Commenter JKH has been doing some thinking about mark-to-market and its role in the current crisis, and WCI is delighted to report that he has been good enough to put those thoughts together and agree to have them posted here:
Lurking in the background to the credit crisis and the unfolding policy responses to it has been the issue of mark to market accounting.
Bankers distinguish between two types of accounting, known as accrual (ACC) and mark to market (MTM). Simplified, accrual accounting includes only ongoing interest or yield income in reported earnings. MTM accounting includes the same accrual plus an adjustment for changes in the value of the asset over the period. For example, annual ACC earnings on a 5 year bond would include interest plus any amortization of premium or accretion of discount, based on the original book price. Annual MTM earnings on the same bond would include the same accrual earnings, plus the change in the market value of the bond over the reporting period. Thus, accrual accounting, in addition to being a standalone method, is also a sub-component of MTM accounting. But when people talk about the issue of MTM, they generally refer to the accounting component that differentiates it from accrual accounting; i.e. the adjustment for changes in asset values. Finally, fair value (FV) accounting refers to the formal application of mark to market accounting under specified accounting rules, including the treatment of various types of assets according to their inherent liquidity and marketability characteristics. FV accounting rules are complex, and we won’t explore them in detail here.
Commercial banks use accrual accounting in accordance with the intended hold to maturity nature of their loan books. Broker dealers use MTM accounting due to the liquid nature of their securities sales and trading businesses. So called “universal banks” combine both types of banking and both types of accounting under one roof. Commercial bank deposit taking and lending is captured in the accrual book; broker dealer securities activity in the MTM book. The two segments are also known the “banking book” and the “trading book”, and the resulting accounting combination as the “mixed model”. Citigroup, JP Morgan, and Bank of America are universal banks. Goldman Sachs and Morgan Stanley are broker dealers (although they’ve recently obtained commercial banking licences). All five major Canadian banks are universal banks. (This overall description is generic and simplified.)
Regulators of universal banks have steadily expanded the scope of FV accounting over the past two decades. The motivation has been to increase the “transparency” of financial statements, so that changes in underlying asset values are open to investor scrutiny and evaluation. The result has been an incursion of MTM measures into what were previously accrual banking books, and an FV accounting regime of increasingly wide and complex scope within universal banks.
The issue of MTM accounting as it pertains to the credit crisis has much to do with the resulting ambiguous border-line between the two types of accounting within universal banks. When questioned at last week’s Congressional hearing, Goldman Sachs’ CEO suggested that the MTM problem lay primarily in the reluctance of universal banks to mark down assets properly to market (Goldman is not a universal bank). Citigroup’s CEO on the other hand claimed that assets already marked down to distressed levels on an MTM basis did not reflect true value, and therefore the bank was reluctant to sell them. (Citigroup is the prototype example of a universal bank.) These are different interpretations of the MTM issue. Such different viewpoints are widespread and contribute to the debate on how to solve the credit crisis.
The wisdom of MTM accounting has been debated before and since its original implementation. On the one hand, it “shines a light” on developing asset value problems. On the other, it has the potential to exaggerate volatility in reported earnings, in some cases unnecessarily. As a simple example, a 5 year fixed rate loan or bond that matures in tact may exhibit substantial MTM volatility throughout its lifetime. But such volatility accumulates to zero net effect by the time the bond matures. To the degree that MTM based risk measures such as “value at risk” (Var) and capital measures such as “risk adjusted return on capital” (Raroc) pay attention to this volatility, measured risk and attributed capital are higher than is the case where the bond is assumed to be held to maturity. This capital effect in terms of both risk measures and unrealized losses has been critical to the dynamics of the credit crisis. Unrealized MTM losses create capital shortages, motivating liquidations, creating realized losses, pushing prices lower, feeding back to further unrealized losses. Potential distortions spread from such plain vanilla examples to the wider scope of various credit risk instruments. Much of the credit crisis problem as it pertains to banking revolves around the pricing of so called “toxic” or “troubled” assets, and other assets that are at least guilty by association. The fact that both composition transparency and market liquidity are lacking means that the appropriate MTM treatment for these assets is problematic. Various credit crisis solutions have been proposed, such as MLEC, TARP I, bad bank, good bank, TARP II, and full nationalization. All of these depend on the problem of asset valuation and pricing and MTM, one way or another. Nevertheless, the wisdom of such aggressive MTM application is a question that lingers.
Willem Buiter (see below) has commented recently on one aspect of FV accounting, that being consistent treatment of assets and liabilities. E.g. an increase in market interest rates reduces the value of a fixed rate asset, which reduces FV earnings. The same effect on a similar fixed rate liability reduces its value, which increases FV earnings. The pathological case is that of deterioration in a bank’s credit quality, with a widening of credit spreads that reduces the value of its liabilities and increases its FV earnings. Buiter has noticed what bankers themselves complained about almost 20 years ago when FV accounting was first proposed. Given the broad transparency objective of FV accounting, there is no rationale for applying it to assets alone. This apparent “foolish consistency” is symptomatic of unintended consequences.
Events are rapidly unfolding in the global credit crisis. There is increasing momentum toward the view that governments should urgently nationalize banking systems on a broad scale. The tendency in that context is to assume the MTM issue is increasingly irrelevant. Before allowing this, we should highlight several fallacies about MTM, which are at the conceptual origin of the issue.
The first fallacy is that MTM accounting is necessary in order to produce balance sheet transparency. This is not the case. Given the nature of the information it conveys, we can say more accurately that MTM accounting is a sufficient, but not a necessary condition for transparency. Insofar as asset values are concerned, the necessary condition is MTM disclosure, not MTM accounting. Exactly the same information can be made public through disclosure, without necessarily affecting reported earnings and capital positions. This would still allow the market to incorporate internal MTM information in the stock price. Shareholders could evaluate the impact of illiquid asset markets, uncertain pricing, and the longer term relevance of immediate MTM asset values, and impound all of this in the current stock value. This avoids a compound and to some degree duplicative and arguably inefficient pricing process in which internal assets and external stock value are both subject to an MTM valuation process.
The second fallacy is the contention that choice of accounting has no bearing on the economics of value. This would be conventionally correct if accounting had no bearing on the actual requirement for bank capital. But it is wrong for precisely this reason. And this is of particular importance to the credit crisis.
A relevant and connected analogy exists in the household sector. The housing boom was based on easy credit and an implied belief in MTM accounting for houses, otherwise known as the ATM effect. Current house prices, however inflated, were the basis for many hundreds of billions of dollars of mortgage equity withdrawals (MEW). Those who bet on housing MTM as an indicator of sustainable price appreciation behaved accordingly. So did mortgage lenders. Those who restrained from using MTM as a mental accounting of a sustained trajectory of personal wealth, and who considered such MTM information with more restraint, probably checked their behaviour more wisely in terms of allowing for risk. In order words, behaviour was a function of how households viewed the effect of housing MTM on their personal balance sheets and longer term capital positions. Those who resisted incorporating full MTM into their own capital evaluations were probably more restrained in MEW transactions and related spending. Those who acted aggressively on their housing MTM profile overextended their balance sheets and spent the money from their MEW proceeds. The economist Steven Roach referred to the corresponding macroeconomic effect in terms of the “asset economy”. The trajectory of this economy is tracked in the Federal Reserve’s quarterly computation of US household wealth. Trillions of dollars of wealth have now been eroded from household balance sheets since the credit crisis began.
A number of reputable economists and analysts have judged the US banking system to be insolvent. They conclude this in part by comparing the probable value of bank assets and liabilities with system capital. Forecast loan losses apart from MTM losses are also an important factor. These forecasters may be right. Who would bet strongly against Nouriel Roubini at this stage? President Obama has invoked “catastrophe” as the worst case scenario for the US economy, and positioned the importance of fiscal action accordingly. One could describe the banking problem similarly, and the importance of policy action there. Prescriptions for resolving the banking crisis include permutations and combinations of government intervention and asset reconfigurations such as “bad bank” (MLEC, TARP I, TARP II), “good bank”, and full nationalization. More commentators are pronouncing both US and European banking systems as insolvent, and urging quick nationalization, in order to avoid a Japan style protracted bank balance sheet deflation. Martin Wolf (see below) alleges the new US administration has already failed to recognize that the US banking system is insolvent. In his view the current policy response has already failed; nationalization is required. He makes the point that aggressive action is required to prevent a calamitous consequence that is asymmetric in its severity. All of this may be right. The MTM issue has been overtaken by this momentum. So where does it fit now?
The government assumes asset risk in any of these bail-out mechanisms. But unlike private sector banks, it incurs no additional capital requirements due to unrealized MTM losses on assets that it purchases (not that it guarantees). Neither the Treasury nor the Fed requires more capital funding because of MTM changes in the prices of assets that they hold. (The issue of Fed capital adequacy is really part of the same question for the government as a whole.) In other words, Treasury and the Fed can hold assets to maturity, but the private sector may be inhibited from doing so, given its required response to MTM unrealized losses and capital constraints.
The Treasury and Fed balance sheets offer considerable potential leverage to a financial system that is undergoing massive deleveraging. This is the essence of the requirement for their balance sheet intervention. But they also offer MTM immunization by virtue of their own balance sheet process. Therefore, why not provide MTM immunization (i.e. “relief”) directly to the banks, as part of a broader package of intervention? Indeed, this is what a number of commentators have urged for some time. Among them are Paul Volcker (former Fed chairman), William Isaac (former FDIC chairman), and Bob McTeer (former Fed governor; see below). Opposing this general proposition is the purist MTM view, which happens to note correctly that Japan’s banking system failed to recover due to half-way measures. But this doesn’t deny the potential dysfunctional effect of MTM on bank capital requirements in any environment.
TARP II as outlined by US Treasury secretary Geithner envisages a public-private partnership for the purchase of bank assets. The idea is that government will provide the leverage necessary to make these assets attractive to private equity capital. This would presumably also lift current MTM pricing, simply due to financial engineering. The irony is that private capital because of this financing may discover assets worth holding on the basis of underlying cash flow, i.e. on an accrual basis. Thus, the government may move assets out of the banking system that are disabled on an MTM basis to an investment platform where they make sense on an accrual basis. This would include the decomposition of complex assets such as CDOs in order to identity cash flow arising from the underlying assets. So long as these individual assets generate cash flow, they are “worth” something rather than nothing.
In summary, the banking crisis reflects the problem of dealing with so-called “toxic assets” and associated write-downs forced by MTM and FV accounting. Various solutions have been proposed involving different ways of severing toxic and non-toxic portions of a bank balance sheet, including full nationalization. These mechanisms will depend on the price at which these assets can be sold or transferred away, and how MTM accounting will factor into the arrangement. There may also be some scope for meaningful relief on MTM accounting in universal banks. The credit crisis itself reflected an asset bubble that in good times was enabled by aggressive MTM accounting, explicit or implicit, across all sectors of the economy, including banks and households. Universal banks combined and integrated MTM oriented investment bank operations with more staid, accrual accounted commercial operations. Perhaps the financial architecture of the future will feature a return to commercial banks that resemble deposit taking and lending utility functions, with minimal exposure to MTM businesses, and investment banks that are still MTM driven but small enough to fail.
Various opinions on mark to market:
Superb. A great analysis of why - potentially - the banking system may not be in such dreadful shape after all. Does anyone have an estimate of the quantity of assets which may have a substantially higher value-to-maturity than their MTM value?
Another way to look at this issue: if the market value of an instrument is $50, that does not mean its value to all market participants is exactly $50. It may legitimately be worth $100 to the bank that owns it. After all, why would anyone hold an asset if they did not value it more highly than the market price?
The risk of not using MTM accounting is that banks can invent their own valuations, bypassing capital requirements. Accrual accounting seems like a good way to limit this.
Thus, assuming banks can access enough liquidity to hold their assets to maturity, the MTM value need not matter.
This last point - liquidity and capital requirements - points to why, as you clearly describe, the state can hold any asset to maturity without the same difficulties as private entities. This is related to what I was trying to describe on http://www.knowingandmaking.com/2009/01/borrow-borrow-borrow.html but you have expressed it much better than I could.
Posted by: Leigh Caldwell | February 17, 2009 at 09:44 PM
Leigh Caldwell,
Thanks for your comment.
I’m not sure on your question, although I did see a private equity manager interviewed the other day who had a number of about $ 900 billion in CDOs etc. that he thought could be of interest to “the street” (to the degree it still exists) if government came in with the right funding.
This idea of the government (Treasury and Fed) coming in to provide leverage to partly offset private sector deleveraging is an important one, I think. There was considerable debate in the early going of the crisis as to whether it was about liquidity or solvency. It seems you don’t hear that debate so much now - perhaps because it’s both, where solvency is not a simple yes/no binary question. I don’t spend a lot of time try to figure that one out, but it strikes me that liquidity and solvency are very much mutual partial functions of each other. The debate about what liquidity is will go on forever. To complicate things further, some people define solvency on a cash flow (i.e. accrual or liquidity basis) rather than a balance sheet equity or present value basis.
In any event, pricing is front and center to the “toxic asset” problem and it is front and center to the MTM debate. I hope we’ll see the two connected a little more clearly when Geithner does his “stress tests”. I know that universal banks with their risk management functions do their own stress tests on both an accrual basis and a present value basis, where PV for trading books amounts to MTM, and PV for banking books amounts to “economic value” or some such concept. They can then look at the different parts separately or on an integrated basis.
I tried to compress a lot into one post. One thing I could have brought out more clearly is that stress tests or any kind of projection can be either static or dynamic. Static basically models the runoff of the existing balance sheet, accrual or MTM. Dynamic generally is a runoff of the MTM trading book but includes an assumption about new business on the banking book (e.g. new mortgages; new deposits). This latter assumption, if PV’d, takes into account the positive contribution of the franchise going forward, which can be used to offset partially the effect of the existing “intoxicated” book. This is also a very important aspect at looking at bank viability – it models the “value” of the franchise going forward, sort of like modelling the “good bank” solution while retaining it as a component of the existing organization.
It will be interesting to find out what the Geithner stress test methodology is (hopefully it will be transparent) and how the various accrual and MTM pieces are done.
P.S.
The font in the post is pretty small (for my eyes anyway). Anyone who’s interested can find a version that might be a bit easier to read at the following post, where it appears several times at the end of the comment section:
http://worthwhile.typepad.com/worthwhile_canadian_initi/2009/02/average-debt-in-lake-wobegon.html
(It’s there due to an earlier problem with comment retention referenced by Stephen).
Posted by: JKH | February 17, 2009 at 10:59 PM
Thanks, very interesting post. I enjoyed the accrual distinction, and how you related it to cash flow. A point that I think worth making here is that there is massive misunderstanding of MTM and accrual (cashflow) accounting issues, surpisingly or not, amongst MBA-educated businesspeople. I have had repeatedly had two separate but related discussions (not exclusively, but predominantly with MBAs (from very good schools, by the way):
1) Complete and utter misunderstanding that everything is, can and should be on a balance sheet on a MTM basis - whereas the reality is that accrual and/or historical cost still dominates the balance sheets of almost all companies. IBanks are the exception, not the rule.
2) Complete misunderstanding of the frequent divergence between cash flow and market prices (or cash flow and income).
I think you have hit the nail on the head that the housing market was contaminated by a belief in the MTM values of housing, whereas for most consumers of housing (buy and hold, if you will), only a cash flow valuation could possibly make sense. Most consumers cannot (save the rare person who e.g. sells in San Francisco and moves to Montana) can realize that MTM value, and the cash flow value of the houses they sit in are either negative (cost of servicing and debt) or should only be compared to equivalent rent.
Here's a thought experiment: would it be possible to Mark to (Comparable) Cash Flow much of the so-called toxic assets? If you could trade a CDO for a bond or deposit (adjusting for risk), would you get a different price? I honestly don't know.
One of the massively contentious and problematic issues is that many of these new instruments have binary cash flows - you get something or you get nothing. And they're all correlated.
Or as I read from someone else, "We live in non-linear times."
Posted by: Greg | February 18, 2009 at 08:10 AM
Greg,
Thanks for your comment.
That’s an interesting point from your MBA discussions. My impression is that investment bankers beginning years ago had a vested interest in extending MTM to commercial banks balance sheets, and that the accountants fell in line with the investment banker mindset for other reasons. The vested interest of investment bankers was the creation of cash flow PV’s in order to accelerate the recognition of profit and associated compensation. I think this was very much a driving factor for securitization, notwithstanding the alleged systemic benefits of increasing “liquidity” and distribution channels for financial assets. And, although Enron was fraud, I believe the mechanism for revenue acceleration was pretty much the same as it existed in its more legitimate forms of securitization. (I had thought of titling this post “Extraordinary Popular Accounting and the Madness of Crowds”.)
In a broader sense, MTM is actually a cultural phenomenon, as it relates to the influence of investment banking on commercial banking over the past twenty years. Close to WCI home, the Canadian banks are very interesting to analyse from this perspective; they each have their own internal investment dealer and commercial bank DNA sources, going back to 1988 (the year of the bank/dealer consolidations) and the mix in each is quite different to this day.
There are a several other examples of what I think of as “overzealous MTM” technique, or at least a risk in that area.
The first relates to Willem Buiter’s recent analyses of central bank “seigniorage” profits as they relate to central bank solvency. Simplified, he more or less creates a virtual financial asset by capitalizing future net interest income, and uses the value of that asset as cover for the risk of central bank “insolvency”, to some degree. (Again, I think Nick Rowe has also written on this. And in fact, this sort of technique might be well accepted in academic circles. I don’t know, and I’m not saying it’s completely wrong; just that it’s pushing the envelope on a certain comfort zone of valuation technique.)
The second example is the “dark matter” theory of the US current account deficit. The authors of that basically argue that the US has enjoyed an exorbitant privilege of a second kind in that it historically has earned positive net interest income on a negative net international investment position. The authors then capitalize that income to come up with a revised figure for the net international investment position, showing it as an effective economic surplus. The technique here effectively was to use a risk free discount rate on a current benefit extrapolated into the future, as if there were no risk in doing so. (Bubble, anyone?) But in any event, they effectively created a new financial asset from future GDP income that was not previously capitalized. That falls into my overzealous category.
The final example, not so much in the accounting vein but somewhat similar to “dark matter’ was the “Dow 36,000” theory which I’m pretty sure was based on a similar extrapolation using something much closer to a risk free rate in capitalizing current earnings, justified by historic observation of an apparently reliable outperformance of other investment categories.
Posted by: JKH | February 18, 2009 at 09:19 AM
Nice post and comments. It helps me understand the MTM and surrounding issues.
One aspect of the banking crisis, the nationalization solution, never brings up (at least from what I've read so far) the public utility nature of a national bank. A national bank is not just another bank. This type of bank is a tool to further national policy and presumably the common good. In this environment such a bank would be able to do what private banking cannot do: Lend. Such a strong ability to lend would also draw in private wealth because of the strength of the national bank balance sheet. The MTM debate would be rendered irrelevant.
Much of the various bailout funding could have been provided through such a bank because it can act as a strong conduit of money by its very nature.
Plus this type of bank (a commercial bank as a public utility, not an investment bank) would be more transparent. It's employees would be politically immunized civil servants (other than the board of directors, who would need to be watched carefully).
And forming such a bank allows the government to harbor illiquid securities and hold them until the economy begins its recovery, without spending any money (other than for administration). If additional capital is needed after the illiquid securities are stripped off and warehoused, then capital supplied would be taxpayers paying for their own bank (from one pocket to the other pocket of the same pants). Cash flows from the warehoused securities can be used to honor debtholders income. Return of capital levels will be increased as the securities are sold into an improving economy.
So let's pluck the low hanging fruit (Citi and BA) sell off the investment bank functions, and form a nice, solid not sexy, national bank. We could use our own bank right now.
Posted by: beezer | February 18, 2009 at 11:17 AM
Beezer,
Thanks for your comment.
I’ve not done much thinking about nationalization. But some smart people wonder why banks aren’t nationalized in the first place, given the role of FDIC insurance in enabling the “maturity transformation” function.
One of the difficult things now I think is distinguishing between the response to the crisis as systemic life support and the response to it as transformation to a successor system. An example would be the distinction between temporary (enabling) and permanent (structurally destined) nationalization, or between selective and systemic nationalization in some broader sense. Events are unfolding so rapidly and debate is being forced so unexpectedly that potentially useful ideas are not clear.
I agree that a national bank is a logical and bold way to implement a “good bank” concept with the idea of a permanent public utility at its core, and probably relatively quickly, with new lending right away. Maybe such a prototype should be a permanent entity and viewed as a systemic risk management buffer as well. You could even capitalize such an institution according to some sort of cyclical or countercyclical rules that make sense relative to the privatized portion of the system. I think it can be justified easily in the context of a free market economy on the basis that it constitutes prudent risk management at the macro level. Unfortunately, such national institutions tend to die away when capitalism is working at “normal” levels of efficiency. The core idea might be tough to sustain if the cycle is presumed to be 100 years long and things like the Great Depression and whatever this thing is are assumed by the next generation to be bumps in the road.
Posted by: JKH | February 18, 2009 at 02:04 PM
Who is this guy, JKH? [as per that line in the Sundance Kid, where the tracks are followed over bare stone]
I feel like I should commit several hours to a responsible sass-free reply...an impossible task, let's face it.
Where to hit and run?
Roubini (recent video interview NPR?) notes that some failed US bank was bailed out and is now back in business. Not the entire industry, but causing some of us to think that the "nationalism" is facetious --that GOPers and conservatives in general, need to be softened up with another label like "pre-privatization"...so hard when your cherished ideology hits the skids.
I'm with Delong here about the nature of the US banking industry (and marvel that it does not include the Canadian banks...yet): "illiquid" is the MTM evaluation by the banking industry.
Posted by: calmo | February 21, 2009 at 11:14 PM
calmo,
Thanks for the drive by.
Yes, Roubini seems to be in full MTM mode.
Some say Geithner has been an opponent of relaxed MTM rules. I’ll be interested to see if this is revealed in the stress test methodology.
Somehow I doubt it.
A few interesting stats on Canadian banks:
No major Canadian bank has cut its dividend since the Great Depression (oops). My internal software suggests a 30 per cent probability of across the board cuts starting late this year. They may get sucked into this like Canada geese.
The following is a list of the top 10 banks in North America by market cap in US dollars (slightly dated, before the most recent slide). All 5 major Canadians are now on the list:
J.P. Morgan Chase: $76.9
Wells Fargo: $50.8
Goldman Sachs Group: $43.4
Royal Bank of Canada: $31.2
Bank of America: $25.0
Toronto-Dominion Bank: $23.3
Morgan Stanley: $21.4
Bank of Nova Scotia: $21.1
US Bancorp: $19.1
Citigroup: $13.7
CIBC: $12.6
Bank of Montreal: $11.2
Royal Bank, the largest, has a residential mortgage portfolio (on balance sheet) of $ 122 billion CDN, roughly 13 per cent of total Canadian residential mortgages outstanding.
Its loan loss provision against the $ 122 billion was $ 16 million for 2008.
Yes – that’s 1.3 basis points of loan losses on residential mortgages.
We’ll see.
My regards to Butch and the Kid.
Posted by: JKH | February 22, 2009 at 07:35 AM
Thanks for the reply (as calmo sacrifices....sacrifices, I tell you! his casual (and worse) style...to meet current exigencies of the somewhat formal JKH (how am I goin to keep you and JDH at Econbrowser straight?)).
$16 million was fontized up several times without producing a more agreeable result.
So, hard to disagree with your view about the Canadian geese...except that 30% seems timid (Canada, incredulously about a year behind the US recession (as I fight valiantly against this impression learned here at WCI), and its 5 major banks would appear in a different order if we examined the market cap a year ago, yes?).
Ok, remember the joy of bare foot blogging...you could relax a little, you could. And I would B less distracted at the prospect of mussin your hair up, you know?
Posted by: calmo | February 22, 2009 at 01:08 PM
calmo,
“how am I goin to keep you and ...” That’s easy. He’s the one who knows economics.
Canadian banks are now down 50 to 65 per cent from peak prices in 2007.
30 per cent is actually bold, not timid, compared to even the most pessimistic analyst forecast at this point (no Meredith Whitney yet on Canadian banks). Analysts are generally so sanguine they don’t even put a number on it, yet.
On formality: point taken. I may try something crazy next week, like picking a day at random, and dropping a verb.
Peace.
Posted by: JKH | February 22, 2009 at 04:26 PM
I'm accounting ignorant, but accrual accounting seems to have no methodology for writing off projected cash-flow contraction.
I've seen many valid hypothesees about why MTM valuations are so painful:
1) Porjected Great Depression.
2) Projected finance industry indefinite deflation; banks always wating til tomorrow to loan (my guess).
3) Projected future USA inflation (lowering value of long-term assets).
4) Projected future USD depreciation.
5) Projected poisoned well permanently of all CDO instruments.
I'd feel more comfortable modifying MTM if it is too draconian and the above 5 reasons aren't remotely possible. Say take some investor/business confidence index, and tie it to a MTM premium: when 90% of players are scared, induce a 9% premium on MTM values, when only 10% scared, only 1%. Accrual accounting looks backwards at a cash flow trend graph, and draws an optimistic line. With MTM you pop these bubbles.
Posted by: Phillip Huggan | February 22, 2009 at 05:41 PM
Phillip,
Sometimes accrual accounting is associated with backward looking and MTM with forward looking. On the other hand, accrual accounting results can be run as forward looking simulations to see how future earnings combined with current MTM unrealized losses. Also, forward looking simulation of an existing MTM book can show how some of the unrealized losses can amortize over time.
You’re right in that accrual book loan losses tend to be more subjective and tend to occur gradually over time, whereas MTM unrealized losses are upfront valuations. Again, however, the passage of time can affect both types of measurement.
Banks, although they’ve done a terrible job at their own macro level risk management, do use both accrual and MTM evaluations in their risk modelling. As far as this is concerned, central banks historically have exhibited disconnect with commercial banks in terms of how they do their risk management. Central banks have tended to rely on GDP accrual type indicators of growth and inflation, rather than asset value MTM type indicators such as house prices and stock prices in setting monetary policy. There is some sense now that central banks should consider asset prices more directly in monetary policy, and regulators should consider pro-cyclical approaches to capital requirements – along the lines of the adjustments you’ve suggested for MTM – such as increasing risk measures and capital requirements in boom times. The value at risk models minimized measures of MTM risk during the “great moderation”, due to low volatility and unusually low risk premiums, when they probably shouldn’t have.
Posted by: JKH | February 22, 2009 at 06:46 PM
From Bernanke’s speech today:
“The ongoing move by those who set accounting standards toward requirements for improved disclosure and greater transparency is a positive development that deserves full support. However, determining appropriate valuation methods for illiquid or idiosyncratic assets can be very difficult, to put it mildly. Similarly, there is considerable uncertainty regarding the appropriate levels of loan loss reserves over the cycle. As a result, further review of accounting standards governing valuation and loss provisioning would be useful, and might result in modifications to the accounting rules that reduce their procyclical effects without compromising the goals of disclosure and transparency. Indeed, work is underway on these issues through the Financial Stability Forum, and the results of that work may prove useful for U.S. policymakers.”
http://www.federalreserve.gov/newsevents/speech/bernanke20090310a.htm
Posted by: JKH | March 10, 2009 at 08:58 AM
The mark-to-market issue has been gathering quite a head of steam in just the last few days, with a congressional hearing on it today.
Holman Jenkins, Wall Street Journal, yesterday:
http://online.wsj.com/article/SB123672700679188601.html
“Now comes Warren Buffett, a big investor in Wells Fargo, M&T Bank and several other banks, who, during his marathon appearance on CNBC Monday, clearly called for suspension of mark-to-market accounting for regulatory capital purposes ... Mark-to-market accounting is fine for disclosure purposes, because investors are not required to take actions based on it. It's not so fine for regulatory purposes. It doesn't just inform but can dictate actions that make no sense in the circumstances. Banks can be forced to raise capital when capital is unavailable or unduly expensive; regulators can be forced to treat banks as insolvent though their assets continue to perform. CNBC, sadly, has been playing a loop of Mr. Buffett's remarks that does a consummate job of leaving out his most important point. Nobody cares about the merits of mark-to-market in the abstract, but how it impacts our current banking crisis. And his exact words were that it is "gasoline on the fire in terms of financial institutions." Depressing bank stocks today, he said, is precisely the question of whether banks will be "forced to sell stock at ridiculously low prices" to meet the capital adequacy rules. "If they don't have to sell stock at distressed prices, I think a number of them will do very, very well." He also proposed a fix, which CNBC duly omitted from its loop, namely to "not have the regulators say, 'We're going to force you to put a lot more capital in based on these mark-to-market figures.””
So what Jenkins/Buffett are saying here effectively is that MTM should be disclosed, but not necessarily systemically forced through profit and capital accounts, the same as I’ve said above.
Bernanke and Buffett have both said over the past week that MTM should not be suspended. But they’ve also said that meaningful adjustments should be considered in translating MTM information to regulatory capital requirements.
I’ll predict that there will be some sort of adjustment coming out in the coming weeks, and that it will have a positive effect on the banking crisis, the interpretation of the Geithner policy response (details still forthcoming), and bank stock valuations.
Posted by: JKH | March 12, 2009 at 09:25 AM