Mark-To-Market

Factoid:

Mark to market applies to both assets and liabilities. That is, in the "fair value" world of Basel, it isn't only assets that get a haircut. Liabilities also. What does this mean? If your debt is downgraded, then it has a lower market value and ergo, you have a windfall profit.

This isn't allowed in vanilla GAAP, which assumes a going concern will pay off its debt at par or no longer be a going concern. The default option has no value for the GAAP Luddites. A lot of people aren't going to believe this or take this at face value. So here is a real world example discussed in the blog, The Treasurer:

Barclays Capital has reported losses on credit market exposures of £2,831m but has then set against this gains on its own debt securities of £852m. In other words changes in market yields of its own securities have caused the mark to market valuation of its own liabilities to fall creating a windfall gain.

It isn't only the Brits that are doing this, per Bloomberg:

Merrill Lynch & Co., Citigroup Inc. and four other U.S. financial companies have used an accounting rule adopted last year to book almost $12 billion of revenue after a decline in prices of their own bonds. The rule, intended to expand the ``mark-to- market'' accounting that banks use to record profits or losses on trading assets, allows them to report gains when market prices for their liabilities fall.

Let's say you run a vanilla derivatives business, selling listed puts and calls on exchange traded stocks. Like the stuff retail investors buy. And lets say that's all you do -- no real world businesses confusing things. Then you want to know your net exposure at today's market value at the end of every day. So far everyone is on board, I assume.

Here is where I think we started getting lost. The various FAS regulations (133 and 157) refer to accounting for derivatives. Some people like the sound of "mark to market" since they think it isn't "mark to fantasy." The rub is that you have to actually have a market that works. It has to be relatively efficient, liquid and deep. Wanting to "mark to market" doesn't magically create a market. Further, and perhaps most important, do we really want to use accounting set up for the derivatives business to represent best practice? I would like to see a lot of the derivative business disappear along with the financial engineering that contributed to the current train wreck.

 
In the real world, we got into disputes when credit derivatives prices (or alleged prices) were used in asset valuations and the results were very unpleasant. People realized that a firm could go into a downward spiral based on thin, illiquid credit derivative market quotes -- especially when combined with credit rating agencies gone wild with new found zeal. There is more then one variation of this playbook that has been used to grind a firm's stock price to pennies in a few hours. As soon as people figured out that financial firm's financial position was based on their credit rating (collateral), which was connected to their stock price (ability to raise capital), which was tightly linked to CDS spreads -- then a stressed financial firm found it could evaporate in a matter of hours.

Some people were wondering WTF. How could XYZ be AA at 8 a.m. and fail the next day. When they saw the carnage and connected the dots, it seemed to point to the credit derivative Netherworld.

But this is the really galling part of the story.   After throwing XYZ under the bus and making handsome profits shorting XYZ's demise, the former long stock holders got a lecture about how credit derivatives are some higher form of truth. And anyone that didn't want the entire business world to be run like a derivative shop was some sort of liar.  

And then, given the buzzword of the year, every commenter on every blog gets into a moralistic rant about arcane accounting concepts. Stuff they couldn't even began to understand. I'm not claiming to be an expert here, either. This is genuinely complicated. MTM isn't motherhood and apple pie. Just boring regulations regarding how to account for derivatives.

The point of this post is that most people know a lot less then they think they know about this.  The accounting concepts have implications that are counter intuitive - like firms benefitting from a credit downgrade (but only investment banks).  There are also other counter intuitive aspects associated with m-t-m, but they will have to wait for another post.