Marking to Markets.

Banks Get New Leeway in Valuing Their Assets:

The change seems likely to allow banks to report higher profits by assuming that the securities are worth more than anyone is now willing to pay for them. But critics objected that the change could further damage the credibility of financial institutions by enabling them to avoid recognizing losses from bad loans they have made.

Here are two good summaries of why it is worthwhile to keep marking-to-market: from CAP and from Baseline Scenario. Mark-to-market versus mark-to-model is an incredibly esoteric and dorky thing to talk about, even for accountants and actuaries, but the underlining idea of the debate is easy to think about in other contexts – let me give you some in a less serious context for Friday.

The Baseball Card Bull Market of the Early 90s

So in the early 1990s, when I was in Junior High, there was a craze about collecting and trading baseball cards. Our classroom would have a corner during lunch where we’d all compare, with our binders and those 3×3 plastic containers for cards, who had what, and we’d trade back and forth accordingly. And of course we had our model, The Model, in fact, the Black-Scholes of our trading:

So while other kids were mowing lawns or delivering newspapers, I decided I was going to make my profit by arbitraging the volatile Frank Thomas rookie card market. I took a highly leveraged position in the Upper Deck Frank Thomas rookie card – I borrowed against future allowances, and bought several cards for $7 each from a kid who wanted to get out of collecting baseball cards in order to try hanging out with girls (loser!). Upper Deck is like the AAA of baseball cards. The guide said that these cards were worth $9. Buy at $7, sell at $9, instant money. My dad took me to the convention center, and I was all ready to make some cash money, when I found out that all the tables were only buying them for $5. Sensing my frustration (and also perhaps worried, since, like the FDIC or those with a savings account, he was providing all the leverage for me), he asked me, “wait, what are those cards worth again?”

I answered that they are worth $9. That’s what the guide, my model, says they are worth. No doubt those guide values are created by the most brilliant minds available. My dad, not in business or finance, was very clear in trying to explain to me “no son, they are only worth what someone is willing to pay you for them.” I responded that this card convention center was completely wrong in how they were valuing my baseball cards. I was but a little financial engineer back then; now I would have know to say “Dad, clearly the Soxs are having a bad season, and/or this isn’t the time in the year-long sporting cycle when demand is reasonable for baseball cards. I don’t feel I should get punished for the normal ups-and-downs of the baseball cycle.” I may have also noted that the flood of crap Fleer-brand baseball cards, the Mortgage Backed Security of its day, was destroying liquidity in the market, but that I had the trust of then Treasury Secretary Brady to start buying up those crappy baseball cards and get them transferred onto the government’s balance sheet.

So who was right? Me, with the model of the Baseball Collectors Guide and the excuse of the business cycle, at $9? Or my dad, who says they are worth whatever somone is willing to pay you in an open market, at $5? How you answer that question should color how you are disposed to to marking assets to the model, versus marking them to the market. Mind you, this was not just an academic exercise – at $5, my dad realizes I’ve made some terrible calls, and is probably going to make me start mowing lawns until I can pay him back. If I could convince him they were worth $9, I would not have to mow lawns (which I sincerely did not want to do) but instead could probably borrow some more…

Dorm Room Debates

I was chatting with a distinguished older businessman I was introduced to; educated with an MBA, brilliant business mind. He was complaining about Mark To Market.

Businessman (BM): The problem with Mark to Market is that the market can’t get the true value of an asset all the time.
Me: But isn’t the true value what the last person is willing to pay?
BM: Yes but what about assets that are longer than the business cycle, that are getting hammered over the short term? And isn’t it a backwards way of viewing things, from a risk-management perspective?
Me: I worry too that Mark-to-Market is pro-cyclical instead of anti-cyclical – it encourages risk-taking when things are good when solid risk-management requires leaning against the business cycle. I’m more than open to improvements there, but isn’t the general idea of marking to market the right basis?
BM: Not necessarily. What if the true value of the asset is higher than what the market wants to pay for it though?
Me: You keep saying true value, and I don’t know what that means in the context of assets outside of markets. I’m not actually sure if I know what it means for anything… [preparing to drop the Rorty bomb!]
BM: It means what it is actually worth, really worth, independently of markets and cycles.
Me: Wait, what? Is this like a Neo-Kantian thing?
BM: Wait, Huh? No, it is like any asset has a value, an essential value that it really hold outside of people, who may be confused or constrained or otherwise unable to acknowledge the value of the asset, bidding on it. The people holding that can know that better than the market sometimes.
Me: But isn’t the whole point of a market economy that commodities find their essential value within the bidding and trading mechanisms? Isn’t the informational aspect of markets like, the whole reason we have capitalism? Even if I grant your point, insider agents working with secretive ‘models’ shouldn’t be considered the best information agents here. Stocks and bonds valuations don’t, or shouldn’t, exist in an a priori plane; the fact that they go through the business cycle like everything else is factored into their valuation by markets.
BM: But what markets are wrong, because they are blinded by short term interests or their own illiquidity, to see the essential real value of the assets? What if they can’t understand the additional information, or ignore it, or don’t recognize it as information?

At this point, I almost expected him to say “the problem is that all we can see is the shadow of the assets projected on a wall, not the real Form of a bond comprised of $500k loans to junkies. If only we could see them outside the limited cognition of our cave, see these mortgage-backed securities in the light of the actual Sun….”

Want to know how I know your markets are fucked? Because distinguished men of business and finance sound like hipsters trying to make their way through a seminar on epistemology.

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16 Responses to Marking to Markets.

  1. Pingback: The Form of the Bond | Condor Options

  2. Dismalist says:

    Good post.

    This mark to market stuff also reminds me of Smith’s and other early economists idea of a natural price.

  3. Jacob says:

    I’m really enjoying your blog ever since Felix Salmon pointed it out. This is a great post; I love the baseball cards analogy, and I agree with your position on mark-to-market. But I don’t quite follow your Plato argument. The whole point of the allegory of the cave is that the shadows that form the entire experience of the prisoners aren’t real. They need to go see the light. I’m not sure why there’s a problem with resorting to Plato in pointing out that sometimes collective wisdom (i.e. the market) is blind. By comparing acceptance of that analogy to struggling through an epistemology course, it seems like you’re suggesting that the shadows really are what we should go by. But like you said, maybe the markets really are fucked.

    In this particular case, I’m inclined to think that our distinguished men of business and finance are full of shit, markets are valuing things just fine, and that banks need to accept that they bet wrong and lost, but in principle I don’t see a good epistemological reason why the market couldn’t be completely off-base for a while. Surely you’re not arguing that the market is always efficient?

    Suppose in your case that the conventioneers were colluding to rip off kids, and there was in fact a healthy demand of $9 per card outside the convention center. Is their $5 bid the only empirically valid value of the card in that case? Maybe you would learn the truth (see the light) eventually, but as long as you were in the convention hall (cave), $5 per card would be the only price (shadow), no? What’s the problem with that analogy? I don’t think you have to resort to some kind of neo-Kantian pure reason argument for the $9 price, either. The book value may well have been based on actual sales prices outside, in some other market, beyond the convention hall.

  4. Jacob says:

    P.S. I’m not a hipster, I promise. I just don’t see why it’s unreasonable to try to justify suspending mark-to-market (which I agree is a bad idea) with Plato!

  5. Dismalist says:

    Jacob, I think the point is that the very people who would usually be talking about how the markets are everything are now talking like “hipsters trying to make their way through a seminar on epistemology”…

  6. Mike says:

    Thanks for the kind comments all, I wanted to throw out something breezy for this Friday. What would you want to hear more of? I’m not sure if I should take this blog more technical and details orientated, or more abstract and conversational.

    Jacob – ha! It’s ok if you are a hipster. It is totally reasonable argument, of course, hence a lot of people making it – except probably hipsters. I go back on forth on financial market efficiency – I like Andrew Lo’s arguments on “adaptive markets”, personally. I think Mark to Market can be messed up if done incorrectly, because it gets the risk incentives backwards; but mark to model has a whole other hosts of problems.

    To paraphrase Leo Strauss on modernity, maybe marking to the models of sophist financial engineers and back-office kids just leads us to a deeper cave underneath the one we already are in….

  7. financeguy says:

    Beauty! Dialogue was a great read … a Socratic teaching of a Platonic lunkhead! Gotta love it (though it’s a little scary — this is a BRILLIANT business mind?) It’s funny how m-to-m never gets questioned in a bubble but as soon as bitter reality strikes, it comes under intense scrutiny. There seems to be a weird line of thinking that assets have some inner essence, like a fundamental quality of doggedness we can’t glimpse in a live viable dog.

  8. Tom Cole says:

    Well, I’m sure when their models show that the markets are overpricing their crap that they will immediately mark it down to their model and not use the higher market price, aren’t you?

  9. Pingback: Happy Hour | Refinancing

  10. Jacob says:

    Dismalist, point taken, and Mike, thanks for the reply. I wouldn’t presume to suggest content—you’ve drawn in people like me with the combination of hilarity and frighteningly on-point technical analysis in posts about gaming PPIP and looting the FDIC; your perspective is what’s interesting, irrespective of the style.

    As for Strauss, nice. I think that if the Modern is the age that recognizes its own modernity, then maybe it’s time we started marking models to market….

  11. Not the Mike You're Looking For says:

    Mike,

    This is the best explanation of mark-to-market that I have read. Funny, too!

    Can I take advantage of your good nature? I’m confused about today’s announcement that the Obama administration will swap preferred for common stock. The blogosphere seems to be divided between those who think preferred is “tangible equity” or not–and therefore whether this move creates value out of thin air.

    Basically my confusion is about how banks actually work. I’m dimly aware that they can, in essence, create money by multiplying deposits. Related to that, there’s a lot of confusing talk about “Tier I” and “Tier II” capital. (Unfortunately, my understanding ends with Friedman & Schwartz’s discussion of “high-powered money,” which I only half-understood anyway.)

    I’d like you to go into the technical details–in other words, write another “nerdy” post. For instance, what happens when I transfer funds from one bank to another? The funds at the first were a deposit, right? If I convert them to currency, they are paid out in an obligation of the government, while deposits are bank liabilities. So how does that transformation work? More to the point, where does that money come from? Does the bank have to raid its reserves, and thus lose access to a multiple of the actual withdrawal (because of the multiplication of deposits)? Meanwhile, does the other bank gain reserves? (And what counts as “reserves” anyway?) Would it make any difference if I simply wrote a check from one bank to the other?

    I hope this is enough for you to understand where my confusion is coming from. Can you help a brother out?

  12. ts says:

    First time reading your blog (via Ryan Avent).

    Loved the post: A sports analogy, finance conversation that made me think (and re-think) for a bit, followed by a reference I didn’t quite understand (thus spawning a 10 minute personal research project into plato and speleology).

    I have no place suggesting content, but, for what it’s worth, the blog is already on my rss and I look forward to future posts.

  13. Mike says:

    Thanks all

    Other Mike – that’s a tall order! BaselineScenario has some really good guidelines and introductions, and you should be able to trust them all for the most part. If you are new to finance, read up on the difference between a stock and a bond, how and in what order they get claimed, what happens if they don’t, to get yesterday’s plan’s disagreements. Preferred stock is a kind of inbetween a stock and a bond, and the disagreement is how moving preferred stock to stock effects what is going on with the debt.

    I think this isn’t just clever accountancy, but I also don’t think it will do all that much. They are really getting nervous about having to go back for more TARP money, I imagine.

    As for banking in general, grab a textbook or a technical guide. Stay away from ideology, the Austrians and the Economists and the internets, at least until you understand the textbook stuff. Though I’m going to break that rule and recommend this as an excellent money-macro blog:

    http://blogsandwikis.bentley.edu/themoneyillusion/

  14. donthelibertariandemocrat says:

    The way to determine a price is to appeal to agreed upon criteria while negotiating. That’s what auction records are for, for example. Without agreed upon criteria, prices would make no sense. You cannot have a private price.

    It makes sense to argue that the truths of math and logic exist independently of human existence, but I don’t think that it makes quite as much sense to say that prices do.

    One question to ponder is whether “What something is worth” and “What something can be exchanged for” mean the same thing.

    Following Tarski, we can say that “The price of x is y is the true price” iff the price of x is y.

  15. Not the Mike You're Looking For says:

    Thanks for the reference. The blog looks interesting.

    I’m familiar with the difference between a stock and a bond. It’s the “Tier I,” “Tier II,” etc., that confuses me. If I had to restate the question, I’d ask, what is the controversy over?

    Maybe you can just give a thumbs up/down for either of the two scenarios. As I understand it, one way the shift would increase bank capital would be through the private market. Theoretically, investors will be more interested in ponying up funds because they no longer have the government’s claims in their way; instead, they become first in line for any earnings of the firm (presuming they buy preferred). However, they should still be skeptical because with such a large equity stake, the government can’t commit not to take actions against new investors’ interests–for instance, finance General Motors.

    The other position seems to be that common equity counts as reserves but preferred does not. Theoretically, then, the shift from preferred to common actually “creates” money because of banks’ ability to multiply reserves as deposits. However, this probably won’t happen because banks would be willing to multiply deposits only if they thought that (1) there were some incredibly safe lending opportunities out there and (2) they believed that they won’t be receiving demands from depositors, investors, or counterparties that they must redeem in currency.

    So which is it?

  16. Other Mike,
    You may have heard the term ‘regulatory arbitrage’ before, it usually refers to the way investment bankers would ‘innovate’ and create new financial products that are usually fairly basic investment concepts (long asset, short asset, hedged long, etc.) but have been juiced up by moving them to either a more favorable regulatory purview or outside of regulatory purview altogether. A very simple example is securitizing mortgage loans to make them securities rather than whole loans, thereby requiring less capital to be held by a financial institution despite being the same essential item, and therefore allowing more leverage to amplify returns (or losses). For reference, see: http://en.wikipedia.org/wiki/Arbitrage#Regulatory_arbitrage

    The most convincing and ridiculous reason that the preferred to common swap by Treasury should mean very little to those interpreting the situation from the outside (investors, taxpayers, etc.) is that it’s just regulatory arbitrage again, but being practiced by the regulator. Because common equity is counted in a different tier of capital for regulatory purposes than preferred stock, converting the Treasury stake from preferred to common would immediately boost the ‘Tier 1′ measure of each bank’s capital without actually adding more capital to the institution.

    Sure, there are some real world differences (reducing dividend preference and obligation, shifting order of claims in a BK scenario, enhancing voting control for Treasury) but most of these aren’t game changers. If you believe that a few billion is all that’s needed to absorb the incremental losses on trillions in assets, then this would be a good move for management and bondholders (and marginally less bad than losing everything for common, since you’re diluted ridiculously to save something). But if you believe there’s more than a few percentage points of additional loss capacity needed, then this just delays the inevitable need for more money rather than just shifting it around.

    I guess we shouldn’t be surprised that regulatory arbitrage is alive and well, since the investment bankers that used to do it in the private markets now mostly run the regulators. Same guys, same game, much larger playground. Oh, and same victims every time.

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