SEC on Marking to Market: Another Problem Solved

A major market problem relates to how financial institutions must recognize the  value of securities  that are not trading in a liquid market.  The financial assets include complicated securities including various tranches of mortgage debt.  Everyone agrees that these are difficult to value.

Given this problem, buyers have stepped away.  There is no legitimate market, one of the  major problems for achieving some stability in equity markets.  The Fed has addressed this by accepting, at a discount, such securities in TAF auctions, and more aggressively in opening the discount window and taking action in the Bear Stearns buyout.

Anyone in the money management business respects market pricing -- when it is valid.  At "A Dash" we certainly agree.  Freely trading securities should be market to market.

The Problem

Difficulties ensue when specific securities are sold in a distressed market.  Since there is no real market for many CDO's, the various methods of evaluating them may be generating questionable pricing.  Under the recently adopted FAS 157 rules, companies are compelled to recognize such pricing, even if the expected payouts do not conform to the actual sale prices.

FAS 157 was intended to force financial institutions to recognize actual pricing on balance sheets, with the consequences flowing through to income and earnings.  So far, so good.  The problem came when there was no legitimate market for the securities.

This led to a death spiral, where a distressed firm would be forced to blow out assets.  Those who chose to hold the assets -- anyone not under compulsion -- expected to achieve much better results.

But what about the "temporary" marks?

The SEC Action

The SEC released a letter to firms offering advice on how to handle this situation.  It did not give a free pass for bad assets.  It did allow companies, with advice and consent of their accountants, to make a FAS 157 exception when certain assets, sold by other companies, had been, in the indelicate terms of traders, "puked out" , at prices that did not represent reality.

The Impact

This is an important step.  Some have argued that "mark to market' should be suspended.  The SEC is not doing that.  The proposed interpretation is more measured and more thoughtful.  It is very bullish for financial stocks, since it allows them to make more realistic valuations of assets.

The Spin

The story has been picked up by all of the big-time bearish blogs, including Ritholtz and Mish.  It was featured by the New York Times.  At "A Dash" we have some questions for these sources:

1. Do they distinguish pricing when it comes from liquid markets as opposed to distressed markets?
2. Why are they so confident about the true value of Level III assets?

Conclusion

The critics of this move are all guilty of a logical fallacy -- affirming the consequent.  They believe that they are the only ones who really know the value of complex CDO's and that companies should be compelled to use any trade as a mark.  Is this approach one that will actually help investors?

What has really happened is an intelligent step by the SEC to allow companies some latitude when  market trading is not a good indication.

Meanwhile, the average investor who checks out the top blogs and the New York Times sees something that is downright scary.  It is another example of where an intelligent investor, seeking information, confuses sensationalism with sound advice.

We wish we had a specific catalyst to cite, but we do not.  The SEC action is another important step to solving the related housing and mortgage problems.  Who knows when more traders and investors will grasp this point -- something that seems quite obvious to us.

Comments

[Harmso]

Ah, I think I finally got your point.

Of course value is subjective, since even the concept of intrinsic value is elusive at best.

So what really lies at the heart of the debate is if there is something as an intrinsic value or if value is just what someone else will pay you.

Oh, I don't want to go there. I am not sure myself what the right answer there would be. From recent experience I would tend more to the Keynes view though. But the discussion has given me some lines of thought to follow. Thank you very much for that.

One thing though, I think what you should not underestimate are the incentives driving traders when marking their positions to model. They MAY be even worse. But if panic/hype induced divergence in market prices from a potential intrinsic value is better or worse than trader incentive induced divergence in model prices from intrinsic value... well I can't say.

[Bill aka NO DooDahs!]

Clarification: in a market panic, it is possible that additional liquidity moves the market even further away from any intrinsic value based on cash flows and estimated defaults, making the "mark to market" model LESS accurate through increased "verification."

A CFO/CEO who says "get this crap off my books by quarter's end, come hell or high water!" may be reacting to the incentives that HE has (being able to show CDO-free books at quarter end, fear of a run if they're not CDO-free), but that reaction pushes price and the addition of those sales makes the model LESS reflective of value.

At heart, the issue is that value is SUBJECTIVE.

The CFO/CEO in my example sees them as value-less because his incentives (or in the larger market, the incentives of FEAR and GREED) are out of line with calculations based on cash flows, repayment, etc. The "mark to market" valuation model necessarily encapsulates emotional and subjective reactions to conditions.

Hence, my skepticism about the value added by increased market liquidity.

[Bill aka NO DooDahs!]

I think we agree on the existence of increased verification by market participants in arms-length transactions. Where I think we may disagree is on how much value is added by that process, per amount of increased liquidity.

[Harmso]

@Bill
Everything you say is true but I think you are missing the point I tried to make. (Or maybe I misunderstnad what you are trying to tell)
The accounting rules give some guidance on which price (bid, ask, mid-price, etc) to use. There is quite some leeway.

Of course, you are right about the discovery mechansim on the micro market level. But the important difference is that on a market you have an opposite party which has to accept the transaction and therefore the price is to some extent verified by market participants. There is nothing sacred about this and it is certainly not the "true" value. It is just a verification issue IMHO.
Because if you mark the positions purely with your model you don't have that market verification and you have even more leeway to get a convenient valuation.

btw. I think you will rarely see pure mark-to-market small cap stock positions in the sense the FASB wants it. (Again, I have to point out that I am more familar with IFRS)

Cheers Harmso

[Bill aka NO DooDahs!]

Remember that a transaction price is in the middle of a DISAGREEMENT about value. I buy for $10 because I think it's worth MORE. You sell for $10 because you think it's worth LESS. Neither of us think it's worth $10, but that's the transaction price.

Remember that there's nothing sacred or beautiful about the closing price today, or at the end of the month, or at the end of a quarter. Those points in time are just single ticks, and are not necessarily indicative of the ticks executed by the most knowledgeable participants, and are certainly not indicative of the ticks executed by the majority of participants. Therefore, using a closing market price at a predetermined point in time is marking to a MODEL of valuation.

Even in a highly liquid stock market with many transactions and very informed participants, there are price anomalies that can be acted upon. In stocks which are less liquid and less-covered by analysts, the anomalies are more profound.

Why would this not be even more true for less-liquid bonds? The mark-to-market crowd forgets this.

[Harmso]

@Bill

You're absolutely right that the price of items is derived by a model. However the importatnt difference is that if you can get market prices, these are the prices derived by the interaction of many participants (using their models). When market-to-model is used those numbers are mostly based on your own model assumptions, with the usual moral hazard problems.

Of course that discussion is meaningless if you are basically the market maker in your market and your model inputs control the market price. We have see that quite a bit in the last years.

[Bill aka NO DooDahs!]

What y'all don't seem to realize, is that marking to "market" is really marking to MODEL - since the price at which an item trades is only a MODEL of its value ~

as any value investor should know.

:-)

We seem comfortable discussing stocks or markets in this parlance; "it's overvalued" or "it's cheap at this price." So what's the conceptual flaw in viewing other assets that way?

Is the devil just in the details?

[maynardGkeynes]

The problem is that what markets need now is clarity. To the extent that it gives firms the discretion to fudge losses, this SEC advisory will hamper price discovery, and is therefore a poor policy choice. cf. Japan 1990s

[Anon.]

Meanwhile, the average investor who checks out the top blogs and the New York Times sees something that is downright scary. It is another example of where an intelligent investor, seeking information, confuses sensationalism with sound advice.

You seem to equate "average" with "intelligent". Furthermore, you seem to suppose that the said average, but intelligent investor "confuses sensationalism with sound advice". Is that consistent with intelligence?

Finally, you wrote that "prices...did not represent reality". Without getting into an art student-like debate about the nature of reality, as a trader, "reality" is the price I can buy or sell at. Value may be something entirely different.

[Jay Weinstein]

thanks for the response.

I really don't disagree with your position. And I don't have much gripe with the powers that be pulling out every stop to avoid total meltdown.

But I won't buy your argument until the day the SEC issues a ruling and firms mark assets at LOWER than trading prices because of a boom rather than a bust.

Forecast temperature in Hell that day will be unseasonably low LOL

Be well..keep up the good work.

[Harmso]

Jeff,

thank you for your quick remarks. Yes, I forgot about the voluntary adoption.
But still. Am I correct that there are no material changes in the way marked-to-model or marked-to-market is done in FAS 157. Ok the fair value is now more or less defined as the exit price but this was practically the case before, too. All that has changed now is that firms have to put a label on it, to show what kind of assumptions they are using, right?

As to the SEC's move: If it is ultimately good or bad depends on your view of how short-term those market problems will be. Then there is the decade old discussion of marked-to-model vs. marked-to-market in terms of reliability and relevance.

Anyway it concerns mostly instruments held for trading, which are usually sold in one year. And I think there is a good case to mark those short term instruments down to the market value.

Everything else is practically marked-to-model with more or less weight on market input, depending on the reliablility of market data.

I have to say I am at home in IFRS and not USGAAP, though, so please forgive me if I made harsh mistakes somewhere above.
Harmso

[oldprof]

Jay and Venn -
The SEC letter does not say anything about bull and bear markets and it provides a very narrow exception to the new FAS 157 rules -- much narrower than many have been calling for. It is not a vehicle for wholesale exceptions.

They are trying to get the most accurate valuations possible, and the entire process has made this more market-based.

I realize that some people will not believe this, seeing some great conspiracy. The actual letter and the effect have been distorted by several observers already. If you believe these guys, no statement or report from anyone is factual...

Or you could be objective in evaluating evidence. If you take a look at the write-downs and issues between accountants and companies (take AIG for a good example) you will see that the process is working, and this is an important tweak, but a tweak nonetheless.

It is also not a major philosophical change. It is technical. It is also not a game between longs and shorts. There is no set of rules. Long-time readers know that I explained this some months ago. The government leaders are not going to sit back and watch some accounting death spiral as a result of FAS 157.

You may agree or disagree with the policy, but as an investor you should understand it.

Thanks for the provocative comments.

Jeff

[oldprof]

Harsmo - FAS 157 went into for companies with a fiscal quarter after last Nov 15th. Many had already implemented it last year. If you search for FAS 157 on this site, you will see some past articles that explained some of the issues and showed why the chorus of doomsday predictions around last Nov 15th was wrong. I also had a RealMoney article on this, but it might not be public.

Thanks- Jeff

[RB]

"The SEC action is another important step to solving the related housing and mortgage problems."
Are you looking for investors to react to this now vis-a-vis housing? Isn't the fundamental problem one of egregious affordability issues which will take years to resolve? Even the Fed agrees that housing prices are sticky and take a long time to resolve
http://fon.gs/stickyprices

[VennData]

The SEC letter does not outline a procedure for determining if a market is "distressed." This determination seems to be beyond the scope of an audit, does not conform to GAAP, and with this issued so close to quarter end, how will accountants cope with this first retreat from M2M in a timely manner?

Also, where is the precedent for this determination methodology? How will investors know there are apples to apples comparisons in the manner in which distressed markets were determined?

Finally this wholesale change in metrics in the middle of the game follows the philosophical volte-face of this once free-market administration.

[Jay Weinstein]

My problem with your argument is that essentially, it is "Mark to Market in Bull Markets, Mark to Best Opinion in Bear Markets".

We already know what happens when this is left to the discretion of the accountants and banks.

So what is your algorithm for marking assets BELOW their trading value when we are in a puke-up bull phase?

[Harmso]

I am sorry but I think you are wrong with the FAS 157. If I understand FAS 157 correctly it only forces you to make additional disclosures as to what assumptions you used to dervive the fair value of the financial instruments.
And FAS 157 is in effect since January, only - if I remember correctly. So you wont see any FAS 157 till the Q1 results later in April.

Harmso