Mark-to-Market (MtM) Accounting is usually cast as a villain of the piece in most financial crises. This note aims to rebut this criticism from a “system resilience” perspective. It also expands on the role that MtM Accounting can play in mitigating agents’ preference for severely negatively skewed payoffs, a theme I touched upon briefly in an earlier note.
The “Downward Spiral” of Mark-to-Market Accounting
If there’s anything that can be predicted with certainty in a financial crisis, it is that sooner or later banks will plead to their regulators and/or FASB asking for relaxation of MtM accounting rules. The results are usually favourable. So in the S&L crisis, we got the infamous “Memorandum R-49” and in the current crisis, we got FAS 157-e.
The most credible argument for such a relaxation of MtM rules is the “downward spiral” theory. Opponents of MtM Accounting argue that it can trigger a downward spiral in asset prices in the midst of a liquidity crisis. As this IIF memorandum puts it: “often dramatic write-downs of sound assets required under the current implementation of fair-value accounting adversely affect market sentiment, in turn leading to further write-downs, margin calls and capital impacts in a downward spiral that may lead to large-scale fire-sales of assets, and destabilizing, pro-cyclical feedback effects. These damaging feedback effects worsen liquidity problems and contribute to the conversion of liquidity problems into solvency problems.” The initial fall in prices feeds upon itself in a “positive feedback” process.
I am not going to debate the conditions necessary for this positive feedback process to hold, not because the case is beyond debate but because MtM is just one in a long list of positive feedback processes in our financial markets. Laura Kodres at the IMF has an excellent discussion on “destabilizing” hedge fund strategies here which identifies some of the most common ones – margin calls on levered bets, stop-loss orders, dynamic hedging of short-gamma positions and even just plain vanilla momentum trading strategies.
The crucial assumption necessary for the downward spiral to hold is that the forces exerting negative feedback on this fall in asset prices are not strong enough to counter the positive feedback process. The relevant question from a system resilience perspective is why this is so. Why are there not enough investors with excess liquidity or banks with capital and liquidity reserves to buy up the “undervalued” assets and prevent collapse? One answer which I discussed in my previous note is the role of extended periods of stability in reducing system resilience. The narrowing of the “Leijonhufvud Corridor” reduces the margin of error before positive feedback processes kick in. The most obvious example is reduction in collateral required to execute a leveraged bet. The period of stability also weeds out negative feedback strategies or forces them to adapt thereby reducing their influence on the market.
A healthy market is characterised not by the absence of positive feedback processes but by the presence of a balanced mix of positive and negative feedback processes. Eliminating every single one of the positive feedback processes above would mean eliminating a healthy chunk of the market. A better solution is to ensure the persistence of negative feedback processes.
Mark-to-Market Accounting as a Modest Mitigant to the Moral Hazard Problem
As I mentioned in a previous note, marking to a liquid market significantly reduces the attractiveness of severely negatively skewed bets for an agent. If the agent is evaluated on the basis of mark-to-market and not just the final payout, significant losses can be incurred much before the actual event of default on a super-senior bond.
The impact of true mark-to-market is best illustrated by highlighting the difference between Andrew Lo’s example of the Capital Decimation Partners and the super-senior tranches that were the source of losses in the current crisis. In Andrew Lo’s example, the agent sells out-of-the-money (OTM) options on an equity index of a very short tenor (less than three months). This means that there is significant time decay which mitigates the mark-to-market impact of a fall in the underlying. This rapid time decay due to the short tenor of the bet makes the negatively skewed bet worthwhile for the hedge fund manager even though he is subject to constant mark to market. On the other hand, loans/bonds are of a much longer tenor and if they were liquidly traded, the mark-to-market swings would make the negative skew of the final payout superfluous for the purposes of the agent who would be evaluated on the basis of the mark-to-market and not the final payout.
Many of the assets on bank balance sheets however are not subject to mark-to-market accounting or are only subject to mark-to-model on an irregular basis. This enables agents to invest in severely negatively skewed bets of long tenor safe in the knowledge that the low probability of an event of default in the first few years is extremely low. It’s worth noting that mark-to-model is almost as bad as not marking to market at all for such negatively skewed bets, especially if the model is based on parameters drawn from recent historical data during the “stable” period.
On Whether Money Market Mutual Funds (MMMFs) should Mark to Market
The SEC recently announced a new set of money market reforms aimed at fixing the flaws highlighted by Reserve Primary Fund’s “breaking the buck” in September 2008. However, it stopped short of requiring money market funds to post market NAVs that may fluctuate. One of the arguments for why floating rate NAVs are a bad idea is that regulations that force money market funds to hold “safe” assets make mark-to-market superfluous. In fact, exactly the opposite is true. It is essential that assets with severely negatively skewed payoffs such as AAA bonds are marked to market precisely so that agents such as money market fund managers are not tempted to take on uneconomic bets in an attempt to pick up pennies from in front of the bulldozer.
The S&L Crisis: A Case Study on the impact of avoiding MtM
Martin Mayer’s excellent book on the S&L crisis has many examples of the damage that can be done by avoiding MtM accounting especially when the sector has a liquidity backstop via the implicit or explicit guarantee of the FDIC or the Fed. In his words, “As S&L accounting was done, winners could be sold at a profit that the owners could take home as dividends, while the losers could be buried in the portfolio “at historic cost,” the price that had been paid for them, even though they were now worth less, and sometimes much less.”
As Mayer notes, this accounting freedom meant that S&L managers were eager consumers of the myriad varieties of mortgage backed securities that Wall Street conjured up in the 80s in search of extra yield, immune from the requirement to mark these securities to market.
Wall Street’s Opposition to the Floating NAV Requirement for MMMFs
Some commentators such as David Reilly and Felix Salmon pointed out the hypocrisy of investment banks such as Goldman Sachs recommending to the SEC that money market funds not be required to mark to market while rigorously enforcing MtM on their own balance sheets. In fact the above analysis of the S&L crisis shows why their objections are perfectly predictable. Investment banks prefer that their customers not have to mark to market. This increases the demand from agents at these customer firms for “safe” highly rated assets that yield a little extra i.e. the very structured products that Wall Street sells, safe in the knowledge that they are immune from MtM fluctuations.
Mark-to-Market and the OTC-Exchange Debate
Agents’ preference for avoiding marking to market also explains why apart from investment banks, even their clients may prefer to invest in illiquid, opaque OTC products rather than exchange-traded ones. Even if accounting allows one to mark a bond at par, it may be a lot harder to do so if the bond price were quoted in the daily newspaper!
Mark-to-Market and Excess Demand for “Safe” Assets
Many commentators have blamed the current crisis on an excess demand for “safe” assets (See for example Ricardo Caballero). However, a significant proportion of this demand may arise from agents who do not need to mark to market and is entirely avoidable. More widespread enforcement of mark to market should significantly decrease the demand from agents for severely negatively skewed bets i.e. “safe” assets.