Monday, March 3, 2008 2 comments ++[ CLICK TO COMMENT ]++

Mark-to-Market Craziness: Accounting Profession's Credibility Going Down

Similar to how the accounting profession lost a lot of credibility after the scandals of th early 2000's (Enron, Worldcom, etc), I think they are going to be taking another hit after the current credit crisis. This time, however, their mistake isn't so clear-cut. One of the big mistakes they seemed to have made is with the requirement to force mark-to-market of illiquid assets. Marking down assets during stressful periods (like now) yields misleading prices. I feel that it is detrimental to the capital markets and exacerbating the problems. Investors are sent misleading signals and in the end, no one has additional information about the value of these illiquid assets. It's not clear to me what the accountants are trying to accomplish.

Martin Whitman commented on this problem in his 4Q07 commentary late last year:

In analyzing each of the financial institutions, Generally
Accepted Accounting Principles (“GAAP”) tend to be
quite misleading. This is because GAAP require that
derivatives such as the Credit Default Swaps be marked
to market – and market prices now are highly capricious,
to say the least.
Marks to market are the most appropriate, and helpful,
tool in the appraisal of publicly-traded common stocks
held in trading portfolios. Marks to market are an
inappropriate, and unhelpful, tool in the appraisal of
credit instruments held in portfolios where the intent is
to hold the credit instruments to maturity.
MBIA and
Radian intend to hold their credit instruments to

When I first trained as an
analyst – some 50 plus years ago – the primary role of GAAP
was to meet the needs of creditors who held credit
instruments to maturity. That’s all changed now. The
primary role of GAAP seems to have become to fulfill the
perceived needs of equity holders who are vitally affected
by day to day changes in common stock prices. As I’ve
pointed out in previous letters – What a waste! GAAP can’t
really be very useful to stock market speculators, but it can
hurt issuers
like MBIA and Radian.

As I have discussed before, the mark-to-market writedowns have been hampering the monolines for months. These GAAP requirements increase uncertainty! The monolines can survive because what matters to them is actual losses that they have to pay out (although marking down assets does increase capital requirements to maintain their ratings).

The companies that really suffer with these markdowns are companies like Thornburg Mortgage (TMA). Thornburg is a mortgage REIT that holds its assets to maturity. However, it is forced to price highly illiquid securities based on the market price. Given the stresses in the credit market right now, marking to market is causing margin calls to be triggered at Thornburg. These margin calls can easily bankrupt companies like Thornburg. Wouldn't it be bizarre for a company to go bankrupt when its portoflio of assets haven't really taken large real losses?

You can see how bizarre these mark-to-market pricing is when you look at companies like Freddie Mac or Fannie Mae. Fortune touched on this issue in one of their articles:
While no one doubts that the market environment is challenging, some observers say the mark-to-market writedowns don't always help investors seeking to accurately assess a firm's health. For one thing, the writedowns generally don't reflect actual cash losses. In the case of Fannie and Freddie, Goldman sees more writedowns ahead in part because declining interest rates reduce the value of the hedges the firms use to protect the value of their mortgage portfolios - even though the declining rates don't cause Fannie and Freddie to lose actual money during the period.

Similarly, many of the leveraged loans now trading at a discount continue to perform; the drop in the index partly reflects investors' fear that debt-burdened companies will go bankrupt if the economy heads into recession. Similarly, the bonds underlying many illiquid securities such as CDOs continue to pay interest on time, even as related indexes show readings that would suggest widespread default

Do these marks for Freddie and Fannie mean anything? Not really. If anything, it wouldn't surprise me if they show huge profits (off marks that reverse) in a few years. (As a sidenote, even a conservative-run organization like Berkshire Hathaway may start showing the effects of these misleading marks. If I understood Buffett correctly, he says in his latest shareholder letter that there is a possbility of huge mark-to-market price swings due to his derivatives contracts (he wrote 15yr and 20yr European-style puts (i.e. only exercisable at expiry) on 4 major indices)).

I suspect the notion of pricing illiquid assets off the market will go the way of the dodo bird within 10 years. It doesn't help investors for sure; and it probably won't help accountants in the end either.

This is one more reason for investors to avoid GAAP... A lot of the accounting seems structured for accountants to make their living rather than rooted in anything real that investors should use...

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2 Response to Mark-to-Market Craziness: Accounting Profession's Credibility Going Down

March 3, 2008 at 2:37 PM

Marty Whitman 1st q letter, if you haven't seen ...


March 3, 2008 at 4:06 PM

Thanks Cak...

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