Sunday, December 21, 2008

MTM - More to Come

I noticed that there are several important, but distinct aspects to the prior post:

1.  The facts that the logic of mark to market requires liabilities be handled the same as assets.  This conflicts with most people's understanding of mtm, since it is inherently less conservative then current GAAP.  Further, they don't believe it is logical, or they don't believe it is being done.  The fact that it is being done right now would be useful to further document and highlight.  

2.  The background of mtm and its cousin, fair value accounting, is rooted in derivative accounting.  People always want better accounting and also prefer conservative accounting to lax accounting standards.  However, they also tend to not be big fans of derivatives.  Unfortunately, mtm has been associated with writedowns which are more conservative -- all else being equal.  There is a sense in which people view mtm as conservative which is good, and therefore want to see more of it.  Also embedded in this view is a sense that markets are inherently efficient, liquid, and deep.  They are the best of all possible worlds regarding price discovery, etc. 

The truth is that mtm is Derivative Accounting, at its core.  People aren't big fans of leverage, and credit derivatives are particular unpopular among a lot of people. 

 A lot of people correctly associate derivatives with leverage and speculation.  The idea that accounting that was designed for derivatives should be a core principal of all accounting doesn't sound quite so benign.  Yet that's were we are heading with Basal II, etc.   

3.  The case against credit derivatives is much less clear cut then the above.  I don't like them in their current form.  Its too late to put the toothpaste back into the tube, but tight regulations regarding transparency is a minimum.  The more paranoid arguments against CDS's may be true, but aren't necessary to suggest significant reform.  In fact, regardless of the truth, speculation regarding organized efforts to short stocks detracts from the strong case that can be made for significant reform simply on its merits.

As a goal, I would like to substitute "Derivative Accounting" for "Mark to Market" and the various "fair value" proposals to be labeled as efforts to reduce capital requirements.  

Of course, this isn't uniformly the case, but the general thrust of Basal I and II and fair value reforms has been to put all financial entities on an equal footing.  Fair enough, but more then a little of it is a race to the bottom, with banks and insurance companies that are forced to comply with legacy, rule of thumb capital requirements believe they are inefficient and put their firms at a disadvantage.  Since there is little chance to regulate the competition, then their best strategy has been to level the playing field, which amounts to a race to the bottom.


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