Fooling Some of the People All of the Time

CNBC just had a great little interview with David Einhorn, the president of Greenlight Capital and author of a new book: Fooling Some of the People All of the Time: A Long Short Story. I haven't read it yet (just learned of it), but I think that it's going on my reading list. Why? In the interview, Mr. Einhorn suggested a fairly simple idea to help avoid the sorts of financial problems that he saw at Allied and that we're seeing today with CDOs and mortgage-backed securities: why not mark-to-market all securities?

Marking-to-Market is simply the idea that your portfolio should accurately reflect the value of your investments even if they are not yet realized. For example, if you sold a call option (sold the option to buy a stock/security to someone else), then you have the obligation to deliver that stock or security if that call option is ever exercised. Now, let's further assume that you sold that put right at the money and it has since declined by $10. Since options are marked-to-market, your broker may require you to place the $10 in your cash account as a security against the $10 that you will be obligated to pay upon the exercise date. Sure, the exercise date may be months away and the price may very well reverse in the meantime, but the concept of marking-to-market ensures that those investors issuing those securities have the assets to finance them. From the perspective of the big banks doing the same thing, the marking-to-market would clarify the value of their balance sheets and make retail investment in those banks that much safer.

So why isn't Marking-to-Market not done all of the time? Well, the principle reason is cost. Marking-to-Market on some securities can require a great deal of monitoring expense that would undercut the earnings investors were collecting from those investments. This is a valid point, but like most things in life, there should be some compromise. Moreover, as the digital age advances, our financial transactions are increasingly computerized. As some of you know, however, at least part of the problem with the CDOs and mortgage-backed securities is the documentation: it's a mess. Marking-to-Market of such securities would undoubtedly increase the cost of these assets, but it would also require the financial institutions both issuing and purchasing them to keep very accurate records of their value.

What I like most about this idea, as Mr. Einhorn explains, is that it doesn't require more legislation or regulation besides requiring companies to do what they already must do on other (similar) securities. Even monitoring by the government and its agencies would be simple. I'm going to have to think this idea through further, but for now... it's a very interesting idea for both its simplicity and effectiveness.