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Mark to Market is a Feedback Oscillator

Posted by Bob Warfield on March 13, 2009

Lots of good discussions among my colleagues, the Enterprise Irregulars lately.  I want to comment on one that is somewhat outside the domain of computer software, Cloud or otherwise.

There is a discussion on lately about the mark to market rule and whether it is a good idea to leave it in place or to change it so it is less effective, as the system is now doing.  One view is that it was a good attempt at transparency for the value of things, that there is no better alternative available, that nobody complained during the go-go period, and so therefore it should be left in place.

Jeff Nolan is on the other side, and was questioning mark to market (FAS 157) some time ago.

Think of the mark to market rule as requiring a company holding financial instruments for which there is a market (debt, securities, etc.) to constantly revalue those instruments based on their apparent market value.  Sounds like a good way to improve transparency, right?  After, even though the company didn’t sell the instruments, if they had to on the day they were marked to market, we have an idea what they would have been worth.

The flip side of all this, which I’ve been reading everywhere from the EI discussion to my various investment groups, is that mark to market has been a big player in our current financial crisis.  The complaint is that it forces a very negative valuation in times like these even though the entity holding the instruments has no intention of selling them right away and may in fact have a good plan for working through the crisis.  But they don’t get a chance to do that because mark to market damages the overall perception of their financial solidity.  This has been particularly insidious for banks of all kinds.

This is bad enough in terms of the impact of investment markets who make decisions on whether to buy or sell other securities (everything from complex derivatives to the public stock of the instrument holders, e.g. banks) based on valuations heavily impacted by mark to market.  Where it has gotten really ugly is in its regulatory impact.  Capital liquidity requirements and the like are affected by mark to market valuations.  This impact has been so negative that no less a figure than Warren Buffet (who generally has no patience for anything but the harshest accounting) is calling for regulators at least to quit using mark to market altogether.  When the Sage of Omaha weighs in on a topic, you have to at least consider it.

My own view is pretty straightforward:

As can happen, this particular attempt at transparency has clearly failed.  Just because we don’t have one in mind that works perfectly well to replace it yet, and just because we did not (necessarily) know it had failed in the go-go period, these are not reasons to let it continue unchecked. 

Reality is that so much leverage was let loose that most of the banking system is now painfully interlinked.  It isn’t a matter of letting a few bad eggs go to clean up the mess in classic free market style.  It’s a matter of dominos so linked to one another that they all must fall if left unsupported.  That’s not acceptible.  Yes, it stinks we’re in this position.  Yes, some very undeserving people are going to be protected and some will even profit at everyone else’s expense.  But the alternative is much more painful.  We are way past standing on dogma or principle. 

We got here by fiat when a very simple decision, call it a poor negotiation, created too much leverage:

http://c21org.typepad.com/files/edge-1.pdf

We won’t get back out except by fiat, and fiat is much cheaper than propping up the dominos with taxpayers cash.  I’m not sure there is enough cash.

The market today is acting like an undamped oscillator.  Normally, it does a good job correcting itself whenever it gets too high or too low.  But sometimes, it can swing much to wildly in the process.  We would all be better served if that oscillation could be damped just a bit.  Mark to market is the opposite of damping.  By definition, it creates the kind of feedback oscillation you hear when you put the microphone next to the speaker.   It values assets according to the market, which then change the value of the asset holder, which reflects back to the market, which then revalues the underlying assets, and over and over until we have a nasty mess like the one we see today.  Leverage adds tremendous additional “spring” to the oscillation, making it even harder to damp.  Leverage means the organization that issued the debt actually has very little ability to be responsible for the debt, because it is using its own debt to finance it.  That’s what ties all the dominos so firmly together.

So, we need to first dampen the oscillation by lessening the effects of mark to market.  Then we need to see about reducing allowable leverage in some manageable way that doesn’t create panic.  It’s going to be a long painful process, but we can see from the market of the last few days that even a little hope from major banks cheers everyone on.

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