Is mark to market the problem?

on Mar 18 in Financial Market tagged by Trevor Hicks

One of the underlying factors in the financial meltdown is the imposition of mark to market accounting by the Financial Accounting Standards Board (FASB) in November of 2007.  This was not a crazy decision, really, what this means is that the banks (I’ll use that term inclusively to keep the language simple) were required to value their financial assets based on a market price for them.  For the securities most of us are familiar with this is no big deal, your on-line stock broker shows your portfolio balance based on the price of the most recent trade for each security you own.  If you take a loan against your portfolio, this is the valuation that will be used for collateral requirements.  Nobody cares if your own personal valuation of the stock is higher than the market says.  So if mark to market accounting is good enough for all of us, why was it a problem for the banks?

Well, the banks have more than one use for the data about their balance sheet.  For disclosure purposes, mark to market is I think an improvement over mark to model, as the use of their internal valuation is called.  The shareholders should know what the market’s valuation of the securities is.  Fine.  But the banks also are subject to capital and reserve requirements and these require that they maintain certain ratios of assets to liabilities based on their risk profile.  The fact that the Basel II regulations considered a mortgage backed security filled with loans originated and paid by many people anonymous to the bank as less risky than a mortgage it originated, serviced and held with someone its loan officer personally met is not the cause of this particular problem.

What the capital requirements mean is that if the valuation of their assets declines, they may have to convert them into cash to bring their portfolio in compliance.  This regulation has what is known as a “pro-cyclical” effect meaning that in a rising market, the assets become overvalued, allowing the firm to take on even more risk.  And in a declining (or plunging) market, the assets become undervalued and force the firm to sell them at the worst possible time.  In other words, it’s kind of a rule, when in combination with mark to market accounting, that says banks must buy high and sell low.

So let’s say you hold a bond that is performing very well.  Maybe it has a 5% interest coupon and you are earning that $5 per year on the one hundred dollar investment.  Now imagine that because of various factors, the chance of this bond defaulting shoots up to 10%, you might imagine the price the bond sells for would go to $90 (note - this is a gross, gross simplification of the math I know, just illustrating the point).  But the market price for the bond is actually $50 because nobody wants these bonds.  Well, your asset value just shrunk in half, the government says you have to raise cash to balance your portfolio, so you sell the bond for $50.  Without that regulation forcing you would never have sold at that price because your model says the bond is worth $90.  And frankly, since the cash was still coming in you had no intention of selling the bond anyway.

So yes, let’s keep mark to market accounting for disclosure purposes.  But for capital and reserve requirements we should do better.  Even for the complicated mortgage backed securities, it should be possible from public data to assess the quality of the cash flow based on actual default rates and use that for valuation purposes rather than a market price.  It seems completely backward to base regulations on a possibly bubble induced market price (either too high or too low) when the cash flows are what you really care about anyway.

Individual investors experience this same phenomena when they get margin calls on loans they have taken against their portfolios and you might reasonably wonder why I would argue for separate treatment for banks.  Well, I’m not.  Margin calls are a feature of a private contract between a lender and borrower and the borrower is free to decline to enter in to such a deal.  The capital and reserve requirements are very different as they are a regulation from the government dictating that a firm’s balance sheet look a certain way.  Imagine if the government required you to convert some of the holdings in your 401(k) to cash because it doesn’t like the ratio between your portfolio balance and your mortgage.  That would be a more apt analogy.