Posted on 02/21/2010 12:15:09 AM PST by TigerLikesRooster
Sunday, February 21, 2010
Das: Mark to Make Believe – Still Toxic After All These Years!
By Satyajit Das, a risk consultant and author of Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives
In 2007, as the credit crisis commenced, paradoxically, nobody actually defaulted. Outside of sub-prime delinquencies, corporate defaults were at a record low. Instead, investors in high quality (AAA or AA) rated securities, that are unlikely to suffer real losses if held to maturity, faced paper – mark-to-market (“MtM”) – losses.
In modern financial markets, market values drive asset values, profits and losses, risk calculations and the value of collateral supporting loans. Accounting standards, both in the U.S.A. and internationally, are now based on theoretically sound market values that are problematic in practice. The standards emerged from the past financial crisis where the use of “historic cost” accounting meant that losses on loans remained undisclosed because they continued to be carried at face value. The standards also reflect the fact that many modern financial instruments (such as derivatives) can only be accounted for in MtM framework.
MtM accounting itself is flawed. There are difficulties in establishing real values of many instruments. It creates volatility in earnings attributable to inefficiencies in markets rather than real changes in financial position.
Alan Greenspan once noted that: “It has been my experience that competency in mathematics, both in numerical manipulations and in understanding its conceptual foundations, enhances a person’s ability to handle the more ambiguous and qualitative relationships that dominate our day-to-day financial decision-making.” He may be the only one qualified to understand modern financial statements.
MtM accounting falls well short of its objective – the provision of accurate, reasonably objective and meaningful information about financial position.
(Excerpt) Read more at nakedcapitalism.com ...
P!
I have advocated “mark-to-contract” which is then has mark-to-market” as a backstop. By that I mean, if the contract is performing ... no delinquencies on the contract, conforms to best practices in lending, the customer is not in default with anyone else, then the firm can use the contract value. However, if any of the above occur, the mark-to-market rules apply.
This rule screwed up a lot of banks in terms of liquidity, and leverage all due to moving the values of securities held for investment to market.
I agree completely. How else would you value these contracts? What makes me nervous is hearing you say what OUGHT to be the rule, because apparently it isn’t. That’s scary.
What is at issue is the understanding of “performing”. If the value of the underlying security / asset drops below the amortization schedule, how do you handle that situation.
When that instance happens and the borrower is unable to make the payment, then it is obvious that the value of the contract is now less and there needs to be a reset of the value of the underlying asset.
However, what do you do when the borrower continues to pay full value for the contract? If there is no reason to suspect that the borrower will default, the the risk percentage has not changed but the volume of the risk has increased. Mark to market attempts to expose the risk to investors by requiring the lendor to take the loss right away -— even if the borrower continues to pay on schedule. I believe this increases volatility in the lending markets by forcing a faster write down that what is happening in reality.
Another option might be mark-to-value and report risk. If we evaluate the decline in value of the underlying asset at market price and then compare to the relative schedule (amortization) and assume that loss of value is first absorbed by the borrower, then the current percentage of ownership under the orginal schedule could be used as a measure of value. For example, lets say a borrower put 10% down and has paid on the mortgage for 8 years and thus has build up say 15% of equity against the original value. That would leave the lender with 85% of the original value. If the market value drops below the original value say down to 70%, then the lender is holding an additional 15% risk. If the borrow continues to pay on schedule, then the asset is reported as performing and no further action is required. However, it should be reported that the contract is carrying an additional 15% of risk in it’s reports so that investors will be aware of the situation. This would continue until the value drops below the scheduled value.
If the borrower misses payment, or is late, then the percentage of default is much higher and the asset needs to be reported differently. Mark-to-market should then apply and the risk loss is taken right away.
This way, performing assets (90% of mortgages) are not going to burden the banks capital reserve or solvency numbers as long as their customers continue to pay the mortgages.
My only remaining question is about the reporting. Your example lists single instances of performing but over valued and non-performing over valued assets. How would the reporting be done for a large number of assets, i.e. valuation of the total assets, risk percentage, etc? Would it be done by average level of risk? Would an "average risk" reporting method present any risk of mis-stating the real risk? Thanks for any input.
What do you do with commercial loans with balloon payments due, say, in six months.
You know they can’t refinance in the current environment—which means you are facing an imminent major loss.
You know that the loan will need to be restructured (at best) to make it work. If you don’t show some sort of mark-down on your books now you are misleading the public.
Well, we are way into hypothetical here so let me position how I would expect it to be handled. Understand I am on the IT risk management and assessing IT risk with regards to overall regulation and reporting for the purposes of capital reserve.
In the “most accurate” world, one would assume that you could track annual performance against value. In that scenario, the 15% of additional risk could be valued to a reasonably hard dollar and in the comments section of liabilities, you would total the additional risk. I would call it risk projection or some such. It would not actually modify the bottom line but a savvy investor would certainly want to take it into account under liabilities to gain a greater picture of the value of the business.
Another possibility would be to declare the total number of assets that are additional risk projection. You could then provide a range of risk percentages or an average percentage. Not as good as the “most accurate” model but still a solid indicator. If the total number of additional risk assets is viewed as a percentage of the total number of assets say 50% then the lender is likely to be in some real trouble.
This is more of a future contract risk as opposed to a current or past contract risk. In the case where the customer has not made payment, then there is no issue, the contract is non-performing and must be marked down.
In this particular case, you have a future event that MIGHT or MIGHT NOT, create a situation where the customer is unable to pay. Projecting future risk is far more guess and far less science. However, the same method could be applied.
At the point of time where the demand payment is due, the lender does not know if the customer will pay the note or not, and probably does not know the method of payment. The could pay in cash, pay by refinance, or some combination of the two. Heck, they could even sell the asset outright.
So to make this work, you would need to project the value of the asset at the time of the balloon payment and work the percentage calculations as a percentage of the original contract. Again, assume that the borrower will suffer the loss if the value is lower. If you think of this in the abstract, the borrower would be revaluing the asset with a loss of equity, cash and refinance.
What is material to the financial statement is “Do the original terms and values still apply, and if not, what risk does that represent to the lender”.
So lets assume that the bank would rather revalue the asset and decides to convert the terms to a straight line payment. The asset would need to be revalued and the difference between the original contract value and the new asset value would be a loss that would have to be reported. Until revaluation or default happens, you are not changing the books but alerting investors via comments.
So lets say the balloon payment is $200,000 and the property is only projected to be worth $150,000 when the balloon comes due. That is a $50,000 risk that needs to be reported. Until the contract is revalued, that would need to show up somewhere in the financial, and I would assume it would be under the liabilities section under comments.
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