Friday, April 3, 2009

Mark To Market Eased: Making A Silk Purse From A Sow's Ear? Example Included Below

Taking From Peter To Pay Paul

The FASB (Financial Accounting Standards Board)relaxed the rules that require a bank to mark the value of an asset on its books to a"market" price, IF a transaction that takes place is distressed and/or if the market that security trades in is inactive. This would probably describe pretty much every asset that is considered toxic, and that if marked to market would most likely cause a bank to become effectively insolvent.

These are complicated products that even the banks themselves, save for a few of the quants that created them, could either explain or describe. Products created with and about most every type of esoteric financial product available. Products with bid/ask spreads wide enough to drive a truck through. Products so illiquid that they may never trade and therefore can't be priced yet that allow the firms selling them to make huge money on them. You get the gist.

Now there also happens to be a Treasury plan that was recently created to let the private sector buy some of these assets off of the books of the bank in conjunction with the government at what is determined to be a market price. Before these mark to market rules were relaxed there was much concern that the bid/ask spread would never narrow enough for any of these assets to sell. Now that he banks can value them as they wish, it is pretty much a given that they won't sell.

The end result is that most of these assets will remain on the banks books, the banks capital positions will strengthen, earnings, at least in the near term will look good but the problem will still remain. Now some or even many of these assets will be fine, but the jury is out on the rest. The whole idea of removing them and replacing them with new capital that the banks can lend to you and me seems to be on hold. The banks will hopefully lend based on this new and improved capital position created by loosening mark to market, but what will happen if these positions really head south? Hmmmmm.

It all seems a little like hocus pocus.

Mark To Market: An Attempt At A Simple Example Of Trader Magic

Mark to market is a term that is getting thrown around all over the place: on Capital Hill, T.V., the newspapers, the internet and anywhere else the financial markets are covered. But what exactly is mark to market?

Back in the day, fresh out of B School, I was a municipal bond trader in a time when the most complicated product on the market were futures. Traders would use the firms capital to go out on "the street" and bid on bonds, buy them if they were the winning bid, put them into inventory and pray that the market would go their way.

R.I.P. Lehman Brothers (1850 - 2008)

You would buy them "on the bid", and then "offer them out" at a higher price (i.e. pay $94 and try and sell them at $94 3/8). If you paid to much you would eventually have to sell them at a loss, get bailed out by the market or try and get the retail brokers to sell them to their clients (the thought was that retail would buy anything).

Now bonds have ratings (AAA down to junk or unrated), and although all bonds with the same rating are not worth the same, there is a ballpark value that you would use. There are strong AAA bonds and weaker AAA bonds, but if the "scale" for AAA revenue bonds due in 10 years was 5.10%, then the range might be 5.00% to 5.20%.

Now at the end of the day, you have to mark all of the bonds in your inventory to the market. But let's say the market has gone against you hard, and you are sitting with large losses. You have two choices. The first is to mark correctly, show the paper losses (because losses are not real until you realize them) and get called back to the head of the departments office for a spanking. You only seemed have to much inventory when the market went against you. The second choice is the hope and pray, where you mark your bonds higher than they should be, show a small loss or no loss at all, and hope and pray that the market bails you out.

Now in the hope and pray the firm really had paper losses that should have been recognized when figuring out the capital position, but did not know about them unless someone in management knew about the market and went through every traders books to make sure the marks were correct. Now multiply that situation by the massive numbers we are talking about today, and you can begin to see the scope of the problem.

Now the hope and pray would work until either the market rallied (good)or your positions got to old or "stale" and the department would force you to liquidate at which time you were screwed (bad).

Instead, take today's esoteric incredibly complex instruments that don't trade, that no one understand, are incredibly illiquid, may or may not be performing and that in no way can be valued effectively. Picture the bid/ask spread on those puppies. That is where we are today.

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