Wednesday, March 11, 2009

Mark-to-market: Buffett's take and more

Warren Buffett in Margaritaville...and revisiting the evil spawn of Goodhart's law

Yes, I know that Warren isn't Jimmy. But his suggestion on mark-to-market puts him on the OUTS with regulators, hence in Margaritaville, La LA land or some other location of banishment.

The issue here I think is much broader than should we use mark-to-market. No one I know thinks that the markets for these derivative Securities are being priced 'right.'

So if markets can't get the prices right WHY EVER MARK THINGS TO MARKET for ANY purpose?

This is the question no one wants to touch. Marking to market is a Holy Grail with a curse attached and so is Free Trade. Touch either with ill-intent and you turn to stone.

As a guy with a PhD in economics writing about how Free Trade is not all its cracked up to be could get my degree revoked- well not really but it could pull your reputation out from under your feet and brand you as a quack. The Fed's are doing the same thing with mark-to-market. It is being canonized by the establishment and it is time to STOP IT before that happens.


If markets do get distorted and dysfunctional why would you want to mark to THAT?

We know that market do these things. The IMF has rules that apply to when countries are allowed to intervene in dysfunctional currency markets and it cites things like volatility and wide bid/offer spreads and the like. So it's not like MAINSTREAM economics says this can't happen. Quite the opposite. How wide are bid/offer spreads of mortgage derivatives-could they be any wider? Do they they even exist?

Warren has an idea to free bank balance sheets from this M-2-M constraint for regulatory capital. But that misses the point: if is bad for the goose it's bad for the gander, to turn an old expression, just a bit.

In economics there is something called Goodhart's law that is a counterpart to the Heisenberg Principle in physics. In economics the application has been to targeting money supply. Charles Goodhart (former B of E Governor) declared that any measure of money the authorities chose to target for policy purposes instantly became irrelevant.

What I suggest is that we have another example of Goodharts law (GL) applied to financial assets and their markets.

To 'get' this you need to understand the idea behind GL. The notion is that you have a an economic relationship that 'works' to start with. You identify a variable that is related to a policy objective in stable way. But once you elevate your target variable to the status of a 'target' or 'market benchmark' - that is, once you begin acting like the relationship is immutable, it changes. So the indicator you have elevated in status, stops working. You are back to square-one.

After this experience , we can understand why central bankers are unflappable by the failure of mark-to-market since they have used flawed, patched and redefined money measures again and again and again in their most recent history. Some central banks still rely on these flawed indicators.

So why not have regulators ignore the flaws in market to market too? That is exactly what they are doing. And that is the problem. They are worshiping the golden calf and breaking the stone tablets.

What I am suggesting is controversial. I am not simply arguing that central bankers have another flawed policy crutch but that a certain circular reasoning has been introduced by relying on a market valuation system that puts values on securities that even its owners cannot price. Market value may not be 'the sum' of all the individual values but when only the market can assess value that's a BIG RED FLAG. How does that happen? At the end of the day its a critique that is a bit like the Lucas critique but of a different sort.

I do not argue perfect information, quite the contrary. If people believe that 'markets know' even when people don't, you set up an infallibility loop that is very dangerous. The question is whether Adam Smith did not realize that the invisible hand could also give you the invisible finger - the fickle finger of fate.

To wind this up let me say that this may not so much be a property of markets but of how they are used. Putting market judgment ahead of your own I think is subversive and wrong. The drift in economics to use ARIMA models for anything gives us an understanding of nothing about the underlying economic structures. Derivatives pricing is one example of interposing 'statistical regularity and probability statements' in the place of knowledge. George Stigler once sneered at Ricardo's 93% labor theory of value as being nothing to base a whole theory upon- theory is not 93% but 100%.

So if we have incomplete knowledge how can we build on that as a base and expect anything other than bad to occur? Marking to market is one of those traps. One problem may be that we used heuristic devices to make this market work (just as we used some measures of 'money' to stand for theoretical money when we tired to do money supply targeting in the real world). I have no problem with monetarism based on a theoretical money, but once we try to give that concept of money life and use it in the real world we run flat into Goodhart's law. Now we see it happen again.

The same goblins come to haunt us when we make markets for hybrid securities. Where do these markets come from? Do they spring full-formed out of the head of Zeus? No. We begin by making assumptions. Apparently in setting up worst case scenarios for derivatives 'it was decided' that the lower bound for national house prices would be to assume that they might not rise Yr/Yr. In fact nationwide they have fallen quite sharply, by over 20% in all depending on the measure you choose. No wonder mortgage related securities fell so much more than their theoretical 'theoretical' limits.

In valuing options it is standard to use a set period to measure volatility. But why? Volatility shifts around.

In short it may not be markets 'per se' that get things wrong but the way in which they are used and constructed. The 'rules' that are adopted to 'get pricing results' may simply be wrong, in which case the market will fail to function since its participants will reject prices (fail to transact on them) when they find them to be not credible. The upshot may even be that the actual market prices are really not so wrong, but that users simply can't get themselves to believe that they have invested under what have proved to be such Pollyanna assumptions.

It is also true - and this is Goodhart's law in action - that when the authorities adopt a method for valuation it can take on life of its own and affect valuation itself. Suppose some stabilizing bank speculator thinks mark-to-market prices are a joke and wants to buy distressed securities at a higher price? Once he deposits them on his balance sheet he will have to take an immediate loss and write down of capital. He can't hold them for long term gain. Rules that did allow for that were in effect in 1982 when we emerged from a bad recession and banks were also woefully under capitalized (or they would have been had mark-to-market been imposed). The point is that mark-to-market actually affects reality it is not a passive observer.

In any event I think there is ample reason to distrust market pricing. Warren Buffett always used say that everyday you can pretend there is little guy called Mr Market and he is wiling to buy and sell at set prices. Warren never bought into the idea that markets get it right. That notion is the purview of economists who have a lot at stake for that be true. If it is not true, then most of the the conclusions economics comes to are simply irrelevant. There is a lot at stake when you get critical of markets and their ability to get it right.

But when regulators put so much strain on markets it is not surprising that markets crumble under the load. What if bankers had forced Best Buy to value all its inventory at the prices Circuit City was selling its inventory, as it had its going out of business sale? Hey that's mark to market! Suppose that caused Best Buy to violate lending covenants related to capitalization requirements for its own loans? Then it too may have been forced into bankruptcy, then PC Richards then J&R Stereo then, then, then... Let's don't pretend mark-to-market has no real world consequences. Mark-to-market is most vicious in finance where you buy and sell at the same market price (bid/offer spreads). Not as damaging in electronics and retailing where you have healthy markups to sell at retail over wholesale costs.

There are real world consequence you set in motion when you create a regulatory feed back loop as we have done with mark to market. It changes the world.

The rule is STUPID.


It is pro-cyclical

It is damaging

It ought to be rescinded for all purposes and accountants and auditors should have to find a better way to do their job than to rely on Mr Market all the time.

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