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Wednesday, October 01, 2008


sfas 157 -- what the market has right

marking to market has become a commonly cited bugaboo, one many people blame for perpetuating the financial crisis. the SEC has tried yesterday to relax mark-to-market rules under pressure from its constituency.

few people offering commentary understand the securities in question which are clogging bank balance sheets than david merkel. and this is the most cogent examination of mark-to-market rules i've read, titled appropriately "accounting rules do not affect cash flows".

Accounting is a way of portioning economic results by time periods. It doesn’t affect the cash flows, but tries to allocate economic profits proportional to release from risk. If we were back in an era where the financial instruments were simple, then the old rules would work. But once you introduce derivatives, and securities that are called bonds, but are more akin to equity interests, you need to mark them to market.

... Mark-to-market accounting should pay a role in valuating volatile financial instruments. Now that financial institutions have bought financial instruments more volatile than tha buy-and-hold attitude of the old days would have done, ther rules must adjust to present a fair value.

I don’t see any way that lets the markets gain from the suspension of the rules. The rating agencies will still do calculations of risk based liquidity on financial firms to set ratings.

... Let the advocates of eliminating fair value explain why reducing information to investors is such a great benefit. In the end the cash flows will be the same, and maybe it will take a little longer, but the results of bad investment decisions will be revealed, and the same firms will fail — perhaps in yet more ugly ways, as their shenanigans will go on longer, with less to recover for the bondholders, and wiping out the equity entirely.

In the absence of fair value, suscpicion will take the place of information, and companies will still get marked down as failure takes place in fixed income assets classes. The same things will happen, just in a messier way. You can’t fight the cash flows arising from bad investment decisions, and too much leverage.

what merkel is saying -- and he knows, as suggested by his earlier dissections -- is that defaults in the underlying loan pools are real, and because of the leverage in the capital structure these securities really are deeply impaired. their current market value is at least approximately reflective of the cash flow reality, though there is also certainly a liquidity discount as well. merkel is suggesting that a suspension of mark-to-market is essentially a denial of reality which can only buy a little time.

that time may be valuable, of course, if the interim sees a sincere effort -- more sincere than the paulson plan -- to nationalize and recapitalize american banking. absent that, it is just a waste of time.

the use of mark-to-market is appropriate because banks moved away from ancient modes of banking and into securitization, accepting more risk and volatility in an effort to increase leverage and profitability. as the ft says:

Mark-to-market accounting is the price that banks must pay for a securitised credit system. But because it is volatile, those that use it need to be well-capitalised.

if only banks had truly understood that they were turning themselves into hedge funds. would that have motivated them to overcapitalize? probably not -- and so disaster ensues.

UPDATE: more from mark thoma.

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Gaius Marius -- glad I took six years of Latin. Thanks for citing me, I appreciate it. Talking with a friend who writes for Fortune today, the media is puzzled because there are so many bright people on both sides of the issue.

As for me, I have worked in risk control and financial reporting for insurance companies for most of my working life. I see how these standards get applied. Companies look for the easy way out. SFAS 157 isn't perfect, but gives guidance to a better answer.

Davidus Merklus

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thanks david -- your blog has been a really meaningful read both before and all throughout this disaster.

it's what one would expect, i suppose, isn't it? in the aftermath, one hopes that a lesson is that financialization carries increased, not decreased risk -- and that banks, if they want to be safe, FDIC insured and holding assets at cost, should stick to their ancient knitting and leave this stuff to others.

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