01 October 2008

Could it all just be a matter of words?

One thing you may hear quite a bit about in today's coverage is the phrases "marking to market" and "fair value", and how that may really be the root cause of the Financial Meltdown of 2008. Indeed, the Senate version of the "rescue" bill that will be debated and voted on tonight includes a "magic wand" provision allowing the SEC to waive the "fair value" requirement for certain types of assets, and that's likely to be a point of contention.

The theory behind marking to market is so simple and so common-sensical that you might wonder what the fuss is about. It says that, at any given point in time, the assets on one's books have to be valued at then-current fair market value. So, if you have a house, you value the house at what you could sell it for at the moment you're asked, "What's it worth". Seems simple, right?

One problem, however, is that marking to market can be abused in a situation where you have an asset that has no obvious "market value", because there is no day-to-day market, or because the asset is complex enough to have no intrinsic, obvious value. Enron used this to their advantage and used a "mark to model" standard that of course could be manipulated by manipluating the model.

Out of that scandal came a set of rules defining "fair value". This defines a hierarchy of markets and market-like data sources that were to be used in assessing mark-to-market value.

This leads us to our other problem: if an asset becomes "toxic", like mortgage-backed securities have become, there ceases to be a market at all. Under the "fair value" rules, if there is no market at all, then the assets essentially have no value at all, even though that's not strictly true. Even with housing values having crashed, one could foreclose a house, fulfill at least part of the mortgage with the foreclosure proceeds, and thus provide value to the securities. But since nobody right now wants to buy them, they're considered valueless.

And so, many economists are now arguing that the entire crisis basically comes down to a mistake in accounting rules, and that simply changing the rule might eliminate the crisis without spending an additional penny of taxpayer money.

So, as I said, the Senate version of the rescue bill will apparently include a provision that will allow the SEC to wave a magic wand and waive the "fair value" rule on a selective basis. It will also direct the SEC and other agencies to conduct a thorough study of both "mark to market" and "fair value" rules.


Anonymous said...

One of the more sane (I thought) proposals I heard as far as how the Treasury would go about buying the toxic waste if they did get the $700bn was to do a "reverse auction". Let the banks who are holding the dirty paper bid down their own prices to sell them to the government.

In a way, I like it because it solves a bad market issue by creating a new kind of market. It, if nothing else, has the advantage of being conceptually consistent.

Anonymous said...

I saw on the news last night where all these "experts" are like, "Please Media! Stop calling it a bailout! Start using the term RESCUE PLAN so that middle america doesn't realize that we are giving tax money to rich people."

Uncle Mikey said...

@aarhead: Yeah, and I'll admit I catered to that whim and switched my language. Really, being something of a formal sort when I write, I would just as soon refer to the thing by its formal title or HR number, but I get lazy.

At any rate, Middle America is paying just enough attention (for a change) to see through the fluorescent pink lipstick to the really dirty pig underneath...

Uncle Mikey said...

@chesther: I may do a bit about the whole reverse auction thing at some point. I did see that, though. The bill's proponents should be playing that up more (and explaining it better).

Blaise Pascal said...

The Long Run blog today also posted about mark-to-market. I was looking at mark-to-market on Wikipedia the other day, and there were two things which stuck out.

First, in comparing mark-to-market and mark-to-model, it said that mark-to-market helps keep people honest, as compared to mark-to-model, which allows poor models to boost book-value.

Second, it also said that in late 2007 the accounting rules changed, and the type of securities at issue in this crisis now had to be mark-to-market, not mark-to-model.

My immediate thought reading those two was that perhaps part of this crisis was triggered by the change from fantasy valuations to honest valuations.

Uncle Mikey said...

@Blaise Pascal: Yes, that's more or less it, exactly, and what a lot of economists are saying, albeit not in those exact words. The requirement to value based on what you could sell it for if you had to sell it today, based on real market data, is why a whole swath of assets on the books of many banks are basically ranked as having zero value and therefore being complete losses.

But my point, and the point of those who want to allow the SEC to re-examine and bend the rule, is that there's a way to look at these securities that is not a fantasy but also not based on a solid market, because right at the moment there is no market for the securities themselves, which in turn is because they have no value. Yes, it's a tautology, but that's basically what's happening.

But, let's look at it this way. I buy a house with a mortgage--any mortgage, not just a crappy ARM. That mortgage itself now has a value as an asset: if you assume that it's going to be paid back, then it's worth the amount that was borrowed, plus interest. And it's collateralized. It's backed by my house, which may well be worth more than the mortgage in just a few weeks (or so it was for most of the 2000s). So no matter what happens, the mortgage is worth at least as much as what was borrowed for, as long as the housing market doesn't get screwed. And mortgages, by themselves, are traded amongst banks, all the time, so the market value of a mortgage is knowable.

Now someone creates a derivative, a kind of bond, that itself is collateralized by my mortgage (along with others). The house has instrinsic value and market value; the mortgage is being repaid, so the mortgage has market value, and being based on a house that could be foreclosed upon if necessary, retains some intrinsic value even if defaulted upon. Therefore any securities based on the mortgage ought to have market value...if there's a market to buy them.

When the housing market started to slump, and mortgage defaults began to rise, the perception of value began to shift. These things were not actually completely worthless, any more, but they did now have lower value.

Then everyone panicked and trade in the securities based on mortgages simply stopped. On that day, all of those securities ceased to have any value at all if you stick to mark-to-market, fair-value rules, because there was no longer a market to mark to.

But there is still a market for houses. It's lower than it was, but houses are selling, even foreclosed-upon ones. And there's still a market for mortgages themselves, which means they have value. Therefore, it actually seems a little silly to say that the securities derived from them at one more remove are completely valueless.