More M2M

Today's WSJ has another article about M2M that is confusing, to say the least.  The journal says that FASB is considering widening M2M to include loans.  Per the journal, "FASB taking a more holistic view of accounting for loans, bonds, derivatives and stocks."

Meanwhile, the blog WebCPA noted:

FASB decided to loosen rules that kept banks from accounting for the cash flows they expected from mortgage-backed securities and other assets during impairment tests when they are categorized as available for sale, rather than just as held to maturity.

Note the major disconnect -- The Journal is implying that held to maturity loans might be marked to market. Meanwhile, the FASB is actually modifying rules related to assets held for sale. Huge difference.

The only modification I would propose is to revise the way that credit derivatives indices are used to value structured investments like CDO's. Plus a complete review of the use of credit derivatives as market proxies.  As far as the Journal's views regarding "fair value" -- it is safe to say that the world is converging on standards, and US GAAP can't let the IASB be the only body working on this issue.

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.  

    

Mark-To-Market Liabilities - Citibank

From Citi's 10Q:


This is impossible to read without double clicking the schedule.  So here is the line, and it was $1.3 billion at 12/2007 and $2.2 billion at 9/2008, for 9/2008.

This may or may not be all there is. However, these particular fair value marks aren't counted in Tier 1 Capital. This schedule breaks out the components of Tier 1 Capital and therefore has the figure I'm looking for. Or something close to it.

I like the way the line reads -- attribtable to own (lack of) credit worthiness.  I also don't know exactly how one values one's debts to "market".  Does one simply look it up as a traded bond?  Or is this simply a haircut based on credit spreads from credit derivatives.  One could even imagine a bond selling for more then par -- what to do then?  

It isn't unreasonable for a firm that has assets like bonds issued by other banks that just got a haircut to want the same treatment for its own debt.  It's never that simple and the bond assets might be supported by deposits and the debt stands on its own  -- so they couldn't simply sell the asset to buy the debt in the open market.  In fact, if they had the cash to redeem the debt, it would probably be at par or par plus call provisions.  Really bad companies can do tenders on their own debt for, say 60%.  Like Level 3's recent tender.  

This is just an interim piece while I figure things out.  This is the best I could do in an hour, although I suppose I could have copied a lot of quotes on fair value.

One thing I will say is that this isn't something that Citi seems to want to make easy to understand and find.   Actually, there is a HUGE amount of information in these statements.  I wonder if management, outside of the financial reporting guys, actually read this stuff.    

Financial Buzz Words of the Year - Clawback

Last year, my favorite was tranche.  

The word tranche is French for slice, section, series, or portion. In the financial sense of the word, each bond is a different slice of the deal's risk.

The very notion of taking something that makes (at least a little) sense as a whole -- like a pool of assets, and then slicing them in complex ways that give the slices significantly different characteristics is suggestive of a general approach to life.  Tranches of love?  Very Post Modern.

The New York Times has a number of candidates in their annual article. I like the word malus (opposite of bonus), fail (as a noun, like a bucket of fail), TBTF ( too big to fail), and recessionista (Originally, someone who favored a recession as ultimately good for the economy.).

The fact that they all need explanations does not particularly recommend them. My vote would be for malus. It turns out that malus has been used in experience rating of personal lines insurance, but not primarily in the United States. Here everyone gets a discount or bonus and a malus would just be called a standard rate or price.

I'm going for something more/better then a simple malus. A clawback. Per investopedia, a clawback is an: .

...obligation represents the general partner’s promise that, over the life of the fund, the managers will not receive a greater share of the fund’s distributions than they bargained for. Generally, this means that the general partner may not keep distributions representing more than a specified percentage (e.g., 20%) of the fund’s cumulative profits, if any. When triggered, the clawback will require that the general partner return to the fund’s limited partners an amount equal to what is determined to be "excess" distributions.

The term clawback captures the mood of the public. They want accountability. They not only want to slash bonuses, but also to recapture the excess and unwarranted bonuses of yesteryear. And further, they don't just want them back -- they want them CLAWED back, which in the best case would include actual blood.

Like something from Kafka's Penal Colony.

"In the Penal Colony" is a story about the last use of an elaborate torture and execution device that carves the sentence of the man on his skin in a script before letting him die, all in the course of twelve hours. As the plot unfolds, the reader learns more and more about the machine, including its origin, and original justification.

I think this just about sums up the mood of the country.

Ultra Smart or Ultra Dumb?

2008 is the year of the ultra shorts. There is a good article by Eric Oberg in The Street.Com regarding friction and other issues with the ultra ETF's.


I won't repeat any of his observations, but note that the winning strategy is to go short the ultra long and vice versa. Or at least that would have been a winner last year.

Of course, that lets the little guy out who can't borrow shares or is doing it in his IRA. I like the sound of it, also -- Short the Ultra Short to go long and Short the Ultra Long to go short. Would have been a huge improvement over buying and holding these over the course of a year.

A better idea for amateurs would be to avoid leverage.

Financial Blogs of the Year

1.  Calculated Risk

2.  Abnormal Returns

3.  Accrued Interest

4.  Marginal Revolution

5.  Naked Capitalism

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.