Mark To The Market

Hi Mark,

I would love to hear your take on the mark to market debate. I have been saying for awhile now that mark to market is responsible for the steepness of this banking crisis, but obviously not the root cause itself. Do you agree that the financials and the market in general would benefit from abolition of these rules? Do you agree that this is an issue that should have been addressed months ago?

Mark to market helped the financials skyrocket in boom periods and has sunk them in this crisis.

Income Trader

Hello IT,

I'm no expert on this situation, but I do have strong opinions.

1) Yes.  I agree that this issue should have been resolved months ago.  And must be resolved now.

2) Here's a question for you:  Assume you have a large  position that is short a substantial number of long-term strangles and that you have a downside bias – i.e., you are delta short.  Further assume that market conditions become uncertain and implied volatility soars to record levels. 

You love your position.  The market declined and starting with acceptable risk, believe you are in great shape.  After the market decline, you are now delta neutral and anticipate that the strangles will begin to shrink in value.

There's one little problem.  The strangles you sold @ $30 when VIX (CBOE Voltaility Index) was 50, are now trading @ $180 and VIX is 120.  Your account cannot take the loss of $12,000 per strangle because you sold too many.  Your account is in deficit.

When your broker threatens to liquidate your account unless you wire a huge influx of cash, do you believe you can tell the broker that: "It's just marks.  If we ignore mark to the market, my account is in great shape.  See how neutral I am."

You know you cannot.  You are over-leveraged and lost far more money than you thought possible.

How can your broker evaluate your account by any method other than mark to the market?  And if you cannot repay your debt, it's their money on the line.  They are going to liquidate – and probably at very unfavorable prices.

3) Thus, I'm a big believer in MTM.  If the financial institutions were forced to MTM daily, it would have been obvious that they owned assets in trouble (worth less than the value carried on the bank's books), and would have been forced to begin unloading them far sooner.  I don't know who would have bought these positions, but being allowed to continue to hide losses, become more and more over-leveraged, and essentially gamble with (what turned out to be) taxpayer money, is not right. 

I believe MTM is essential and levels the playing field for everyone.  The problem is, that it should have been enforced far sooner.  We would not be in this mess (It would be a different mess) if MTM had been enforced from the beginning.  Enforcing it now is going to make things more difficult.  But the fact that MTM was not enforced earlier is not an adequate reason for not enforcing it now.

4) I believe several of these big banks are insolvent, will remain insolvent forever, and have zero chance of recovering.  I admit that I do not fully understand the consequences, but I'm for nationalization right now

I believe the government should take all the garbage assets (we are paying for them anyway) and create new, clean banks.  Imagine Citibank with all of their assets: branches, customers, deposits, etc – and no bad loans on the books.  That would be worth many, many billions of dollars – and the taxpayers would benefit as the government sold 80% of that bank (gotta retain some ownership in the new, thriving business) to new, qualified investors.  Current officers, not eligible.  These healthy banks would have no reason to be afraid to lend to each other, or to the public.  Thus, the economy would have an increased chance of recovering quickly.  Continued stalling is not going to help these banks become solvent.

One more point.  I know there would be a market for all those currently toxic assets.  The government could sell those positions to anyone who wanted to bid.  That way, the taxpayer would no longer own them, would no longer have to throw good money after bad, and would have temporary, partial ownership in the recovering banking system.

Naive?  Perhaps.  But it sounds right to me.


6 Responses to Mark To The Market

  1. Income Trader 03/09/2009 at 8:08 AM #

    Good morning Mark!
    Thanks for entertaining my question even though it may not be necessarily directly related to options.
    I agree over leverage is definitly a major reason for the mess we are in. Not only by companies but by the government and individuals alike. It is going to take some time to deleverage our economy and more pain is in the cards.
    My issue with MTM is that it forces banks to take marks on all assets. Level 3 assets, which by definition are assets that are difficult to value using accepted valuation models, can distort the profit and loss statements of financial institutions in both good times and bad. I am all for marking to market securities that have readily available market prices or assets that can be marked by using like securities in valuation models that have market prices (level 1 and level 2 assets) but level 3 assets when marked in times of crisis, panic or in times of extreme speculation and boom, do not correctly reflect values.
    I believe that market is the best way to value assets but not thinly traded assets in times of crisis. In good times, banks were able to book these “phantom” MTM gains as income on profit and loss statements which distorted earnings and shareholder equity which in turn helped inflate stock prices. Now, the opposite has occured and these banks have had to write off billions worth of these assets.
    I guess to narrow down the issue my concern is not with MTM in general but with MTM of level 3 assets and especially in the application of these marks to banks.
    The truth is that the vast majority of mortgages in the US are current and the vast majority of mortgage backed assets are going to be worth a lot more than what they are being valued at today.
    Here is what I think (if I may be so presumptious)the government should do. Keep mark to market of level 1 and 2 assets exactly as it is. Freeze level 3 assets at 85% or 90%of nominal value until an effective market is created to trade these securities. This would allow banks to write down these assets as needed and not have the volatile effect on P&L statements. This would absolutely have the effect of unclogging banks appetite for lending and unfreeze the credit markets. That is why the original idea of the Treasury buying these assets and then creating a market to trade them was in my opinion a great idea and a good way to use taxpayer money.
    Have a great day!

  2. Mark Wolfinger 03/09/2009 at 9:07 AM #

    This discussion has moved beyond me. I don’t know what level 3 assets are, but I’m sure Google can rectify that.
    Thanks for the comments.

  3. GMG 03/09/2009 at 3:53 PM #

    Mark, as I understand it (Income Trader, please correct me if I’m not explaining this well), level 3 assets would encompass mortgage and asset-backed securities and things like CDS contracts that are based on the underlying MBS/ABS securities. Since these are loan receivables and depend on various factors like interest rate adjustments, prepayments and defaults over many years, the theoretical present value of the assets are not always the same as the market price of the corresponding securities or derivatives.
    I guess in a perfect market, buyers would fully evaluate loan characteristics and the fair market value based on bids would be close to the model value, but when buyers are in short supply and fear takes over, the market price takes a nose dive. That’s my understanding of it, and it’s not an easy problem to solve. I think most people would agree that these assets should be marked to market somehow, but that this is not a very objective method. If you’re interested in learning more, search for “FASB 157”, from whence these MTM rules come.

  4. Mark Wolfinger 03/09/2009 at 5:22 PM #

    I firmly believe that if anyone chooses to own thinly traded assets, then there is the risk of going bankrupt when ‘fear takes over.’
    I don’t see why a bank should be able to pretend it’s solvent when it isn’t. I know my broker would not allow me to do that.

  5. Russ Abbott 03/10/2009 at 12:25 AM #

    Great answer and great example Mark. I love your example of a delta neutral position that has exploded because of increased volatility but that still looks, on paper, like a potentially profitable position. As you said, no matter how potentially profitable it is, the owner of that position got over-leveraged and should not put others at risk as a consequence of that miscalculation.
    It may be the case that as Income Trader says some assets are difficult to value. In that case the banks that own them should not claim them as having any particular value and should not use them in the computation of their capital structure. They need not mark them to market. They can count them as zero! If they are worth more than that (as they surely are) then that will come as a nice earnings surprise. If a bank can’t afford to work this way, it shouldn’t be in the business of owning these assets.

  6. Mark Wolfinger 03/10/2009 at 9:57 AM #

    Glad you love my example. I hate it because it has happened to me. Many years ago.
    You cannot expect banks that have invested billions of dollars in assets that are difficult to value to assume they are worth zero. That’s not fair.
    It’s not a question of an earnings surprise. Banks use their capital to make loans and other investments. If assets are worthless on paper, they are out of business. If you say ‘well, then don’t buy those assets,’ then who is going to buy them? Sorry, that suggestion doesn’t work.
    Banks used to be allowed to leverage 12x their capital. When it was raised to 30 or 40, all hell broke loose.