now held to the same standard. The result is the same. There’s no real market at all for most early stage venture capital investments, so you “mark to make-believe” as you say, at least on some investments, and hope your auditor blinks before you do so that it’s over for another quarter. Meantime your paper returns take a hit for an investment you have no intention of exiting for years.
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March 12th, 2009 at 1:42 pm
These are the topics the Sunday shows,Face the Nation, Meet the Press and George S. should be giving the people so we could be educated on things like this.PRO and CON. I would guess only about 1 or 2 percent of our Washington reps. could explain this or understand it.
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March 12th, 2009 at 3:24 pm
Excellent explanation of the stupidity of bean counter “accounting rules.” It is interesting at how pig headed the SEC lawyers are in refusing to consider suspending a rule that has almost distroyed the banking industry.
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March 12th, 2009 at 3:42 pm
I agree completely with the article! AS a Chartered Accountant and one that used to audit financial institutions it is complete ludicacy! This is an age old debate, even from the days I was in University and one meant to be left for debating, not affecting capital. Disclose, sure, the more information (with integrity is the key) the better, but the ones who came up with this will certainly be looked at in hindsight as adding to the crisis.
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March 12th, 2009 at 8:47 pm
Hi there. My previous formula should be modified to read;
M(t) = M(t-1)*( 1 + L(t-1) * (P(t)- P(t-1))/P(t-1))
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March 12th, 2009 at 10:52 pm
Mr. Basenese is one among very many who have been able to show exactly why the mark-to-market rule should be suspended. In fact, SEC Cox could have suspended it in August of last year during the Bush Admin., and in time to prevent much of the damage it has done. Why didn’t he? Did President Bush say no? If so, tell us he said no, and why? Why haven’t we heard from the horses mouth why, against the best of advice, the rule has remained in place? The short term goal of transparency is hardly worth the long term consequence of global disaster, which no one can deny. So either the holders of the reins of power in this and the last administrations don’t really know what is going on, or they have another agenda, or what Mr. Basenese and the others have said is simply not true. We, on the other hand, have a right to know where the truth lies. Let’s get to the heart of the problem! Let’s call a spade a spade.
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Joe Reply:
March 17th, 2009 at 11:10 am
I’m a newcomer, so I’m somewhat confused. If the M2M rule wasn’t in effect, then what would we be marking to? Would it be the original value? Would it be the original value plus some percent to account for inflation/deflation? If so, inflation/deflation of what? Certainly not the market to which the investment belongs, correct? Otherwise, that would be mark to market, right?
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March 12th, 2009 at 11:41 pm
How do you reconcile your conflict of interest as an investment advisor user of financial information with what is best for the public interest in advising what accounting rules should be. It seems you are one among many who provide differeing special interest opinions as to what accounting rules should be. Perhaps the Government shall listen to many comments in making their deliberation. However, I believe these rules should be left to regulatory bodies other than the SEC and the accounting industry: These are the bodies that must develop and work with accounting and auditing rules governing regulated industries. The Office of the Comptroller of the Currency (OCC), Federal Deposit Insurance Corporation (FDIC) and the Federal Reserve Bank all have outstandingly enlightened enforcement records related to accounting and enforcement records. It is dreadfully unfortunate that these regulatory/supervisory bodies have not ever had the authority to extend their supervisory oversight over the investment banking community members.
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March 15th, 2009 at 5:47 pm
For the last two years I have repeatedly called the SEC asking them to reinstate the uptick rule, and t0 stop Mark to Market which were destroying the financial stocks. I further asked them to better regulATE SHORT SELLING HEDGE fUNDS AS THEY WERE DESTROYING THE FINANCIALS WITH THEIR NAKED SHORT SELLING, and spreading of untrue rumors. The SEC gave me supportive lip service and hope of corrective action, but they did absolutely nothing. COX of the SEC was either the world’s greatest stubborn idiot, or he was completely corrupt as he helped short sellers to destroy the markets; and thereby wreck the economies of the world. The SEC was set up to protect investors from unfair trading practices. SS hedge funds have been manipulating the markets, and the SEC has done nothing to stop them, and by eliminating the uptick rule they further helped them to destroy millions of investors and bring the world to crisis mode.
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March 17th, 2009 at 11:42 am
Someone please help a newcomer out here…To me M2M doesn’t seem like the problem. In reality (and the present time being the only true reality there is) the true value of anything is what it can be sold for right now, or at least today. The reason being is that 1)the economic climate of yesterday is history (ie the boat has left the dock), and 2)the economic climate of tommorrow is always a mystery, which is why I’ve never played the markets. So to me, the concept of M2M is a good one. To me the crisis has been created totally by a misrepresentation of what the M2M values actually were at the time, either by not taking into account the risk involved with loans made to people who more than likely wouldn’t be able to sustain their mortgages, or by over-estimating the then current value of the mortgages by marking them to what they speculated their value would be in the future…which is not marking to current market value, but marking to future market value. To me, it’s pretty obvious. You can only lie so long, but the truth eventually will come out. It’s so unfair that so many have been hurt, and those who will be hurt in the future that had absolutely nothing to do with this nasty little game. Another failure of government to do its job, which is to govern in order to protect innocent people from criminals. The question is, are the people in government so stupid, or are they so criminal.
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April 1st, 2009 at 8:21 am
iam a new comer to this market and i do not understand the up tick rule or the mark ti market rule ,please explane it so people like me canget into the fight. thank you
glenn austin
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