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Mark To Market, A Beginner's Guide
Feb. 29th, 2008 12:20 pmThere's an old saying in the financial world that, as usual, contains more than a kernel of truth. That saying is that "the definition of a long-term investment is a short-term investment that has gone wrong".
Back in the 20th century in the US (and for the first five years of the 21st Century in
mainland Europe), you could book investments at something called "historic value". This led to all sort of distortions, with some companies booking investments that were little more than worthless (non-performing loans being a favourite in the banking sector) at their initial value. This led to "book values" being, more often than not, a pile of toss.
So, in 1993 the US accountancy profession came up with a plan that would solve this, or so they thought. Under this plan, you couldn't value your assets at what you bought them for, but at what you could get for them if you sold them in the market tomorrow.
"But!" cried financial institutions (particularly banks with non-performing loans and companies in Europe with rather dubious cross-booked shareholdings at artificially high values) "therein lies potential disaster!"
Unfortunately, banks are past masters at crying wolf, so the accountancy profession told them to STFU.
And, lo and behold, the banks were proved right, although not for the reasons that they thought.
One thing that the banks spotted back in 1993 was that mark-to-market valuations (also known in a rising market as "what some other fool is willing to pay for something") could create an upwards spiral. Banks look to achieve a constant leverage multiple of their balance sheet (remember that phrase, it's important). If they fail to do this, institutional investors start moaning about inefficiencies of capital. In simple terms, in a rising market, more capital is created, which needs to find somewhere to go, which encourages banks to make loans that they would not make in "normal" circumstances.
You can see where this leads, and the banks could see where it was going to lead. The loans, if the interest is being repaid, create more capital in companies that are expanding, thus leading banks to lend more because the asset of their loan gets better. And, with mark-to-market accounting, the positive feedback is exacerbated.
What even the banks (and the academics) failed to notice in 2003 was that the creation of mark-to-market valuations also helped create a whole new world of valuations - via securitisations.
In simple terms, a residential backed mortgage security is a synthetic (although in the rarefied world of finance, it isn't actually seen as a synthetic) product which makes an illiquid asset (lots of people's houses) a liquid asset (a tradable security).
If you then take a lot of these RBMSs and slice and dice them, putting them back together in a form that categorises the risk more "plainly" you get collateralized mortgage obligations (a 'genuine' synthetic). If you do the same with other types of debt, you get collateralized debt obligations.
Why does this matter? Well, it matters in two ways.
One is that it creates more capital that looks liquid (a tradable security) that isn't really liquid (because its fundamental building block is a house). In the world of mark-to-market "fair value" accounting, this is important (far more so than in historic cost accounting) because, instead of valuing the house, so to speak, you are valuing what someone thinks the debt on the house is worth.
The second is that these securitisations shifted the mortgages off the banks' balance sheets. This meant that capital was freed up, so that they could lend more. Indeed, they had to lend more (see above on constant leverage multiple of balance sheet). Huge wodges of capital were going in search of borrowers, any borrowers.
Once the rising asset markets go into reverse, you get a negative loop, and that's what we are getting now. This morning, AIG wrote off $11bn for Q4 -- that's, er, more than 10% of what Bernanke thought last Summer would be needed to cause a systemic crisis (he doesn't talk about that too much these days). Swiss Re said that another CHF240m had disappeared since January 1 -- a sum that these days barely causes a tremor.
With all of this money "vanishing", it's all very well for AIG and Swiss Re to say that it's not real money because in the end things will work out fine and that they don't have to sell the stuff at the moment anyway (the old "historic cost" accounting argument). Things might well work out fine. But, for the moment, it's not just dubious loans that won't be made anymore -- it's loans that would in normal times be seen as "reasonable". Fair value accounting is crucifying capital, which means (and, once again, we come back to
the mantra of "constant leverage multiple of balance sheet") that only the safest of the safe will be able to borrow cash.
This is basically seriously bad news for anyone looking to refinance a loan, be it a company or an individual. You could be a perfectly good customer in "normal" times, but these are not normal times.
For not a few companies, I can't see this meaning anything else but rights issues, lots of rights issues.
_______
Back in the 20th century in the US (and for the first five years of the 21st Century in
mainland Europe), you could book investments at something called "historic value". This led to all sort of distortions, with some companies booking investments that were little more than worthless (non-performing loans being a favourite in the banking sector) at their initial value. This led to "book values" being, more often than not, a pile of toss.
So, in 1993 the US accountancy profession came up with a plan that would solve this, or so they thought. Under this plan, you couldn't value your assets at what you bought them for, but at what you could get for them if you sold them in the market tomorrow.
"But!" cried financial institutions (particularly banks with non-performing loans and companies in Europe with rather dubious cross-booked shareholdings at artificially high values) "therein lies potential disaster!"
Unfortunately, banks are past masters at crying wolf, so the accountancy profession told them to STFU.
And, lo and behold, the banks were proved right, although not for the reasons that they thought.
One thing that the banks spotted back in 1993 was that mark-to-market valuations (also known in a rising market as "what some other fool is willing to pay for something") could create an upwards spiral. Banks look to achieve a constant leverage multiple of their balance sheet (remember that phrase, it's important). If they fail to do this, institutional investors start moaning about inefficiencies of capital. In simple terms, in a rising market, more capital is created, which needs to find somewhere to go, which encourages banks to make loans that they would not make in "normal" circumstances.
You can see where this leads, and the banks could see where it was going to lead. The loans, if the interest is being repaid, create more capital in companies that are expanding, thus leading banks to lend more because the asset of their loan gets better. And, with mark-to-market accounting, the positive feedback is exacerbated.
What even the banks (and the academics) failed to notice in 2003 was that the creation of mark-to-market valuations also helped create a whole new world of valuations - via securitisations.
In simple terms, a residential backed mortgage security is a synthetic (although in the rarefied world of finance, it isn't actually seen as a synthetic) product which makes an illiquid asset (lots of people's houses) a liquid asset (a tradable security).
If you then take a lot of these RBMSs and slice and dice them, putting them back together in a form that categorises the risk more "plainly" you get collateralized mortgage obligations (a 'genuine' synthetic). If you do the same with other types of debt, you get collateralized debt obligations.
Why does this matter? Well, it matters in two ways.
One is that it creates more capital that looks liquid (a tradable security) that isn't really liquid (because its fundamental building block is a house). In the world of mark-to-market "fair value" accounting, this is important (far more so than in historic cost accounting) because, instead of valuing the house, so to speak, you are valuing what someone thinks the debt on the house is worth.
The second is that these securitisations shifted the mortgages off the banks' balance sheets. This meant that capital was freed up, so that they could lend more. Indeed, they had to lend more (see above on constant leverage multiple of balance sheet). Huge wodges of capital were going in search of borrowers, any borrowers.
Once the rising asset markets go into reverse, you get a negative loop, and that's what we are getting now. This morning, AIG wrote off $11bn for Q4 -- that's, er, more than 10% of what Bernanke thought last Summer would be needed to cause a systemic crisis (he doesn't talk about that too much these days). Swiss Re said that another CHF240m had disappeared since January 1 -- a sum that these days barely causes a tremor.
With all of this money "vanishing", it's all very well for AIG and Swiss Re to say that it's not real money because in the end things will work out fine and that they don't have to sell the stuff at the moment anyway (the old "historic cost" accounting argument). Things might well work out fine. But, for the moment, it's not just dubious loans that won't be made anymore -- it's loans that would in normal times be seen as "reasonable". Fair value accounting is crucifying capital, which means (and, once again, we come back to
the mantra of "constant leverage multiple of balance sheet") that only the safest of the safe will be able to borrow cash.
This is basically seriously bad news for anyone looking to refinance a loan, be it a company or an individual. You could be a perfectly good customer in "normal" times, but these are not normal times.
For not a few companies, I can't see this meaning anything else but rights issues, lots of rights issues.
_______
