Page 2 of 2 Bankers get a model rush
By Julian Delasantellis
banks to use "significant" judgment in deciding the prices of some investments
on their books. It's called "marked to model", and marked to model has had
quite a checkered history these past few years.
Marked to model implies the replacement of mark-to-market prices with
valuations derived from proprietary mathematical models used by the company.
Obviously, just as with the phenomenon of real-estate appraisers being paid
more to value properties higher than they actually were worth during the boom,
allowing companies the leeway to value their own assets opens
whole heaped-up barrelfuls of moral hazard that threaten the system as a whole.
Indeed, this issue was central to the crisis exploding all over the credit
markets in the summer of 2007. It was then that Merrill Lynch, in seizing a
portfolio of subprime securities that Bear Stearns was using as collateral for
loans to two of its highly leveraged subprime mortgage funds, discovered that
the loans, previously marked to model as having significant worth, were, in
reality, just about worthless. (See
Of termites and index mania, Asia Times Online, July 3, 2007.)
But the core of the anti mark-to-market movement is that market prices can't be
trusted in these markets for mortgage-backed securities because the markets are
"distressed" and "illiquid".
The new FASB 157 allows "fair value" (marked to model) over mark to market:
When
the market for an asset is not active [fair value] is the price that would be
received to sell the asset in an orderly transaction (that is, not a forced
liquidation or distressed sale) between market participants at the measurement
date under current market conditions (that is, in the inactive market).
" But the key question is, where just a few years ago, during the now long-gone
era of market suprematism, we had weak governments and strong markets, why are
the markets for mortgage-backed securities not now working? Why are they now
"dysfunctional" and "illiquid?"
For the answer to that, through the miracle of pundit vision, let's go to
Mumbai, to the executive suites of Tata Motors, as they decide where to price
the Nano, new car they are bringing to the world market.
"Sir, the experience of the Germans, the Japanese and the Koreans is that they
must enter the world auto market carefully, with a low-priced product to
establish the brand's credibility."
"I don't want to do that," says Tata chief executive Ratan Tata. "Let's price
it like a Bentley. Do you know what they sell for? US$200,000 or more."
"Sir, we couldn't do that. The cars wouldn't sell."
"Wouldn't sell? Is the car market dysfunctional, distressed or illiquid?"
No, it's just that the market doesn't think cars are worth that much, so no one
will buy them."
It's the same with mark to market. The reason why the banks can't get a market
price at which to value their mortgage-backed securities is that the banks are
not willing to sell them into the market at a price the market is willing to
pay. It's far cheaper for the banks to hire some fuzzy-faced,
frappachino-fueled math PhD to dream up some model that, amazingly enough,
consistently shoots out a valuation to the bank's liking - especially now, when
FASB allows the new, higher valuation to count in the bank's capital reserves.
In a just-released paper by Harvard economists Joshua Coval and Erik Stafford
and Princeton economist Jakub Jurek, the point is made that it's not the low
prices that mortgage-backed securities and collateralized debt obligations
currently fetching in the market that are divorced from reality; it's the crazy
prices of the boom a few years ago that were the real problem.
"The analysis of this paper suggests that recent credit market prices are
actually highly consistent with fundamentals. A structural framework confirms
that bonds and credit derivatives should have experienced a significant
re-pricing in 2008 as the economic outlook darkened and volatility increased.
The analysis also confirms that severe mispricing existed in the structured
credit tranches prior to the crisis, and that a large part of the dramatic rise
in spreads has been the elimination of this mispricing."
Seen in this light, mark to market was not some capricious destroyer of wealth
and dreams but a necessary component of prudent banking regulations. Now, with
mortgage-backed securities valuations a la carte, banks are free to push more
and more loans out into the market, with little or no thought about the added
risk to the system should everything go bad. In much the same way that, during
the boom, buyout kings seemed to be in a regular, weekly competition to see who
could do the biggest private equity deal, now we could very well see a new
contest - which institution will need the biggest government bailout when it
fails.
Notwithstanding the right's supposed devotion to traditional and unchanging
standards and customs, it's not at all surprising that it has led the charge to
end mark to market. Like a parent defending a child who has turned to crime or
delinquency, conservatives apparently will now do anything to find a scapegoat
that transfers the blame for the financial crisis away from their deeply loved
but now discredited pure laissez-faire economics.
What may be more surprising was the similar opposition to mark to market on the
political left. Barney Frank pushed for the new accounting rules, as did,
behind the scenes, the Timothy Geithner Treasury. Upon their adoption, Frank
welcomed them with this.
I applaud the very important actions taken by
FASB today, which has made significant progress toward addressing inaccurate
asset valuations in the markets. The FASB believes the rule can be applied more
fairly and take into account the currently dysfunctional state of some markets.
The integrity of the standard-setting process is preserved, while avoiding the
pro-cyclical effects of improper valuation practices.
With both
sides of the political spectrum in this rare agreement, when the situational
ethics utilitarianism of the left joins hands with a right furiously obsessed
with covering its keester, what chance would poor defenseless truth have to
stand up to the full force of the bipartisan onslaught?
To me, the saga of poor mark to market, tried and now convicted of crimes, the
takedown of the world financial system that it did not commit, quintessentially
illustrates a key problem that President Barack Obama will have in fulfilling
his central campaign promise to fundamentally change America.
In the winter of 2007-08, when the turndown was just beginning, and when the
lines to buy the huge plasma TVs were still thick, full and jolly, candidate
Obama got tremendous political mileage sitting around Iowa farmhouse kitchen
tables and New Hampshire volunteer firehouses talking about a new America, one
where economic growth would not be generated so much by financial speculation
and legerdemain, by mindless consumption funded by unsustainable debt, but
through a new emphasis on "green" investments in energy independence,
eco-friendly food and fuel production, and 21st century technologies that
promised tremendous breakthroughs in health, education, and the future of the
Internet.
Then the crisis hit. Five million Americans have lost their jobs since that
winter, and, in contrast to the "official" unemployment rate of "just" 8.5%,
the key "U-6" unemployment gauge shows almost one in six American workers now
either involuntarily working part time (so most likely not receiving health
benefits through their employer) or being still unemployed and becoming so
discouraged at their job prospects that they have ceased the search for work
itself.
All of a sudden, patience is running out on all those wonderful pie-in-the-sky
green prospects and projects that always seem to be forever glimmering just
over the horizon. Now the demand is to put people back to work, get our
retirement accounts back up, right now, by any means necessary.
And if those necessary means include returning to all the lies and mendacities
of the recent past, like the now virtually worthless South Florida condominiums
that used to go up 50% in value between the time the deals to purchase them
were agreed to and then closed upon, well, notwithstanding what Americans told
Obama on those cold nights, notwithstanding the huge majorities of them that
regularly told pollsters that America in the fin de siecle of the Bush
dynasty was on the proverbial "wrong track", looking around at America
belaboring under the punishing new rule of truth, the powers that be in
Washington seem to be getting the message to bring back the lies - fast.
The US stock market, the body that interpreted Bill Clinton's under-the-desk
dalliances as perfectly moral just as long as he continued to follow
pro-equities economic policies, rose 2.8%, 217 Dow points, on the day following
the sacrifice of mark to market. Not only was the sacrificial lamb slain, but
then, the sinners supped well on its entrails as the golden calf was once again
brought out of storage to be venerated.
As per Chan Akya's observations of the G-20 meeting and its protesters, perhaps
the next time the outraged proletariat finds itself face-to-face with the
cosseted oligarchy on the streets of some major financial center, perhaps the
two should become better acquainted. The proletariat could offer the oligarchs
the tangy fruit punch and tasty homemade fudge brownies that are the signature
delicacies of the counterculture; in return, the oligarchs could relate tales
of making money out of thin air with their now FASB-blessed mortgage
derivatives while flying on the company's $60 million Gulfstream G-550. As The
Byrds sang in 1966, that's what I call being eight miles high.
Julian Delasantellis is a management consultant, private investor and
educator in international business in the US state of Washington. He can be
reached at juliandelasantellis@yahoo.com.
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