Never slow on the draw, the always yummy Abnormal Returns catches The Economist pointing out that "Mark to Market," really isn't so bad after all. As a lover of markets and price discovery, I find many of the arguments proffered quite compelling. But, and it pains me to say so, I think The Economist naive in this particular case. Consider:
In a crisis prices fall until bottom-fishers start to buy. Yet when assets were booked at their original price, rather than the market one, banks could delude themselves—and investors—that dross was gold. Under historic-cost accounting, the banks had every reason not to restructure assets, because that meant owning up to their losses. Look at Japan, where the economy was sunk for most of the 1990s by stagnant loans to “zombie” companies. Historic-cost left investors in the dark about valuations; it was also prone to fraud and fraught with moral hazard, since sloppy lending went unpunished.
True, from a historical perspective, it is interesting to reference 1990s Japan, or fret that "banks had every reason not to restructure assets," but this presumes that banks even hold these assets on their books today, and mostly they do not. In fact, they take rather great pains to avoid doing so.
Today the dynamic is different, but the effect the same. Instead of holding the assets on their books, the banks hold derivatives with the underlying assets elsewhere- certainly "off balance sheet" somewhere. Moreover, instead of possessing no incentive to restructure, they have every reason not to permit a market transaction- an easy endeavor in an already illiquid market and where their fingers are on the pulse of any number of other instruments (credit default swaps, collateralized debt obligations, etc. etc.) in the marketplace.
Are we surprised when people point fingers at Bear and suggest, for instance, that they are buying up the underlying assets and loosening credit terms on the debtors to avoid a default, a mark to market problem and, to boot, to avoid paying, for instance, on credit default swaps- for which their liability is much greater than taking a complete loss on the debt itself would be?
There are any number of instances where firms that stand to lose from "Mark to Market" or other provisions in instruments that might be triggered by chaotic markets, employ any number of tricks to avoid a repricing, or the pain of market action. CDOs and such are not nearly the beginning or end of such tactics. The wonderfully emergent Financial Crookery (a new favorite here at Going Private) spots similar flips in the LYON markets. To wit:
Merrill Lynch today announced it was exiting the subprime mortgage origination market. Probably good news, right? At the same time it announced a modification of the terms of one of its existing convertibles. No discussion, no reason, just a modification. Probably bad news, but not for convertible holders.
Today's sweetening amendments (i) increase the conversion ratio by 17% and (ii) add a couple of put dates in 2010 and 2014 (the maturity date is 2032). Merrill get nothing in return for these new features, they are unilaterally value-enhancing for the bonds. The bonds' fair value is now presumably sufficiently above next week's put strike that bondholders will not exercise. Cash call avoided, at least for now.
Beware "Mark to Market" accounting where:
1. Liquidity is limited
2. Instrument issuers/holders have:
(a) An incentive to avoid markdowns via a transaction
(b) The ability to prevent or delay market transactions
that would trigger a markdown
In chaotic markets, be prepared for holders and issuers to "pay any price, bear any burden" to avoid the consequences of chaotic markets. Structure yourself to be on the winning side of these dying gasps, and never forget that you can win "too well," if you aren't careful, and be hulled by a government bailout, sympathy for the stupid or the subject of malicious envy from the slower wildebeests in the herd. Remember, there are few animals more dangerous than a wounded and envious wildebeest facing markdowns connected to derivative liabilities.