Mark to Money

One of the objectives of this crisis is for the “Mark to Market” rules to be replaced by Mark to Shitpile rules, where banks and others can use their own “internal estimates” of what an asset is worth. The reason for this is that many of the derivative bets were, just that, bets. The instrument has no future payments attached to it, but instead, the company that sold the Credit Default Swap or other derivative took a one time payment, and then essentially bet that there would never be a default. The “value” of the derivative is, no more and no less, the chance that the person writing it will never have to pay.

It’s time to get real about this. The solution is not to suspend mark to market, but to provide an alternative market mechanism to mark to, one that is not in the hands of the people who created the instruments. If it can be marked to market, it should be. However, if there is no market, then we can create one.

Like it? Buzz it, Digg it, and Heat it.

Thus there are two hearts of restructuring, one is a replacement for “market value” as the value of a security, because market value is too volatile, and other rules are too prone to abuse. The other is to essentially admit that private entities were collecting taxes, and then walking away. In effect, they were taking money for a situation that they knew was the “eat babies” case, where the government would be bailing them out any way. If IBM defaults, then chances are, everyone else is too. More over these bets were then layered on top of each other, an entity selling swaps, would then cover it’s own risk of default more cheaply than it’s outstanding bets, and the entity owning that swap did… nothing. It would be like a company writing an insurance policy for your car without having any money, and then turning around and selling the risk of having to pay for less than you paid them, and then that company doing the same, and so on.

Market of Last Resort, or Fool of Last Resort

The solution to the first is to use the government as the “market maker of last resort.” This concept explained by economist Paul Davidson is to add to the arsenal of other last resort market functions of the government, to act when on one else well. The idea I am proposing is called “mark to money.”

Mark to money takes the total capitalization of the derivative issuer, the revenue collected or scheduled to be collected as an income stream and computes an implied rate of interest. It then prices this at the risk/return of the comparable market based security. The game with derivatives that are called “Credit Default Swaps” was to try and sell off all reasonable risks and keep the last bit of what economists call “liquidity preference.” That is, what having money in your hand is worth to you.

Now ordinary risk is generally priced in the market well, but that last little bit of risk, is something people are willing to pay a great deal more to get rid of. People don’t like to die, they don’t want to be thrown out on the street. Getting that last incremental bit of stability is, from empirical data, expensive. Chasing the next sigma of uptime is as expensive as all the ones before it. This last bit of risk aversion and liquidity preference is the difference between, for example, the best corporate bond, and the best government bond.

The theory of the market fundamentalists was that it should be possible to arbitrage that last bit. Arbitrage, remember, is when the same thing is being sold in two places for different prices, and it is possible to buy it in one place and sell it in another without the costs of buying and selling eating up the profits. LTCM made a big bet on being able to do this, and failed. The Credit Default Swap market was trying to do the same thing, in reverse. If there is a spread between the cost that people are willing to pay for that last bit of security, and what a bit of security would ordinarily cost, why charge less than it really costs to remove the last bit of risk, act as if you have just bought ordinary easy to manage risk, and pocket the difference? Since, if it ever comes to pass that everyone defaults, “well, we will all be eating babies if that happens, so there is no need to even worry about it.”

Let me put this in computer terms. You can reduce the number of crashes in your home computer very cheaply by using a simple disk utility one a month, keeping dust away from the computer, and not allowing it to be cluttered with downloaded bloatware. By doing this you can reduce the number of crashes considerably, at almost no cost. Let’s say it has reduced 75% your risk. But to go from a computer that locks up once a week to a computer that locks up once a month, is very different from going from a computer that is down one minute a year, to one that is down less an 1 second a year. What the CDS market did was pretend that if you pay to have someone run their disk doctor utility every day, that was the same thing as quartering the risk to a large data center filled with complex databases, web servers, applications and having millions of users. It other words, it pretended that there was no diminishing curve of risk avoidance.

The CDS market assumed that the public would be the “fool of last resort.”

The reason that government is often more expensive than the free market, is that people demand that government get rid of this last bit of risk. Therefore, we can offer a principle: the last bit of risk cannot be sold in the market. Regardless of the excuse, regardless of the instrument, the public liquidity preference may not be bought, sold, borrowed against, or loaned except under terms that the public specifies. Thus Social Security, Universal Health Coverage, the cost of protecting the financial system, and other functions, are part of the public risk aversion and public liquidity preference. Since the public must, ultimately, step in when these risks go bad, the public has the right to collect the natural cost of protecting against them as fees, insurance, regulations, or public monopolies.

So the first step to the problem is to insure the wider market, and to charge the natural cost of insuring.

Insolvency Relief

George Soros, Paul Krugman, James K. Galbraith and others have proposed different variations on recapitalization of the banking system. Recapitalization and recollateralization mean that the public makes an assurance of being the insurer of last resort in the cast of everything else going wrong. It can do this because it is also the borrower, and in the models being proposed, the market maker of last resort.

This would mean that instead of buying up toxic assets, that is assets that have no upside value really, but only might not have downside value, that in effect the government is stepping in and backing the Credit Default Swap, For this to work the government has to cancel out arbitraged straddles and the leverage based on them. These leveraged bets were then moved into the financial system, because they were equal only by the fiction that it is as easy to go from one crash a month to less than one slowdown a year, as it is to go from one crash a month to one crash a week. If you are selling something at much less than it costs to make, there are always plenty of people ready to buy.

Robert Rubin, former US Treasury secretary and currently a senior adviser to Citigroup, said fair value accounting worsened the financial sector’s problems. He told a Financial Times conference that fair value ”œis not serving our system well” and urged regulators to change the rules.

But regulators and investor groups have so far supported fair value and the transparency it brings.

Many regulators impose stricter standards when assessing banks’ capital requirements.

Auditors have also defended the accounting. Sam DiPiazza, head of PwC, the accounting firm, said in an interview with the Financial Times on Tuesday: ”œTo suggest you don’t track and report fair values means you end up in a world where management still knows the real prices, as do market counterparties, but not the investors.”

This is crucial. Mark to market was a replacement for the previously abused standard, “Historical value,” which was used to pretend well into the crash that assets were worth what they had been during the run up. Mark to market basically forced everyone to take their medicine as soon as it became clear that the losses were there. Derivatives offered a way around this, by throwing the day of reckoning out into the future. One can do this with options as well.

The crucial part was to create heavily leveraged securities, which were above market risk return ratios, because of their illiquidity. Losers in these would not be able to sell easily, and when they began getting claims on them, were forced to take those losses, or double up on bets. A similar unravelling of reinsurance took down the previous incarnation of Lloyds of London where new members did not realize, or it is alleged were specifically recruited to bear, the costs of “Incurred but Unreported” claims.

The core of Lloyds, in small scale, is the core of the problem now. Each security was, in effect, a company without reserves. Thus the creators of these instruments had no reason to have reserves to cover the risks, once the profits had been extracted. But even this would only have led to a bath on the part of a few people, if it were not for the crucial next step: Leverage Laundering.

Leverage laundering is the process by which profits based on borrowing are made to look as if they have an underlying revenue stream. For example, a company manufactures something, they lend money to another company to buy it, and then book the “profit” of the sale right then. The company then issues shares, those shares seem to be backed by “earnings” which are then used to value the shares. Leverage has been laundered, mutual funds by the shares, ordinary people borrow money thinking they have assets and so on. This example of leverage laundering becomes unravelled when the original borrower defaults, and the lending manufacturer takes back the, much less valuable, equipment.

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Stirling Newberry


17 CommentsLeave a comment

  • This is a comment which I posted somewhere else, but I think is relevant to asset valuation:

    Any asset whose value is a random variable cannot be assigned a (deterministic) value by any assumptions about a stochastic process of which it is a term.

    Such assets can be assigned a positive value by some drastically conservative mark-down algorithm or should be kept on the books only of companies specializing in gambling.

  • The solution is not to suspend mark to market, but to provide an alternative market mechanism to mark to, one that is not in the hands of the people who created the instruments.

    Yeah, well, I don’t think Congress is daring/principled/smart/willing enough to draft anything other than a shit sandwich at this time.

    I mean, who needs Congress?

  • …Sticky Wicket. And the timing of any change to “Mark to Model” couldn’t be any worse! The True Believers in financial innovation have turned into a lynch mob!

    Funny, though. Of all people, the Bear’s Bear, old James Grant of Interest Rate Observer fame (9/26 Edition), stated that he was “warming up to be Bullish” regarding mortgages.

    The houses that back these abstruse (some might say feculent) financial instruments can be income producing assets. And, they are still worth well north of zero, even by Case-Schiller standards. One huge problem is that our ruling kleptocracy has lost so much goodwill and trust. So much for: “Full Faith & Credit”. Any new model needs the respect & trust of both Americans and our foreign creditors.

  • Daily Telegraph – The US regulator told banks that despite fair-value accounting regulations they did not have to use only fire-sale prices to value bad assets but could also use their judgement.

    The move led to a late rally in US stock market with the Dow Jones index up 485.2 to 10850.7 while the S&P 500 rose 58.3 to 1164.7, its biggest one-day rise in six years.

    “The mythical John McCain is an affable, straight-talking, moderately conservative war hero who is an expert on foreign policy” – Bob Herbert

  • I looked at the wikipedia article on CDS pricing. Financial jargon bit heavy, but statistics, I like. Especially the bit about probability, populations and assumptions.

    Looks like a flawed pricing process, assuming that future prices can be calculated for the present. Good for life insurance (much actuarial history, known populations), bad with CDS because of the lack of good data (no actuarial data on sub prime, because there never were sub prime borrowers before, because they weren’t allowed to borrow).

    No data on homeowner debt-to-income ratios for Stated & No Income loans (liars loans).

    The people on wall street made assumptions about people’s behavior when the people they made the assumptions about had never experienced the conditions under which the assumptions were made. Or, the set of people and conditions with historical data was a null set (that is, empty, or zero).

    In mathematics, bad things happen when one uses zero (null) in a set to make predictions of assumptions. In statistics comparing a null set with a populated set is invalid. In engineering, it results in “failure”, and the management says, “Oh Shit”. In law it’s called negligence.

  • while hauling wheat seed down the highway.

    One politician after another saying how important it is to save Wall Street. Painting everyone that’s against the bailout as angry people out for revenge.

    We have a SOB (Paulson) asking us to cosign a loan for an incredible amount of money. bush appointed the man. bush has earned not one fucking iota of trust from me. None.

    Tell me who you run with and I’ll tell you who you are.

    I have corn presently worth $5 and a few cents a bushel in a bin. If the bailout fails I expect the price will fall. My dad has oil and gas production. The prices for his products will fall.

    Our land value will fall.

    But these things need to happen for the long term health of our country.

    I can’t justify farming our land with its inflated value as potential recreational land. People running small businesses can’t afford the rent they pay. Neither can those buying a house.

    Our system of values is way out of balance.

    I recently gambled with the few dollars I had by training a couple of racehorses. They couldn’t run–I lost every dime invested. I’m not going to cry about it. I lost. If you can’t afford to pay, don’t play.

    People buying stocks gambled with their money. They liked the game when they were winning. Now they want to be rescued when the pendalum swings the other way. You knew the rules going in and you shouldn’t have gambled if you can’t take the losses.

    We need to tighten our belts, go back to work. We’ll go through a rough spell but we’ll survive.

    If congress wants to stimulate the economy, let these folks reap the consequences of their actions.

    Use that trillion or so they’re asking for to build a new rail system, to install wind and solar powered generators and the lines needed to carry the electricity.

    Loan money to upstart businesses once again that produce something, that won’t send the jobs to foreign lands.

    Reward those that have lived within their means by allowing them to buy the remnants of these monstrosities at firesale prices, just like they have done to literally millions of Americans late on their payments.

    Come up with a way to mark to market home mortgages and refinance homes and small businesses.

    Despite all the talk, this bailout plan will help the rich stay rich and bleed the rest of us.

    I did inhale.

  • I wonder how much of the difference between this and the House vote is because only 1/3 of the Senate is in a position to be fired in November.

    I wish Obama hadn’t already lost my vote, so I could deny it to him for this.

  • GE is going to do a $25 billion stock offering and Warren Buffer is buying $5 billion in preferred stock.

    This is not about Wall Street but corporations getting cheap money via stock offerings, etc… ’cause if they can’t float their business on their stock, they’d have to borrow money and that would cut a chunk out of their bottom line.

    At least, that’s the way I see it. It’s a pyramid scheme.

    And I’ll never forget Stirlings post about people buying paper (useless stock certificates) from corporations instead of real assets.

  • High testosterone makes investors bullish: study

    Although I didn’t choose her because she is female, after reading this article I’m sure glad my financial advisor is.

    In a letter I received from her today, she uses great psychology to try and persuade me to invest. Here’s what she says:

    When investors experience months and a week like the past one, the pain of investing is immediate whereas the gain is in the future. If you avoid stocks, the gain in peace of mind is immediate, but it is false. Because, the pain of lost opportunity and the jeopardy brought to achieving long term financial objectives which would accompany such a short term comfort is in the future.

    In times like these, sitting on the sidelines can be tempting and that’s certainly an option if you truly cannot live with the volatility we have experienced of late. However, to do so would involve the risk of missing critical market gains when they do occur.

    Avoid making decisions based on fear and greed.

    Decisions based on fear and greed can destroy the value in a portfolio. My role as an adviser is, in part, to be an emotional anchor for clients, preventing the emotional highs from generating an overly optimistic viewpoint. And, preventing the lows from causing an excessively pessimistic and negative outlook.

    I’m not asking for advice as I mostly base my decisions on what I read here.

    “While not a Playboy reader, she invites a male acquaintance in for a quiet discussion of Chagall, Nietzsche, jazz, sex.” – not a Hugh Hefner quote

  • risk becomes so unacceptable that it doesn’t make sense to play. Why commit anything in a crooked game? That’s the problem that the US markets now face. Trust is blown and it will be difficult to recover.

    People might argue that the game has always been rigged for insiders. That is true, but now the curtain has been drawn back for all to see.

    The house never loses in the long run, no matter what — loaded dice, tables not level, you name it. But here, they’ve had to reveal it.

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