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.