In response to last Friday's blog entry, one of our friends asked about mark to market accounting and what role it plays in the current financial situation.
First, let's explain what mark to market is, because it's been bandied about in the media, but I wonder if many of those talking about it know what it means. To make financial statements useful in analyzing a company, we need to know (among other things) what the company owns. It's relatively easy to figure out when the company's assets are buildings, equipment, inventory, cash, etc. But when it comes to other types of assets, it's not so easy to decipher. So a few years back, the Securities and Exchange Commission adopted new accounting rules requiring that companies show the value of those types of assets utilizing a methodology called "mark to market".
Marking to market requires assigning a value to an asset based on a reasonable estimate of what that asset would bring in a transaction between a willing buyer and a willing seller, in essence, the market value of the asset. For relatively liquid stocks and bonds, that's pretty simple, as you can just look to the price of the most recent trade. But how does one value a mortgage, or a derivative asset based on a pool of mortgages?
Typically, you could look at what similar mortgages are selling for in transactions between mortgage originators and secondary purchasers. And therein begins part of our current problem. As homeowners with adjustable rate subprime mortgages began to see their rates increase, their ability to pay their loans declined. Therefore the value of the loans declined, as the likelihood of receiving repayment fell. So when the bank has to mark the value of the loan to market, they have to reduce the value of the asset on the books.
So what's the big deal? The bank just writes down the value of the loan, right? Well, that's just the beginning of a snowball. Banks are required to maintain adequate levels of assets, based on the value of deposits made by their customers. One of their assets is that loan that just got written down. So now they have to increase capital reserves by selling assets. But no one wants to buy the loan, because it's been deemed to be riskier. So how do you entice a buyer? You lower the price of the asset you are trying to sell. But now your assets become worth even less. Moreover, the market sees that First National Federal is selling its assets at a reduced price....there must be a reason. We now have to assume that all similar assets should also be sold at reduced price. Our snowball is growing.
But wait, it's not over. Many mortgages were originated by banks, and then sold off in neat little packaged products. These products were then sold to investment houses, other banks, hedge funds, foundations, etc. Some of these institutions also have capital requirements, so as the value of the underlying assets is written down, the value of the packaged asset is written down when we have to mark to market. The snowball is rolling faster...
And the hill gets steeper. Some of these packaged products were rolled up into other packages, and the same issues ensue (only magnified). Other investors (typically large banks, insurance companies, and investment bankers like Merrill Lynch, Lehman Brothers, Goldman Sachs, etc.) entered into various types of complex transactions in an attempt to reduce risk on the one hand, and create profit on the other. More assets to mark to market.
It all works fine, until markets begin to freeze up. When markets freeze, we have to mark down the value of the assets. Marking them down translates to a loss on the income statement for an asset you haven't sold. Now your investors begin to sell your stock. Your stock is collateral in a number of the aforementioned transactions. The value of the collateral falls, requiring (per terms of the contracts) that you post more collateral. So you have to sell assets. But there are no buyers, so the value of assets gets written down further. Our snowball is now racing downhill, and there's not much that can stop it.
Mark to market accounting is valid, as it provides more information about potential risks to a potential purchaser (or a current holder) of an asset. However, the way in which it has been implemented is, in my opinion, somewhat faulty. Many of the mortgages that have been written down will never default. At some point in the future, some, if not many, of these same loans will be marked back up in value. We should, at some point, see gains showing up (under current accounting rules) from these same assets that have caused the losses, simply because the mortgages for homeowners that did not default will be written back up. Mark to market can go both ways. It provides additional information regarding the assets owned by a company, but taking any information at face value without understanding it in context can prove to be less than helpful in understanding the true risk profile.
If you have questions regarding this post, please e-mail me at nsnodgrass@evanstonadvisors.com
