Accrued Interest Takes on M2M

 Mark-to-Market: Discussion minus the Zealotry is an attempt to get at a reasonable approach to M2M. AI brings up a number of points. Obviously, a lot of examples are didactic and don't reflect anything that is being done now.

Example 2:

Let's say that we have two firms, both have made loans to XYZ Retailer. But one is a bank which has made a traditional loan, and the other is a brokerage which holds a private placement bond. The broker almost certainly has to mark that loan to market, but the bank may not.

And in both cases, the rapid changing liquidity premium in the market place alters the "mark" for this asset. By this I mean, say the retailer is performing reasonably well, and thus the risk of non-payment remains remote. Given the weak economy, its obvious that the risk has increased by some degree, but given the extremely weak liquidity across fixed income products, the larger portion of the assets price decline would reflect liquidity. If the firms don't intend to trade the loan, is the changing liquidity premium relevant?

This is a problem where similar assets are booked at different prices. Here I would note that the bank would typically book the loan as a loan (intended to be held to maturity) rather then "loans held for sale." However, the brokerage's core business is trading and not originating and holding loans or similar assets to maturity. The bank is required to hold an "allowance for loan losses" on its balance sheet, which is an estimate. The broker's private placement bond doesn't trade, so credit derivatives would likely be an input into valuation. Note that there really isn't a direct market price for this asset. You have dueling models, one based on a bank's historical losses, judgment, and bank specific accounting guidance and the broker using a pricing model with the "observable" input being a credit derivative. As AI has noted, the bond price may include a liquidity premium which is clearly inappropriate for an institution that doesn't need or want liquidity -- the bank is simply going to hold and amortize the loan to maturity. If the broker really intends to sell the bond, then it should book to an estimate of today's market price. If the broker intends to keep the bond until maturity, then it has an issue, but not with accounting. From my perspective, you can have two different prices for a similar asset in this situation without a major problem. There might be "financial reporting" arbitrage opportunities. However, no one ever claimed that accounting should adopt modern portfolio theory.

Example 3:

There are other problems. Say you are a bank that has a private loan to a company with traded CDS contracts. Your best mark-to-market estimate would be to price the loan based on the cost of hedging out the credit risk. But in many cases, the CDS and cash bond markets have decoupled. Many bonds are trading a drastically wider levels than the CDS market, owing in part to easier funding of CDS. Take Amgen, where cash bonds are trading at a LIBOR spread of nearly 300bps, but the CDS are around 90bps. On a 10-year loan, that implies a valuation differential of about 15 points!

So here again, we have a situation where two firms can use "market" prices to price non-marketable assets, and come up with wildly different valuations. We hear mark-to-market and assume that the "market" is some kind of observable thing. But that is just not the case.

In this case, if the bank holds it as a loan, m2m doesn't come into play, so it is a moot point.   It looks like the CDS market is "broken" in that it doesn't model reality very well.  A synthetic bond would yield less then a natural bond.  That would imply an arbitrage situation where a firm would sell the synthetic bond or CDS contract and buy the underlying.  That is, if markets worked.  Which raises the point of why one would consider a "broken" market -- one that violates the arbitrage free assumption -- as a better representation of reality then other estimates. 

The idea of taking a real, natural loan and goofing around with a pricing model using credit derivatives seems silly.  The firm that owns bonds has to deal with the fluctuation in market price as part of the luxury of owning an asset with a real market price.  The bond is a true level 1 asset and has always and will always be booked at the market price.  This isn't m2m -- it's just accounting.  No one has ever asserted that securities that are traded on an exchange or in a relatively liquid market *not* be marked to market to my knowledge.  Here we would have the loan booked at $X (say par), a theoretical pricing model using CDS's that may value the loan at $X + something (but is never used), a real bond selling for a discount in a bona fide market, selling for $Y (say a lot less then par), and a synthetic bond (cash + CDS) that could be purchased for $Z (more then par).  In this case it is simple -- ignore credit derivatives.  I would like anyone to find examples where a company complained about booking real bonds at market prices.  This isn't M2M, it is vanilla GAAP that has been around forever.  

AI Concludes:

But what's the alternative? Those that are calling for an end to mark-to-market are out of their mind. First of all, there is no clear alternative. Second, we have enough trouble trusting firms' balance sheets as it is. Imagine if mark-to-market were suddenly suspended!

It's very important to note that booking listed stocks and bonds is vanilla GAAP and has nothing to do with m2m, FAS 133, and FAS 157.  No one wants to change this aspect of accounting.  Until we can find this straw man, people need to cool their jets.

However, most critics of m2m are people that, say, hold commercial real estate CDO's and don't want to book them at a huge haircut because of a credit derivative index.  They tend to have a legitimate beef, since there is a basis differences between their security and the index.  There are, once again, dueling models and arguing that credit derivative indices are a market is a stretch.  It is one input into a level 2 or level 3 pricing model.  To my knowledge, they don't want to book these at par.  They have their own models and they don't want to be forced to use credit index based models which may be worse then alternative models.  There is a problem in that these critics always want to book higher asset values, and in a declining market, are usually wrong.  At this point in the cycle.  

    

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.

 

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.