Comments on: Strong Arguments Can Be Made Against Mark-to-Market Accounting

By: shepherd

shepherd — Sun, 08 Feb 2009 13:03:37 +0000

I don’t think Chad is advocating irresponsible accounting. Applying cash flow modeling to a security is not the same as saying that a stock worth $50 should be worth $100.

Standard CDOs are not made out of air–they do have structures, rights, trustees, and sources of income. They may be a little complicated, but nowhere near as opaque or dangerous as is commonly believed.

If a person is knowledgeable enough and takes the time, the future cash flows of these things can be reasonably modeled (and there are also other methods you can use in addition to cash flow).

If the bank is planning on holding the CDO to maturity, then the present market value in a time of hysteria shouldn’t matter. Banks shouldn’t be forced to fail because of this.

By: Chad Brand

Chad Brand — Thu, 05 Feb 2009 23:29:50 +0000

Level 3 assets by definition have no market price, so you can’t use mark-to-market. I find it interesting that people are worried about getting rid of FAS 157 when we already have plenty of assets without a market value that are being valued on the books using certain assumptions.

The cash flows from these assets should be booked as the cash is collected. A mortgage held on a bank’s books has no “market” price but we have no problem accounting for those. I don’t see why mortgage backed securities can’t be treated the same way. Why should packaged loans be valued differently from underwritten loans held by the bank?

From my perch it seems that disclosure about what the banks have on their books and the cash flows they are collecting on them is more important than trying to assign a fair value to something that is being held to maturity.

Maybe ABS should be treated just like loans. You monitor their cash flow and build credit reserves for expected future losses based on their performance. Mark to market is a new idea, but bank financial statements were perfectly fine before FAS 157 was written in 2006.

By: Ryan

Ryan — Thu, 05 Feb 2009 23:08:26 +0000

Ok… correct me if I am wrong. What you are arguing is that if you have a level 3 asset(Anything where the price is not easily observable. Ie. loans, securities, derivatives including bonds and options on indexes…yadda yadda yadda) it should not be marked to market? Instead, they should be marked according to the models that are based on “actual cash flows being generated.” How do you take account for the future cash flows over the next 30 year life of that asset? What will the conditions like over the course of,lets say, that loan?

Question:What if it was reversed, If I had a Level 3 asset that according to my “current cash flow” I thought added $1.24B at teh end of 30 years. Should I be able to count that as a $1.24B profit this year? next year? Year 15? or at year 30? What if the “current cash flow” varies over the course of the 30 years?

Also, a large part of the problem is that you don’t take in account the credit derivatives that are leveraged up against these illiquid assets. Awesome. Now there are these CDO that have appeared out of air they can now be marked-to-fantasy because there is no easy way to check this derivatives value against the asset it is being derived from. Leaving you with basically the same problem only 2x leveraged.

I guess what I am saying is that you cant have your cake and eat it too. Marked-to-market even if there is no easily approachable market is the only way to be real with ourselves in present terms…not future expectations.

By: Jeff

Jeff — Thu, 05 Feb 2009 18:16:56 +0000

Ryan’s comments are very valid. Also, not only Warren Buffett, but even Jamie Dimon (JP Morgan) prefers M2M. Conservative M2M is not ideal but it is far superior to a ‘fair value’ number that can be whatever a company wants it to be, and which may have little to no relationship to its likely realistic current market value. In short, we need better clarity on current value not less. Until something more accurate is devised, keep M2M.
Jeff

By: Chad Brand

Chad Brand — Thu, 05 Feb 2009 14:52:59 +0000

I agree with #2 and #3, Ryan. On the first point though, there are methods of assigning fair value to assets other than market value, as the previous commenter pointed out. As a result, not using mark-to-market does not result in “bogus” values. It seems to me that fair value estimates based on actual cash flows are likely to be more accurate than simply using the last market price. Most of these assets don’t have liquid markets, and illiquid markets typically don’t provide reliable estimates of fair value.