No Runny Eggs

The repository of one hard-boiled egg from the south suburbs of Milwaukee, Wisconsin (and the occassional guest-blogger). The ramblings within may or may not offend, shock and awe you, but they are what I (or my guest-bloggers) think.

I’m not a CPA but I did stay at a Holiday Inn Express last night

by @ 7:00 on April 3, 2008. Filed under Business.

Actually, I am/was a CPA but that’s a separate story.

“Mark to market” is a term that few if any, outside of the financial or accounting industries had heard prior to mid last year.   Now, most people have heard the term and know that it is somehow related to the problem of the subprime market.

In short, “mark to market” means that financial institutions need to recognize the market value of their investments as they change rather than waiting until they dispose of the asset and recognizing a gain or loss.   The purpose for “mark to market” is to reflect the estimated “value” change of the asset real time rather than having shareholders or mutual fund holders get surprised (up or down)  in one fell swoop.

Numerous articles have been written suggesting that mark to market while not causing, greatly exaggerated the subprime issues.   The argument, one that I support, is that when the ability to sell what used to be “marketable securities” i.e. the bundled subprime mortgages, dried up and the only way to sell one of these was through   a forced or coerced sale, the value of these bonds was set artificially and unrealistically low.   The result was that financial institutions holding these bonds were required to write their values down to a “market value” which was substantially less than what the reasonably expected value of the loans were.  

By way of an example, imagine you owned a car that had a fair market value of $15,000.   Now, imagine that you found yourself in a financial bind and needed $7,500 immediately.   You are unable to borrow money, you have no money in savings to draw on.   The only way to get the money you need is to sell some assets.   Because the buyer knows you’re desperate for cash, they low ball an offer on your car and because you desperately need cash, you agree to sell your $15,000 car for $7,500.   In the financial world, the fact that you only got $7,500 for your car, regardless of the circumstances, meant that all cars like it now got marked to a market price of $7,500.   Never mind that your sale was “forced” or that it was reasonable to assume that other similar cars could sell for $15,000.

The above situation, while a much simplified version,  is exactly what was happening to the subprime loans.   Yes, there was concern about defaults that would take some of the value out but, as I pointed out here, the NYfed thinks the actual loss after default, could be significantly less than any of the numbers being arbitrarily floated.

The Fed has finally issued a clarification that explains that “mark to market” should discount circumstances where securities are transacted via a “fire sale.” Admittedly this adds some ambiguity to the process. Even so, this seems to make a lot of sense.   While investors and regulators would like conservatism in estimates they also know that numbers that aren’t “real” provide little value.

Over the next few days you’re likely to see and hear comments like this about the Fed’s clarification:

The language is technical, but the arguments here are simple and really quite silly"”especially coming from folks who value market indicators over all else. These folks are saying that when markets are volatile and irrationally pessimistic, it’s just not fair to force people to act as if the market prices are real.

Remember that that isn’t what the Fed is saying.   The rules have always been meant to estimate the”fair value” of the security.   According to the group who promulgates accounting rules, FASB, “Fair Value” is

the price in an orderly transaction between market participants to sell the asset or transfer the liability in the market in which the reporting entity would transact for the asset or liability, that is, the principal or most advantageous market for the asset or liability.

(emphasis mine)

My point is that while critics will try to point to the Fed’s clarification as more “corporate bailout” (and further justification for the “main street bailout” of home mortgages), the Fed is only pointing out language that has always been a part of the definition but, because we’ve never seen such a fast melt down of a specific asset class before, had not been fully thought through and applied.

Based on what I’ve seen since the Bear Stearns transaction, I’m willing to give the Fed the benefit of the doubt.   These are unusual times.    Correcting and adjusting will continue and should be expected.   It doesn’t mean that the Fed is trying to pull a fast one on us.

3 Responses to “I’m not a CPA but I did stay at a Holiday Inn Express last night”

[No Runny Eggs is proudly powered by WordPress.]