If you haven’t been able to make heads or tails of the credit crisis, read this.
Thursday, March 12, 2009 is the day the House Securities Subcommittee will hold a hearing on mark-to-market. The chairman of the committee, Paul Kanjorski (from Pennsylvania) seems to agree with us — mark to market standards have proven “problematic” for banks.
Mark to market (also known as fair value rules) has been only one of the contributing factors in the recent credit crunch.
Many mortgage and bond-related assets, many of which had been AAA rated previously, have been experiencing a mandatory write down in value, because of these accounting rules. Many of these assets needed to be “re-priced” nearly every day. This is how Citibank could lose $28 billion in the last quarter. Think about that number. A quarter is only 90 days long — and not all of them are business days. And yet, for a bank (or any business) to lose $28 billion is hard to conceive. That’s over $300 million lost on a daily basis during the quarter.
How can that be?
Mark to market accounting rules required that banks write down the value of assets on their books — nearly every day. Even though these assets were not bought and sold (they couldn’t be sold — the trading market for asset backed securities has been frozen for nearly a year), they still needed to be marked down.
What I expect we will hear from these hearings on Thursday is something along the lines of “there should be an exemption from a need to repriced these assets on a daily basis since there is no liquid market for these securities presently.” I also expect we will hear a proposal to improve the situation these banks are facing. It would not be a big surprise to hear testimony proposing “mark to the model” instead of “mark to market.”
Mark To A Model
“Mark-to-a-model” is a proposal that has been gaining speed. Many have argued it is not realistic to carry these securities at the full face value of the underlying security, nor is it realistic to carry these securities at zero value either (like now). What might be a better — temporary — solution is a financial “model” that can gauge the average holding period of the securities, the average duration of the portfolio and a model of the credit composition of the portfolio. At least with a model, minimal (floor) values can be placed on the securities.
What would be the result of a change in mark-to-market, or instituting mark-to-a-model?
The first benefit would be a drastic increase in the book value in market value of the securities on hand at banks. No one is trying to game the system. By re-inflating the value of many securities on hand at banks, this will automatically raise the capital ratios at these banks.
So what?
Raising the capital ratios at these banks removes the need for bailout money.
You may have read recently that banks are “hoarding cash.”
Why would the banks hoard cash — especially when lending is needed to restart the economy?
Well, the banks have been required to maintain certain capital ratios, or be declared insolvent and run the risk of being taken over by the government, or closed. So, although the banks have received capital injections, with the purpose of lending, the same banks have been “hamstrung” because they need to maintain a certain amount of cash on their books to meet capital ratios.
These capital ratios will be met if they suspend mark to market accounting, at least on a temporary basis.
It may also help to re-ignite trading in these asset backed securities. This helps improve liquidity and lending capabilities. Put another way, you cannot borrow against securities that don’t have a liquid market and do not trade. While the “marginability” of these securities is severely hampered, just re-establishing a market for these securities is a step in the right direction.
Let’s hope they don’t screw it up.
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Mark to Market Accounting: a basic analogy
by Thomas Mullooly on March 12, 2009
How mark to the market accounting helped kill Wall Street
Mark-to-market accounting is what’s used in your brokerage account — your margin account at a Wall Street firm. To understand mark to market accounting, let’s look at what happens in a retail brokerage account that trades on margin:
Suppose you invest $80,000 in cash in a brokerage account. You sign up for margin capability. Before you place a trade in your account, you have the ability to buy up to $160,000 worth of securities with only $80,000. You will pay margin interest on any outstanding balances, and your “margin maintenance” is recalculated every night – based on the gain or loss in value of the securities in the account. This is how a margin account works.
Using the above illustration, you have 50% equity in the account, and have an outstanding margin (or debit) balance of $80,000.
Suppose the value of the assets in the account drop from $160,000 to $145,000. You now have 45% equity in your account. You still have buying power and seem to be in no imminent danger of a margin call. Remember, you still owe $80,000. If you were to close the account now, you would sell the assets for $145,000. The margin debit balance of $80,000 would be paid (margin interest would also be included). The securities dropped almost 10% in value (from $160,000 down to $145,000) but you lost nearly twice that percentage, because you leveraged the trade. You would be left with the remainder… approximately $65,000.
But suppose the value of the assets in the account dropped from $160,000 to $100,000. You now have 20% equity in your account. Remember, you still owe $80,000. At this stage, you have no more “buying power.” This means you cannot take money from the account, nor can you buy any additional investments. In fact, at 20% equity you have a “margin call” and your broker would be contacting you requiring you to deposit more money (or other securities) to boost the equity in the account.
Margin works wonderfully when the assets in your account are rising in value. But margin will wipe you out when the assets in your account are falling in value.
The assets in the account are repriced every single night in a margin account. And the equity is calculated every day and the amount needed for “margin maintenance” is also calculated every day. And when your account gets upside down, you have a margin call, and it needs to be rectified right away.
Margin accounts are calculated using mark to the market accounting.
Banks (and brokerage firms) that own mortgage backed securities have been required — since November 2007 — to use mark to market accounting on these securities. Coincidentally, this was just around the time these mortgage securities started dropping precipitously in value. 2007 saw many mortgage firms get wiped out, and brokerage firms and banks holding these assets started realizing the volatility of these assets.
Remember banks and brokerage firms were required to employ mark to market accounting beginning in November 2007 for mortgage backed securities. As real estate values collapsed, and foreclosures began to rise, banks and brokerage firms no longer wanted to hold the securities as investments on their books. It is no wonder then, that six months later (March 2008) that one of the biggest holders of mortgage backed securities — Bear Stearns — was caught in a massive credit squeeze. The assets that they regularly borrowed against were no longer “borrow-able.”
Bear Stearns — which had traded at well over $100 per share months before, agreed to sell themselves to J.P. Morgan Chase for two dollars per share. This figure was ultimately increased to $10 per share.
By mid– 2008, Merrill Lynch had decided to unload a $31 billion pool of mortgage backed securities that they owned, and essentially announced they would take the best offer. These mortgage backed securities had been held on the books (it’s estimated) at $.80 on the dollar. This pool was sold for $.22 on the dollar in July, only after Merrill Lynch agreed to subsidize part of the losses that might be incurred by the buyer.
These are anecdotes and examples using vast over-simplification and are being used to illustrate how mark-to-market accounting works.
While not directly connected, mark to market accounting required that other banks and brokers investing in similar type investments market their own similar assets down to similar levels. Thus, the entire mortgage backed market froze. Trades were no longer taking place, because every time a trade would take place, it would require the values of similar securities to be repriced everywhere. These securities could no longer find a value and could not be borrowed against, hampering most lending capabilities at these firms.
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