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MARK-TO-MARKET IN THE REAL WORLD:
It's such a good vibration; Come on come on come on; It's such a sweet sensation...Oh wait, momentary brain freeze...Pocket MBA thought we were talking about Marky Mark and the Funky Bunch, not mark-to-market and the funky bonds. But it's always nice to take a trip down memory lane. And Marky Mark survived the Funky Bunch to go on to fame and fortune as underwear model and movie star, so PMBA is pretty sure that most financial institutions will survive those funky bond instruments, derivatives and whatever else that have to be marked to market. mark-to-market has been called the best way to value securities, the honest way, the fair way. And that may be so when you're in the midst of orderly market conditions. But there are those who argue that the credit crunch of 2007-08 has been exacerbated by mark-to-market; they even contend that mark-to-market turned a liquidity problem into a solvency problem. See, e.g., this recent article in The Economist. Ask the management at Bear Stearns about that.
FAS 133 permits financial institutions to mark derivatives to market, and many do. The new FAS 157 requires mark-to-market for assets with a readily ascertainable street value. Under that regime, it only took high interest rates, some newfangled, funky bond instruments, like CDOs, backed by suspect mortgages that are hard to value in a good economic environment, to result in a situation where the previously obscure term mark-to-market and next week's term, "Mark-to-model," have become close to household names. You also have a recipe for panic and illiquidity leading to a daily, downward cascade in value that resulted in messed up balance sheets and a concomitant need by institutions to begin protecting their capital.
To show you how mark-to-market has seeped into the lexicon, Pocket MBA had a conversation about marking to market in a doctor's office waiting room in Florida recently. That's nuts, but that's the financial world we live in today.
If you go back to the first issue of this year, covering FAS 157, and some prior issues on fair value, you'll see that mark-to-market has been implicit in Pocket MBA from the beginning. Remember, GAAP requires that assets be recorded at fair value. And per FAS 157, fair value is simply "the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date." Sometimes fair value is easy to figure out, sometimes not. If something is readily saleable on a given market, the fair value is the market price. It's like the "fish of the day" on the menu at a fancy restaurant. Under the column where the menu reads "price," you'll see "market." Then you know that you're paying whatever the fish cost that day. In a nutshell, that's all that mark-to-market is.
To put it in terms of FAS 157, mark-to-market is the "quoted price[] (unadjusted) in active markets for identical assets or liabilities that the reporting entity has the ability to access at the measurement date." According to a paper published by MBIA, one of the monolines PMBA featured in Vol. 6, No. 12, one of the primary positives of marking to market is to encourage institutions in the orderly disposition of assets, particularly those that are not performing well, "getting problems behind them quickly." As noted, many argue that marking to market has not served the markets well in the past year, when for more and more derivative instruments, the market disappeared, which simply made asset values deteriorate in search of a market.
If you don't want to think about marking to market in terms of financial instruments and balance sheets (and who does?) or fish, think about a situation where you have to move out of town quickly, so you simply must sell your house...now. If you had time, you might get the price you think it's worth, the price you've been telling everybody it's worth, the price that's made you feel comfortable carrying a huge credit card balance. But to sell today, you have to take the most someone will give you. An easy way to transfer that thinking to the financial instrument world is to think about it in terms of your stock portfolio. If you're someone who checks the value of your assets at the end of the day and determines your own net worth (and self-esteem) based on that value (and experiences the highs and lows of being richer or poorer "on paper"), you are marking to market on a daily basis.
Assume you bought 100 shares of Apple at $100 on "Day One." Your shares have a book value of $10,000 and an actual value, if sold the same minute, of $10,000. Now, you may not sell those shares for 10 years, and you may have done some research (and developed a model based on that research) that assures you that in ten years, those shares will likely be worth $1,000 each. But everyday at 4:00 p.m., those shares have a value based on the closing market price, and if you had to sell them at that moment, that is the price they would fetch. Your model, along with the value you carry them at on your books becomes irrelevant if you have to sell. If that value is $101 per share at the end of Day One, their value is $10,100. If, on the next day, the shares close at $99, their value is $9,900. On Day Three, a rumor starts to the effect that Google's G-phone will obviate the need for the iphone within one year, and Apple shares plunge to $80. On Day Four, Google announces it won't even bother with a cell phone, and Apple shares soar to $107. On day five, Apple shares settle back at $100, just because. Now, most people wouldn't pay attention to the daily gyrations, but if you're marking your portfolios to market, you would record your net asset value on a daily basis:
- Day One: $10,100
- Day Two: $9,900
- Day Three: $8,000
- Day Four: $10,700
- Day Five: $10,000
Those daily gyrations have no particular meaning if you have no present intent or need to sell. Note that on Day Five, you still have the same $10,000 you started with on Day One. So how does mark-to-market turn into liquidity/solvency crisis?
Let's assume you owe $8,500 to your buddy. For fun, let's name him Baird Stern. And your agreement with Stern states that as long as you have net assets worth $9,900 (that's your margin requirement), you can pay him two years from now. But if your net assets dip below that amount, he can call the loan. On Day Three, you had assets valued at $8,000 on a mark-to-market basis. So even though one day later, you had $10,700 on a mark-to-market basis, on Day Three, you're in trouble. You may well have had to sell all your Apple stock to satisfy your obligations. You're also bankrupt.
You might ask Stern not to make you sell. The problem is Baird has his own obligations. He has borrowed money from other people based on his assertion that he has a chit with you valued at a sufficient level to pay them off. But when that value evaporates, he needs capital to maintain his good standing as a lender and to maintain the confidence of his creditors, which means he needs your money. Even with your $8,000, Baird is missing $500 presently. Others might size up the situation and demand their money from Stern. That's called a run on the bank. Of course, Stern also doesn't have enough money to pay back his accounts, which forces him to call other assets at whatever prices they are selling so he can maintain his own solvency. If he can't find them, he will go belly up, as well, or have to take a bailout from someone else, even at a price that doesn't reflect his true worth.
At the simplest (even insultingly simple) level and without judgment about this business practice or the next, that's what financial institutions have been dealing with throughout the past months. They face account holders to whom they have obligations, banking laws that require they maintain particular capital levels, and assets that were being marked to market in a market that devalued them every day. Declining asset bases will challenge liquidity every time, and induce conservation and panic. So it seems panic and mark-to-market don't mix.
Of course, financial institutions deal in more complicated instruments than 100 shares of Apple, such as derivatives and the structured finance products that Pocket MBA discussed toward the end of last year. (See e.g., Vol. 5, No. 38 and Vol. 5, No. 43 on Credit Default Swaps (CDS) and Collateralized Debt Obligations (CDO), respectively.) They also were involved in many off-balance sheet investments, like SIVs. The value of each was premised on the value of something else further down the food chain. And once the dominos of value undergirding them started to fall, all the others follow.
The crescendo moment of it all in a sense was the original sale price of Bear Stearns, which was $2 per share (it's up to $10 now), even while the company said its assets had a book value of something like $80 a share. No matter, if you saw a market value of close to zero for all of Bear's holdings, wouldn't you want to take your money and run? And the fear was, that would spread. One bad apple may not spoil the whole bunch, but if the portfolio of the entire world is made up of bad apples, you have a real funky bunch marked to a market that doesn't exist. That's when you quit the music business and go into movies let JPMorgan buy you out with a helping hand from the Fed and the Treasury, even at penny stock prices.
The Bottom Line
Learn more about fair value and save 20% when you order the one-hour web presentation (audio only) "Fair Value" GAAP Accounting 2008: The Implication of New Rules.
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Save 20% on the latest from the front—use the link to order the 61-minute web presentation Securitization Issues: Mortgage Backed Securities and Collateralized Debt Obligations (from the PLI program Subprime Credit Crisis 2008: Everything You Need to Know Now).
Get the entire program 20% off—use the links to order Subprime Credit Crisis 2008: Everything You Need to Know Now, available in Audio CD, DVD and Online formats.
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