Monday, March 30, 2009

Is mark to market's repeal the missing link?

It is still is not clear that mark to market will be repealed. But it appears to be on that track.

Mark-to-market as a fun house mirror, not a window to value
Some are blaming evil bank lobbies for all the pressure that finally produced capitulation on the issue. AND there may be some truth to that. But the case for repeal has its own special, intrinsic merit. It's the same reason we are not necessarily better off shaving in the reflection of a 'fun house' mirror than in no mirror at all...

No redeeming social value...
The point is that mark-to-market has produced bad results. It has led to no price discovery and yields no transparency. There is nothing really to recommend its retention. Granted that taking it away does not mean that you would get better results; valuations could stray further for reality and in the opposite direction. But it does look like alleviating the market of the mark to market rule could help to revitalize the valuation of securities pricing. That might make the risk worthwhile

Is this the missing link - the missing carrot - to get banks involved in the New Treasury plan?

As an adjunct to the Treasury/FDIC auction plan
When Treasury launched its auction plan one repeated criticism-admitted just this weekend in Tim Geithner's press appearance- is that there is nothing in it to motivate banks to participate in the securities purchase plan by selling 'toxic' assets. The Treasury/FDIC plans offer leverage for investors, low interest loans, plus some substantial protection against risk. To assist and attract asset sellers it offered nothing. Is mark-to-market the missing element to motivate sellers? It could be.

Impact of mark-to-market on bank willingness to sell assets
If you believe as I do that mark-to-market has depressed securities prices, then taking it away could actually cause prices to rise. Once banks were no longer burdened by such a low prices on their books (due to mark-to-market), losses no longer loom and sales become possible. If banks can sell securities above the level where they are now valued, asset sales will produce profits at banks not losses. Ironically it might take the elimination of mark-to-market to make the markets work and to generate transactions on these securities that could help bank examiners ascertain the value of the securities that banks now will have discretion to price.

Finders, keepers
Of course, another possibility is that banks simply markup their prices and put them into earnings. But if banks really need to unburden themselves of the 'assets' that the market views with such suspicion, then actually selling them- getting rid of them- is a superior strategy as long as the price difference is not too great between the price where they can be sold and where a bank would try to 'mark' them. This discussion assumes that the Fed's Bernanke and FDIC's Bair are right when they say things like 'long term value lies above market value' (Bernanke) or that 'banks hold a lot of securities on the balance sheet at distressed prices' (Bair).

Safeguards and Synergy
The key will be to keep bank examiners active when the rule change goes into effect. For banks since there is so little trust about the value of these securities, selling at something less than long run value if it does not require too big of a give away could make real sense. If they take advantage of the rule change simply to hold securities and mark them up, that would have less credibility. So the BEST all worlds right now, is the accounting rule change combined with the treasury auction plan.

Goodhart's law revisited?
I have suggested in the past that mark-to-market was sort of like Goodhart's Law in action. Forcing securities to be marked to market eventually made the markets themselves dysfunctional and unsuited to the task at hand. Similarly taking off the burden of mark to market may allow securities markets to flourish again and to provide a reasonable benchmark of value - but only if that is not required.

Loan modification: an ancillary beneficiary?
There is also an issue here (either real or bogus) pertaining to banks doing mortgage loan modification. Some have claimed that they are 'afraid' to modify loans since 'accounting rules' could cause them to have to mark down all other loans in the same vicinity if they mark down or modify one. This, it is argued, is under the idea that the whole region is impacted. That seems foggy since mortgage modification is such a loan by loan and borrower by borrower unique event. I think that the banker's assertion is a foolish application of mark-to-market. But it would be good to take that sort of argument away from the banks.

Modify or die? The lemon law
Banks could learn from auto companies. The 'lemon law' caused auto companies to have to stand behind their products. They did not like it, but it was the law that was critical in establishing liability and getting product quality back up. Banks have no sense of pride in their achievements- apart from their P&L, asset size, ROA, and bonus payouts. They sell you a mortgage and if it goes bad, they have no responsibility to you- only to their shareholders to foreclose. But foreclosure is expensive and banks need to consider that cost Vs the potential benefit of a modification- a real modification. When banks lend, they do not warrant the house price or the mortgage rate if it is adjustable. But they have mislead borrowers about the ease of refiing and that has not been deemed an issue under fairness in lending laws. Banks need to get some motivation to modify mortgages in a way to benefit the borrower, just as the lemon law once motivated automakers. To date, most bank loan modifications do not do that. In one study, nearly half of the loan-mods wound up saddling the borrower with higher payments. So if removing mark-to-market helps to get a real loan-mod process going, that would be another positive contribution.

Rule change is not just a sop to big banks FUGGETTABBOUDDIT
I am not a banker. I have been arguing for a very long time about the evils of mark-to-market. It has taken a long time to get this issue moving along. This is not about helping big banks. This is about trying to get loans to reflect TRUE VALUE instead of distorted point-in-time-value. There is merit in the idea and the rule change should not be looked at a sop to big banks.

Don't judge a rule by its title
We know that economics sees time and place as important considerations in the valuation process. But when accounting rules disrupt that process, the rules no longer are good or fair or helpful in determining true value, even currently. Just because you call it 'fair value' accounting does not mean that it is.

A change for the better
I like this rule change and I think it could be just what the upcoming auctions need to get banks into the game as motivated sellers. Ironically if you eliminate mark to market rules, the markets might come to value securities in a much better, fairer and more objective way than they do now.

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