Arnold Kling is defending Paul Krugman:
The Fed is treating the problems in financial markets as a liquidity crisis. What that means is that the assets that the institutions are holding, such as mortgage-backed securities, are really worth $X, but their current market value is, say, $X times 0.95, and no one will lend the institutions the money to enable them to carry those assets to maturity. If the Fed acts as lender of last resort, then eventually the Fed will get paid back out of the cash flows from those securities--more likely sooner, as investors regain their confidence.That's if the mortgage-backed securities are really worth $X. But if those securities are actually worth $X times 0.95, then the Fed will take a huge loss on behalf of its owners, the taxpayers.
Krugman thinks that housing market defaults are going to spread from the subprime segment of the mortgage market to the prime segment in a big way, so that mortgage-backed securities really are worth less than $X. I am less pessimistic than Paul in my outlook for home prices and mortgage defaults, but the probability that his forecast turns out to be approximately true is certainly greater than zero. So I don't see how you can say he is irresponsible for speaking out, even if it turns out that his forecast is wrong.
My argument is that the securities are almost certainly worth 0.95X, or perhaps 0.8X. But that isn't enough to produce a general insolvency crisis. Few of these firms hold the majority of their assets in risky mortgage backed securities, or permutations thereof. They will take losses, but banks take losses all the time. They won't go bust unless the crisis of confidence dries up their credit, turning a duration mismatch between their assets and liabilities into a fatal error.
But I certainly agree with Arnold Kling about this:
I am seeing a lot of people argue that the investment banks should not have to mark down the value of their mortgage-backed securities to the market value of less than $X. But the alternative of historical-value accounting (what the assets were worth before the market turned sour on them) is worse.To make a long story short, the reason that the U.S. taxpayers took such a big hit in the S&L crisis of the early 1980's is that S&L's claimed to be solvent using historical-value accounting, and so they kept borrowing more money even though they were actually insolvent. Market-value accounting provides better protection against insolvency.
There is no such thing as a perfect accounting system, but mark-to-market is a much more conservative accounting standard than the historical cost rule it replaced. In general, accountants like to reduce a CFO's discretion as much as possible; that's what mark-to-market does.
On the other hand, we could reconsider the proposal of my old financial accounting professor, Roman Weil: rely less on rules than on broad principles, and rotate the auditors, by law, every five to seven years. But just changing the rule back to "use historical cost" would, IMHO, be a big mistake.
"worth X" in the context of a bond contains both the recovery of principal and the yield needed to hold it to maturity. You need to be more clear on what you mean here.
Assume a bond is generally agreed to be highly certain of principal recovery. We used to say "is rated AAA" in this context, but, well, not so much anymore.
Nine months ago you could, say, finance 90% of that bond at Libor flat, so at a total bond yield of L+20 the return on capital was L+200.
Now, you cannot finance that bond. So, if your return hurdle is still L+200, you need to buy the bond for that yield. Which, if a 10 year bond, is a price of around 85.
Additional fun facts: your return hurdle went up, your available funds went down and since you cant finance the bond anymore, you can only buy 10% as much of it. So, lets just say that the market hasnt cleared yet even if this is a workable price.
So, we can say that this bond is worth X from the point of view that we all agree it will perform and pay X back, or we can say its worth 0.85 X because that's where it trades, even if not in anywhere near the size I need.
Now, let's say that the bond is only going to recover 0.95 X. Well, now the return requirement is no longer the L+200 we applied to a safe piece of debt -- this is now an equity, and needs to return, say, L+1500 (17.6% at today's rate). The price? 29.
This is why the Fed financing on the Bear deal is the right formula. In this case they lose zero if the asset recovers par vs a 15% loss on liquidation, or a 5% loss in the 95% recovery scenario as opposed to a 71% liquidation hit.
So, please clarify what you mean by "worth X" in this context.
"My argument is that the securities are almost certainly worth 0.95X, or perhaps 0.8X. But that isn't enough to produce a general insolvency crisis."
If you've borrowed assets equal to 30 times your base capital, a 3.33% loss on those leveraged assets means you're insolvent. That's the problem: Bear Stearns didn't just buy a bunch of junk; it bought thirty times more junk than it could afford. So a small dip in the value of the leveraged assets put it underwater.
A loss of 5% is not the end of the world if you're relying on your deposits. But these banks weren't. They were borrowing short-term and lending out long-term, at enormous leverage ratios. Now, no one wants to lend to them short-term anymore because no one knows what their loans are worth as collateral. You can either call it insolvent or illiquid or you can say that the banks' business plans are nonfunctional, but any way you look at it, banks are screwed--and so are we.
They were borrowing short-term and lending out long-term
Sounds like the business model of every bank since banks were invented.
My understanding is that a lot of mortgage-backed securities with face values of $X are being valued at $.3X when they might be conservatively worth $.8X or more. If that's the case, wouldn't it make sense for the government to buy up boat loads of these securities at a hefty discount -- say, $.5X -- to get them trading again? Conceivably, the government could unload them in a year or two for a substantial profit.
rely less on rules than on broad principles...
If only Milberg Weiss were still around to lobby for that change.
these guys: http://www.cfo.com/magazine/index.cfm/10788146?f=home_magazine
seem to understand the issue.
Doesn't mark-to-market increase a CFO's discretion, insofar as he or she must make a judgment call about what the market value actually is?
...rotate the auditors, by law, every five to seven years.
Now that would imply that the auditors were supposed to be actually working for the owners, rather than being in the hip pockets of the managers. What a concept!
I agree on auditor rotation, but the rest of the post makes little sense to me.
As many noted above, leverage can greatily magnify seemingly small fixed income losses.
Like Tom T., I do not understand how using historical cost could increase management's discretion. Mark-to-market is fine for publically-traded securities. For all other securities, it leaves plenty of discretion in the CFO's hands.
Tom
Tom G. is correct. In many cases, market value is not readily determinable. A lot of mortgage backed securities and other CDO's are not heavily traded, and in other cases, information about how those securities are priced when they are traded is not readily available.
In those situations, CFO's and auditors typically fall back on financial models to determine market values.
The problem is, which model is appropriate and what assumptions are incorporated into them (discount rates, default risk, dividend growth assumptions, etc.) are open to a lot of debate.
Mark to market accounting probably does allow for more transparency in financial reporting, but it can also allow for more chicanery as well.
"The problem is, which model is appropriate and what assumptions are incorporated into them (discount rates, default risk, dividend growth assumptions, etc.) are open to a lot of debate."
I would think a model that discounted the future interest payments/dividends/whatever the distributions on a CDO are called and adjusted for a default rate on the underlying mortgages would be appropriate.
Fred,
That's true, but what discount rate to use and what default rate to anticipate are far less objective than looking up a share price. The default rate would become more complex as the nature of the securities grow more complex. The rating agencies were not able to untangle them.
Tom G.
Yep. One of the reasons the credit market is in the shape it's in is that the default rates people who buy and sell CDO's were using turned out to be quite wrong in a lot of cases.
Fred's comment is on point. Consider AAA 'super senior' CMBS. These have 30% subordination. The largest loss ever on a single pool is more like 14%. Current delinquencies (not losses) are around 1%. Until a day or two ago you could barely get a bid.
Seasoned AAA home eqs with subordination approaching 40%? ABX (distorted by hedging) suggests $88, even though that suggests *losses*, in many cases, of 50-60%.
There is simply a huge disparity between intrinsic and liquidation value, mirrored weakly in a highly inverted spread curve.
I also recommend Accured Interest's explanation of "structure squared" for a discussion of some securities (not that much in i-bank balance sheets) that truly deserve to be worth nothing.
http://accruedint.blogspot.com/2007/11/do-not-underestimate-power-of-structure.html
I'll reiterate, this is about unwinding leverage, that came in several forms- structure, SIVs, Hedge Funds, bond insurance.
How you view the standards depends, I suppose, on what you think the bigger problem is. Internationally and historically, the problem of firms refusing to take write-downs has been a bigger problem than getting the valuations wrong for a few hard-to-value securities. Of course, as derivatives proliferate, this balance changes--but not using mark to market leaves discretion about when to declare that an asset is impaired. Would we be substantially better off now with management claiming that their mortgage backed securities were fine, just fine? Historical accounting allows companies to operate until they are gutted and the cash runs out, stripping shareholders of a lot of value.
I suppose in the end, we can compare the cost of this crisis with the cost of the S&L bailout and decide which one was worse.
Mindles H. Dreck:
What are you and I missing then? If we are right, why haven't deep-pocketed investors swooped in to make a killing here, and in the process, gotten these instruments trading again?
I should have noted that I do agree that marking to market is a good idea, however not for the reason Megan offered(reduced discretion), but rather because the market value is more meaningful than a historical price.
Tom
Note that FASB 157, a new pronouncement, addresses the fact that not all marketable securities have an easily determined market price. The pronouncement looks necessary but it will add another layer of complexity to valuation of financial services firms.