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Mark to Market explained in laymans terms

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Mark to Market explained in laymans terms

Old 03-22-2009, 11:57 AM
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tka
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Default Mark to Market explained in laymans terms

Suspending Mark To Market Accounting: The Tale Of Two Cows
John Carney|Feb. 6, 2009, 12:55 PM|25

Talking about accounting rules is famously obscure, my-eyes-glaze over stuff. But much of what happens inside of investment banks--including all those writedowns you've heard so much about--turns on accounting rules.

Now there are reports that the SEC is planning to give banks "flexibility" on mark-to-market accounting rules. It may even suspend mark to market rules. What on earth could that mean?

Let's go to the cows.

You have two cows.

You write down on a piece of paper that the cows are worth $100 each.

You notice the cows are on fire.

Your paper still says $100.

Fortunately, mark to market has been suspended so you don't have to pay attention to the fire.

Your cows are dead from fire.

Your paper still says $100.

Fortunately, mark to market has been suspended so you don't have to pay attention to the dead cows.

You notice that you aren't getting as much milk as expected, so you adjust the model and mark the cows down to $98. You are confident, however, that the dislocated stream of milk revenue will quickly revert to expectations.

You need to borrow some money so you ask investors for a loan against the cows. The investors tell you the cows are dead, and you already owe them $200 dollars you borrowed to buy them in the first place. You show them the paper that says the cows are worth $98 each.

They light your paper on fire.

You ask the government to buy the dead cows at $98 each.

The government holds meetings all weekend and finally comes up with a plan to inject $45 dollars into your cattle ranch. In exchange, the government gets a right to milk generated from the cows at some point in the future. It expects you'll buy a new cow with the $45.

You have two dead cows, $45 and $200 in debt to your investors. You have no plans to buy new cows.
Old 03-22-2009, 01:41 PM
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If it wasn't so true that would be hilarious.
Old 03-22-2009, 02:18 PM
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I am in the business of valuing those assets so I can make it even simpler.

Mark to market rules requires the owner of a security to use the value "any willing purchaser" would pay for that security. That value goes on your balance sheet. It doesn't matter what you paid for the security......the value should reflect today's market conditions and if that means your asset is worth less than before, write it down.

For instance, assume you bought a bundle of mortgages for $1 billion two years ago. During the last two years the borrowers have been defaulting out the whazoo and the value of their houses have plummeted. Clearly, the value of that bundle of mortgages has declined since it is unreasonable to assume you will ever see the full $1 billion of mortgage loans......sophisticated investors know that and will only pay you some percentage, less than 100%, of the $1 billion....what they would pay you is the value you use when marking to market that bundle of mortgages.

Suspending this rule allows banks and investment houses to LIE about the value of their assets............this has to be one the dumbest "cures" for our current economic problems.
Old 03-22-2009, 02:25 PM
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I posted about this back last summer, when the housing bubble burst -- that banks were being allowed to claim the value of the property, before the bubble popped, as A1 real estate collateral to secure loans from other banks and the govt.


What's going on now should raise some eyebrows. AIG, Citibank, BofA, all of the big banks have an arrangement with the govt to take the risk on "toxic assets" i.e. defaulted mortgages. The govt's agreement is something like BofA will assume the first $15-billion in losses, the the gov't will back losses after that to 90%. If BofA has $115-billion in toxics, the first $15b gets written down, then the other $100b is back by $90b from the govt. The best BofA can ever hope for is to recover 10% of any of those toxics. Where is the incentive for BofA to make that work? THERE IS NONE!!! The big banks are just startig to sell off repo homes are fire-sale prices, less than 50% of their current appraised value. Can you see any possible opportunity for corruption in that? -- the bro of a bank manager buying presitine properties and flipping them, no work required, and the tax payers foot 90% of the bill. It's happening.
Old 03-22-2009, 03:04 PM
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Like any other law or regulation, it is the combination of regulations and the application of them to particular situations that leads to unintended consequences.

Mark to Market works fine when there is a liquid and efficient market for the asset in question. In the case of the myriad of tangled derivatives, packages, and derivatives of packages, it is impossible to determine fair value. So the price is determined in a fear-driven market situation where there is a gross imbalance between supply and demand, and the realizable price at a point in time (like the past 4 months) overshoots on the downside the intrinsic value that the asset would have in a non-fear-driven market by 20% or more.

Couple that with the current capital ratio requirements, and forcing MTM makes otherwise cash flow generating mega-financial institutions instantly but temporarily insolvent. Extend this throughout the financial system, and the cascading effects on the downstream and upstream counterparties makes the whole system collapse like a house of cards.

That’s why the requirement for continuing instant MTM in this environment is a bad idea. It has the unintended consequence of instigating the very collapse that the regulatory framework is intended to prevent. Since September, it is the main reason why the government has been needed to inject capital into the financial institutions – all to address accounting entries that are artificially and temporarily depressed due to the fact that other institutions assets are artificially and temporarily depressed. It is not serving as a market settling force – it is the equivalent to taking the stones out of the foundation of a building in order to build on another floor.
Old 03-22-2009, 05:01 PM
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tka
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Mark to market is one of the things I struggle with the most.I understand the idea that forcing mark to market in this enviroment could artificially depress the value of an asset and raise the capital requirements for an institution that could render it insolvent.I also understand that it is not appropriate to allow an institution to maintain the asset at full book value when in reality it stands very little chance of ever being worth what it was originally purchased at.
How do you value an asset then in this enviroment??How can you estimate default rates and asset values when the economy continues to deteriorate?How can you estimate demand for an asset when we will probably never see the levels of leverage we have seen over the past few years?If I thought that this was a temporary event and we would shortly return to our past economic levels,then I would probably agree with suspending the MTM temporarily.Unfortunately I don't see our country recovering to previous levels for a long time so I don't see how we can allow these assets to be kept at full value.

I do believe that there is a tremendous amount of money to be made if you can accurately value and purchase these assets over the next few years.
Old 03-22-2009, 05:36 PM
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Originally Posted by Tireless View Post
I am in the business of valuing those assets so I can make it even simpler.

Mark to market rules requires the owner of a security to use the value "any willing purchaser" would pay for that security. That value goes on your balance sheet. It doesn't matter what you paid for the security......the value should reflect today's market conditions and if that means your asset is worth less than before, write it down.

For instance, assume you bought a bundle of mortgages for $1 billion two years ago. During the last two years the borrowers have been defaulting out the whazoo and the value of their houses have plummeted. Clearly, the value of that bundle of mortgages has declined since it is unreasonable to assume you will ever see the full $1 billion of mortgage loans......sophisticated investors know that and will only pay you some percentage, less than 100%, of the $1 billion....what they would pay you is the value you use when marking to market that bundle of mortgages.

Suspending this rule allows banks and investment houses to LIE about the value of their assets............this has to be one the dumbest "cures" for our current economic problems.
So what is the value of the formerly $1 Billion worth of mortgages? Isn't this the problem? No buyers or sellers willing to buy or sell them. They aren't worthless. Just no market for them. Some are performing loans that are worthwhile while others are fradulent crap that will probably only yield .35 on the dollar(after default, foreclosure and subsquent disposition).
Old 03-22-2009, 06:11 PM
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Originally Posted by tka View Post
Mark to market is one of the things I struggle with the most.I understand the idea that forcing mark to market in this enviroment could artificially depress the value of an asset and raise the capital requirements for an institution that could render it insolvent.I also understand that it is not appropriate to allow an institution to maintain the asset at full book value when in reality it stands very little chance of ever being worth what it was originally purchased at.
How do you value an asset then in this enviroment??How can you estimate default rates and asset values when the economy continues to deteriorate?How can you estimate demand for an asset when we will probably never see the levels of leverage we have seen over the past few years?If I thought that this was a temporary event and we would shortly return to our past economic levels,then I would probably agree with suspending the MTM temporarily.Unfortunately I don't see our country recovering to previous levels for a long time so I don't see how we can allow these assets to be kept at full value.

I do believe that there is a tremendous amount of money to be made if you can accurately value and purchase these assets over the next few years.

The answer is to suspend mark to market on assets that do not have viable dependable price discoverey, and just put rules for full disclosure in the 10k/10Q. This provides the insullation against mandated changes in capital structure, but still allows for transparency to the investing community, so that equity prices of the financial institutions can be properly priced by investors.

As to your second point, I am sure that many of the current "financial system saving machinations" will be manipulated in a way to give sweetheart deals to the well-connected, including the Fed.
Old 03-22-2009, 06:29 PM
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Originally Posted by agkpa95 View Post
So what is the value of the formerly $1 Billion worth of mortgages? Isn't this the problem? No buyers or sellers willing to buy or sell them. They aren't worthless. Just no market for them.
If nobody wants to buy the securities I would argue they aren't worth much at this point in time. One could employ a discounted cash flow analysis, incorporating a properly constructed discount rate to reflect current market conditions, to estimate the value of the securities. At the end of the day.......given the vast uncertainty of the probable return of capital and the return on capital of this hypothetical $1 billion bundle of mortgages.....the value of these types of securities deserves a serious writedown. Hiding this reality is unfair to existing and prospective stockholders.
Old 03-22-2009, 06:41 PM
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thanks for this thread guys, keep it up!
Old 03-22-2009, 06:54 PM
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I was worried about this whole credit freeze up issues till now.

I rest easy now that it appears we will be using Enron's special sauce to fix this mess
Old 03-22-2009, 07:02 PM
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OK, let's say they suspend M to M? Then guarantee these bad loan portfolios as much as you say, why did they bail out AIG then? Wasn't this exactly the insurance that AIG sold to the banks? Why not just do this first and let AIG fail? Why do both? If they did that they wouldn't have been giving money to AIG who then gave 30 Billion dollars to foreign banks to cover their losses. When the heck does this pouring money into the abyss stop? Each week they stick another finger in the dike. Each week there is another must do multibillion dollar bail out and each week the politicians look less and less sure of their so called cures? Doing the same thing over and over again and expecting different results, that's called insanity folks, stay tuned.
Old 03-23-2009, 06:57 AM
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POINT OF ORDER!. The scenario with the cows describes asset impairment, not a mark to market issue See, another case where MTM is being applied where it does not belong.
Old 03-23-2009, 07:13 AM
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Originally Posted by Tireless View Post
I am in the business of valuing those assets so I can make it even simpler.
Is there there a standard or regulating body where the methods of valuing the assets are codified?
Old 03-23-2009, 07:43 AM
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Originally Posted by chrisjb View Post
Is there there a standard or regulating body where the methods of valuing the assets are codified?

That is the $64,000 question, and the answer is no. Mark to Market was originally set up to handle publically traded securities, and then on to private equity. Even the latter is problematic, because it relies on subjectivity in the underlying business and economic assumptions.

Extending this on to counterparty hedges on inscrutable packages of MBS or F/X hedges is impossible - there is no open market. The principle just can't be applied to meet the original objective.
Old 03-23-2009, 09:32 AM
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Originally Posted by chrisjb View Post
Is there there a standard or regulating body where the methods of valuing the assets are codified?
No, there is no single codified methodology. The accounting literature tries to instruct the folks on what they should consider, but at the end of the day it's up to the management of a company to convince it's auditors they have calculated not unreasonable values.
Old 03-23-2009, 10:54 AM
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Originally Posted by Tireless View Post
I am in the business of valuing those assets so I can make it even simpler.

Mark to market rules requires the owner of a security to use the value "any willing purchaser" would pay for that security. That value goes on your balance sheet. It doesn't matter what you paid for the security......the value should reflect today's market conditions and if that means your asset is worth less than before, write it down.

For instance, assume you bought a bundle of mortgages for $1 billion two years ago. During the last two years the borrowers have been defaulting out the whazoo and the value of their houses have plummeted. Clearly, the value of that bundle of mortgages has declined since it is unreasonable to assume you will ever see the full $1 billion of mortgage loans......sophisticated investors know that and will only pay you some percentage, less than 100%, of the $1 billion....what they would pay you is the value you use when marking to market that bundle of mortgages.

Suspending this rule allows banks and investment houses to LIE about the value of their assets............this has to be one the dumbest "cures" for our current economic problems.
Isn't the converse true......the bank may have a performing mortgage (someone paying like you and me) and the bank is forced to write it down because in the current environment it's unsellable, so it's value is zero?
Old 03-23-2009, 10:58 AM
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Originally Posted by Tireless View Post
I am in the business of valuing those assets so I can make it even simpler.

Mark to market rules requires the owner of a security to use the value "any willing purchaser" would pay for that security. That value goes on your balance sheet. It doesn't matter what you paid for the security......the value should reflect today's market conditions and if that means your asset is worth less than before, write it down.

For instance, assume you bought a bundle of mortgages for $1 billion two years ago. During the last two years the borrowers have been defaulting out the whazoo and the value of their houses have plummeted. Clearly, the value of that bundle of mortgages has declined since it is unreasonable to assume you will ever see the full $1 billion of mortgage loans......sophisticated investors know that and will only pay you some percentage, less than 100%, of the $1 billion....what they would pay you is the value you use when marking to market that bundle of mortgages.

Suspending this rule allows banks and investment houses to LIE about the value of their assets............this has to be one the dumbest "cures" for our current economic problems.
I think the cow story is more my speed...........
Old 03-23-2009, 02:53 PM
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Originally Posted by WGHowardIII View Post
Isn't the converse true......the bank may have a performing mortgage (someone paying like you and me) and the bank is forced to write it down because in the current environment it's unsellable, so it's value is zero?
Not necessarily. A portfolio of loans has to be evaluated on a case by case basis. I have a straight up 30 year fixed loan with substantial collateral supporting the loan......that is very different than a subprime POS loan where the borrower put nothing down and the house is located east of Los Angeles. The bundling of loans typically involved grouping similar loans into a portfolio. Subprime portfolios are not worth much money.....portfolios of 30 year fixed rate loans are worth more.

The unique problem of the current environment is the lack of willing buyers for any mortgage-backed bonds given the uncertainty of what they are buying. Congress is talking about allowing bankruptcy judges to cram-down residential mortgages and screw around with the interest rates and duration of the contracts........uncertainty of the terms of the agreements, with all other factors being constant, kills the value of a bond.
Old 03-23-2009, 02:54 PM
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Originally Posted by SIM View Post
I think the cow story is more my speed...........
I should have used some crayons.

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