East Coast Economics

Increasing Toxicity: FAS 157 & Marking to Market

with 3 comments

FAS 157, the accounting rule requiring financial institutions to mark their assets to market, has frequently been cited as a factor exacerbating the crisis. Steve Schwarzman is a vocal opponent of the mark to market rule in its current form, arguing that “the rule is accentuating and amplifying potential losses.”  And while I’m sure an accounting rule is not the cause of the mess we’re in, I don’t always see the cause for marking assets to market – especially if they are fixed income products intended to be held to maturity which suffer primarily from a lack of liquidity in the market and only secondarily from fundamental impairment.

Today there’s talk of potential changes to FAS 157; at a minimum, it seems like we can expect to see some guidance on the application of the rule that might qualify or relax the mark to market requirement.  I haven’t yet made up my mind if I should like this development – one half of me appreciates the potential relaxation based on the above reasoning (liquidity vs. fundamentals), but the other half fears that a decrease in transparency may cause prolonged or additional trouble down the road.

In addition to the impact FAS 157 has on asset markdowns, though, there’s another important side effect of the rule that tends to be forgotten:  financial institutions know that they will have to mark their books to market, using whatever price comparable securities last traded at when they value the securities still on their books; as a consequence, when banks unload parts of their portfolios of toxic assets, they will make sure to sell those securities that are of good enough quality to find buyers at the price that the bank’s’ book was last marked at – otherwise the bank would not only take an additional loss on the assets it is selling, but it would also have to take further writedowns on the securities remaining on its balance sheet.  In an environment like today – i.e. one of continuously deteriorating fundamentals – this means that sellers will have a strong incentive to sell higher quality assets first.   The result: increasing toxicity of the assets left on the balance sheets of financial institutions.  Where’s the silver lining?

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Written by eastcoasteconomics

March 12, 2009 at 5:35 pm

3 Responses

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  1. I don’t know much about this, but I read somewhere that banks have mark-to-market accounts and other accounts for securities that are meant to be held to maturity. The banks have the option of putting the securities into whichever account they want. The difference is that they’re allowed to use much greater leverage on the mark-to-market accounts. This makes sense because if they’re highly leveraged, they should be forced to account for that leverage if things go the wrong way against them. The banks are complaining about mark-to-market, but they could have chose to hold those securities in non-market accounts and they would not have to take the writedowns. They chose to take the leverage over the safety and now they complain about it.

    The other problem is that the non-market accounts have to value their assets according to some model. Some models are well-known and give good results, but some securities are very difficult to model. And we need to be careful to not allow them to make up whatever model suites their tastes. As has been shown in the recent crackup, their models don’t account for a lot of things.

    So I agree that there’s a time and place for not using mark-to-market, but I think it’s difficult to apply in any broad-based fashion. Coupled with the fact that the banks chose to place things in mark-to-market accounts when it benefits them and then complain about it when it doesn’t benefit them. I think whatever you do on the way up should be the same that’s done on the way down.

    The argument that mark-to-market makes things much worse than they are in illiquid markets works in reverse. During the boom times, much of this stuff was marked much higher than it was really worth. No one complained about that, but now everyone freaks out when it goes the other way. So mark-to-market is maybe excaberates the problems, but it did so on the way up too.

    Jon

    March 12, 2009 at 6:36 pm

  2. The real problem is with the product. Securitized debt of multiple debtors is crap, whether mortgages, credit cards or car loans. Bond ratings require that any loss on a security requires that security to be rated as junk (CCC). So any of the debtors becoming delinquent or defaulting in a securitization requires a AAA security to become CCC. That’s a very crappy security to have in any portfolio – mark to market – or not.

    The securitization market is dead but the government wants to revive it. It’s a great business for those that originate and sell this crap (read contributers to politicians) – but no regulated financial institution should be allowed to own it. Not in a ‘for resale portfolio’ or in a’hold till maturity’ portfolio. Crap is crap no matter how much room freshener you spray on it.

    kirk clements

    March 13, 2009 at 11:08 am

  3. kirk, I don’t think securitization itself is crap, but the poor implementation of it is. Securitization allows more investors to enter the market and provides greater liquidity and a lower cost of capital for everyone.

    By having different tranches for any pool of debts, you can allow some defaults in the pool while still providing a buffer (via the equity tranch) that will protect the AAA rated tranch.

    Obviously the ratings agencies were not doing their job and had a huge conflict of interest, as did loan originators. But again, that’s all implementation-specific. Securitization itself is a good thing. Do you agree?

    capitalkid

    July 7, 2009 at 4:34 pm


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