How to save the US Taxpayer $700 Billion and the Failure of "Mark to Market"
Politics / Credit Crisis Bailouts Sep 24, 2008 - 06:36 PM GMTBy: Andrew_Butter
So that's the BIG PLAN unveiled to the Senate Banking Committee yesterday, put the assets that you don't want to "Mark to Market" in quarantine, and save them for a rainy day.
OK that buys time, but (a) at what cost and (b) who knows if $700 billion will be enough? Some people say it will take $5 Trillion.
All Mr. Paulson can say is that he doesn't have a clue how much money he will need, but once he's got a cheque for $700 billion, well the next $4.3 trillion shouldn't be too hard. That's the key to any confidence trick, get the mark on the hook so he thinks the only way out when you come back for more is to put more in.
Perhaps Mr. Paulson read my recommendations in "The Value of Housing in USA and UK " on 13th September? I doubt it, because he only got one thing right which is that the correct way to value assets when the markets are not working is not "Mark to Market".
It's a complicated idea for anyone who knows nothing about valuations (which Mr. Paulson and his team freely admit they don't). So at least we are making (slow) progress.
The way Mr. Paulson presented it was like a revelation. But this idea is completely provided for in International Valuation Standards (IVS), which says is that when the markets aren't working (today) it is pointless to value assets by reference to the markets today. An analogy is that if you know that the brakes on your car aren't working, don't drive it.
That doesn't mean you can't do a valuation (at least under IVS), just it's what IVS calls an "Other Than Market Valuation". An a analogy is if you value a twenty year old bottling plant that "Mark to Market" only has scrap value, but still generates cash flow for its owner (and only for it's owner), the value to the owner is more than the scrap value. But to get the value he has to wait for the cash to come in.
Time and cash-flow, that's all that ever matters when you are on the verge of being bankrupted.
What that sort of valuation says is we don't care what is the price of those assets today, and we don't know what they might be worth on some specific day in the future, what we DO KNOW is what they will be worth, on average, in the future.
And all you got to do to find out that number under IVS is to do an income capitalization valuation. Sure it's a lot harder and it takes a lot more skill than "Marking to Market". But it's routine for anyone "skilled in the art", not that you are likely to find anyone like that on Wall Street, based on recent experience of their collective competency.
But why protect the SELLERS (who caused the problem) and screw potential BUYERS who can solve the problem?
It's hard not to wonder whether all this is about is Mr. Paulson helping out his cronies on Wall Street?
• His plan is to bail out the SELLERS (at a price they like).
• The alternative is to allow the sellers to suspend the idiotic "Mark to Market" rule and set up their own quarantine sick-bays, valuing toxic assets using International Valuation Standards or Mr. Paulson's variant of it, and focusing on helping create a transparent marketplace and attracting BUYERS who would bring money to the market.
If you noticed (it was an easy point to miss), he (or one of his team - I can't remember), said that he would NOT be buying any assets from the few people who have been bottom fishing and actually buying those assets over the past few months.
Now that's great way to kick-start a market! Cut out the only market participants there are. One wonders who you are going to have to "lobby" to sell those assets at the price you want in this Grand New Financial Order? Perhaps he will appoint Halliburton to sort out the details?
In answer to questions about who is going to value those assets the plan is apparently to hire all Mr. Paulson's recently unemployed (or soon to be unemployed) cronies from Wall Street to cook the books one more time "valuing" the toxic waste.
And a fine job they did the first time around!
What this mess needs is not more cash printed by the US Treasury, (and quite soon they will find that even they have limits). What it needs is more credit, more buyers, and breathing space for the market in toxic assets to recover.
But the plan now? Kick any potential buyers in the teeth .
There is another problem which Mr. Paulson has either not understood or he is hiding. Some US Courts have ruled that on foreclosure it's the original lender, not the owner of the RMBS that has a right to any funds. In any grand new plan, the Devil is in the Detail
To understand what this new idea is really about, you have to go back in history.
Starting in 2000 the IMF , the World Bank and the International Valuation Standards Committee (IVSC) have been warning that valuations used by many regulators as a basis for assessing capital adequacy were "SERIOUSLY FLAWED" and "BOUND TO BE MISLEADING".
For example the letter from IVSC to the Bank of International Settlements (BIS) of 30th July 2003 (it's on the BIS website). They pointed out that IVS was not either flawed or misleading and recommended it was recognized and adopted.
Strong words indeed. But perhaps it's a shame they didn't use stronger ones, given the size of the hole that the financial services industry and the banking regulators have managed to dig for themselves.
Correct me if I'm being melodramatic but what it looks like to me is that the valuations of those dodgy RMBS's that were sold by those slick Wall Street con-men, and the CDS's that they spawned were "Seriously flawed" and "Misleading as hell".
The good news is that Mr. Paulson does acknowledge that the US banking regulations were seriously flawed.
Now he tells us!
How long has he been on the job? On reflection a good time to have figured that out (and done something about it) would have been BEFORE the toxic waste hit the fan, not AFTER.
Or perhaps he and his team crave attention? Like a bunch of arsonists being heroes and leading the charge putting out the fire they started?
Sorry buddy, but you won't fix the problem with "transparency" and "increased vigilance" and other vague ideas, or by Band-Aid quick-fixes like stopping short-selling incompetent, imprudent and possibly crooked financial services companies, who made fortunes concocting and selling those dodgy instruments.
How did "Mark to Market" and "Fair Value" cause this mess?
"Mark to Market" and "Fair Value" are accountancy concepts. You use accountancy to (a) keep track of the money (b) make sure people are not stealing (if you're lucky) (c) work out the profit and loss and your dividends (e) work out your tax liability.
For this Mark to Market is better than "Book Value", but it's still historical. It tells you what an asset might have sold for in the past.
What Mr. Paulson didn't realize, although he appears to be slowly getting his head around this point, is that the provisions that you need to make for assets going bad IN THE FUTURE , requires a completely different approach to a methodology that only works in the past. Particularly if markets are not functioning properly at the time you nail your value to the mast.
At the heart of all this is timing. Mark to Market and Fair Value valuations assume (a) that the market never lies and (b) that the assets in question might be liquidated today.
This ignores the reality that (a) although long term markets are efficient, sometimes they do not work efficiently and (b) the "price" of an asset today may be different from the value on the day that it is liquidated, which may be some time in the future.
A key cornerstone of a valuation of "Mark to Market" and Fair Value is that there exist ready sellers, and ready buyers. Today there is a deluge of ready sellers of Residential Mortgage Backed Securities (RMBS) and Credit Default Swaps (CDS's), (what some people call "Tulip Backed Securities" or "Toxic Assets"), but there are no buyers. The "system" does not properly provide for this eventuality.
By contrast, International Valuation Standards (IVS) provide an elegant solution to this conundrum, since they explicitly and clearly acknowledge that markets are sometimes not in equilibrium. And if they are not, IVS provides for the seemingly obvious reality, that if the markets are not working (on the day) then it is pointless to benchmark value against price on the day.
So what would have happened if IVS had been recognized in 2000 and what might happen if it was recognized today?
A recent essay published in The Market Oracle titled "The Value of Housing in USA and UK ", explains how adoption of IVS might have prevented the sub-prime and might go a long way to curtailing the "hangover".
Briefly, according to IVS three approaches to valuation should always be "considered" in any valuation, of which two are relevant in this case.
The first is a "sales comparison" which is "Mark to Market" and the commonly used application of "Fair Value". The second is an "income capitalization" approach which requires a projection of future incomes and calculation of the Net Present Value of these future cash flows using a "market-derived" discount rate.
When markets are in equilibrium (i.e. when your brakes are working), both of these valuation approaches should give the same answer. When they are not, then under IVS consideration should be given to relying on the income capitalization valuation in some circumstances (for example for assessment of capital adequacy). Under IVS this is explicitly not a measure of "Market Value" it is a measure of "Other than Market Value".
If IVS had been adopted in 2000 then by 2003 a valuation of a house in UK or USA done using IVS, for purpose of deciding a prudent Loan to Value , would have returned a Value 15% to 20% less than a "Mark to Market" or "Fair Value".
This ought to have put a break on the lending frenzy that followed and would have stabilized the market and held prices steady until the "equilibrium value" caught up with the "Price".
By the same token, although RMBS's are somewhat more complex, at the heart of their value is the underlying value of the assets that collateralize the loans, i.e. housing, and a rational and realistic estimate of the cash flow in the future.
So what happens next?
The problem at the moment, freely acknowledged in Mr. Paulson & Co's presentation to the Sub-Committee yesterday is that apparently no one appears to know how to value the toxic assets any way other than by "Mark to Market".
Auctions are all very well, in principal, but at some point someone has to do a valuation (properly) or your auction will just be an exercise in crony-capitalism.
And sorry buddy, this stuff is not ART sold at Christies, like you tried to get the Sub-Committee to believe. The reason people buy these instruments is as an investment, when you are selling them as ART - like defaulted bond certificates to put on the wall, all is lost.
Here's a thought. Instead of throwing $700 billion up in the air and hoping it lands somewhere good, and instead of employing people who DON'T KNOW how to value those assets (and have a lot of experience not valuing those assets correctly). Why not employ some people who DO KNOW how to value those assets?
I do, and I wouldn't be surprised if you change your hiring policies so that you don't only use your old cronies (like the guys you used to value Fannie & Freddie), you might find quite a lot of other people who do.
Basically the problem now is that no one who is a potential BUYER believes the valuations. If Mr. Paulson knew anything about valuation he would know that 95% of a valuation is getting people - buyers and sellers, everyone, to believe it.
Do that and you will have a market, and if you have a market and if the market is transparent, and has as many buyers as sellers, then you won't need that $700 Billion.
But the longer you wait or go frantically in the wrong direction, the more likely it is that you will need not just $700 billion, perhaps $5 Trillion.
So Mr. and Ms. Congress - Two options:
OPTION A: Hand over $700 billion and perhaps a lot more of the US taxpayer's money for General Hendricks Von Paulson to distribute amongst his cronies on Wall Street, buying assets that he has no clue what the value is, and destroying any chance of ever creating a proper market for those assets.
OPTION B: Recognize and adopt International Valuation Standards. Make sure that the people doing the valuations can convince the market that they are competent (and not just Wall Street Con-men). And put your money into creating a level playing field - that way the problem will get solved by attracting BUYERS to the market.
Think of this like the debate on Iraq . Think of Mr. Paulson as General Colin Powers (the one who lost his "Mojo").
Just remember, sometimes those smudged images are not what the "General" tells you to believe they are, and sometimes the threat of the end-of-the- world being at hand, is not a good reason to throw away hundreds maybe thousands of billions of dollars, just in case.
What is needed here is a lot less reactive carpet-bombing tactics, and a lot more, identifying targets, then aim and fire.
And never forget, in a free market the CUSTOMERS (i.e. the buyers) are more important than the sellers. Shoot them, and you will shoot yourself in the foot. Big time.
By Andrew Butler
Andrew Butter is managing partner of ABMC, an investment advisory firm, based in Dubai ( hbutter@eim.ae ), that he setup in 1999, and is has been involved advising on large scale real estate investments, mainly in Dubai.
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