Marking-to-Market of Debt

I came across an interesting article that discusses the application of a new FASB rule (Statement 159) that permits the marking-to-market of debt. You will recall that marking-to-market is the practice of adjusting the balance sheet valuation of an item, previously only assets, to reflect that current market values rather than the book value or original purchase prices. Well, Statement 159, introduced last year, allows this same practice for liabilities. Considering the declining creditworthiness of the banks, you can imagine what's happened to the yields and prices of the bonds that they have on their books - it's resulted in billions of dollars in illusory revenues.

Why illusory? Good question. Just like marking-to-market of an asset, it represents the accounting adjustment of unrealized gains or losses - this does not represent actual cash flows. The investment banks, having recorded several billions of dollars in such marking-to-market gains, have been quick to offset their losses from the write-down of collateralized assets that have declined to pennies on the dollar. The write-downs, too, are unrealized losses so why then would anyone question this practice? Again, good question.

The difference is in the marketability of the assets or liabilities; put differently, it comes down to whether or not you could actually sell the assets (or buy the liabilities) at the new market price. In the case of the assets, there's no question. There is a market for the CDOs, CMOs and other three-letter depreciating assets that we've come to know over the past year; it's only a matter of price - if it's low enough, then someone will be happy to buy it. The reason is simple: they're marked-to-market based on an expectation (probability) of how much of that asset represents bad loans - the reality may be very different from what the current market dictates and the buyer of these assets could gain substantially from the even a small variance from what is currently predicted. Of course, they're assuming a great deal of risk for that potential.

In the case of marked-to-market liabilities, however, the story is very different. The debt held by investment banks such as Merrill Lynch, Lehman Brothers and other depository institutions such as Citigroup has declined in value as a result of their lower credit ratings, which has caused yields on their bonds to rise and, consequently, their prices to fall. To realize this declining liability value, however, these institutions would need to retire the debt - i.e. buy the debt back from the issuer. The question is, who wants to sell it? Moreover, to do so, these same institutions would need to raise funds, now at a far higher rate, in order to buy the debt, which would increase their actual cash flows going forward. Consequently, no bank will do this and this is why it appears as though an accounting regulation has been twisted in such a way to offer these institutions a paper-out that only leaves analysts and investors like you and me scratching their heads trying to decipher what their financial reports are actually telling them.

Scandals, they are good for something.

Just as was the case with the bankruptcy of Enron, Worldcom and the like, the latest troubles underlying the capital markets will help to reveal some questionable behaviour that has otherwise gone unnoticed. Following the big scandals earlier this decade, newspaper headlines were jam-packed with executives on their way to jail and establishment of new laws and regulations like Sarbanes Oxley. With the spotlight now on acronyms like CDO, CDS and CMO, the next round of similar headlines is not far away.

I just read this article and it really drove-home how the big banks, in their take-no-prisoners approach to turning a buck, may have unwillingly taken those dollars straight out of the pockets of the people who could least afford to be separated from them. Jefferson County, Alabama, is the latest municipality at risk of bankruptcy and the cause are the swaps it purchased to avoid this very situation.

JPMorgan, Bank of America, Lehman Brothers and, yes, Bear Stearns, all sold interest rate swaps to Jefferson County to help them hedge their risk on loans purchased to finance the county's latest public projects. With interest rates going in just the opposite direction, it's left the County with the obligation to pay rates in the double-digits only weeks after paying as little as 3%. The county, now in dire straights, has hired its own independent analysts to review their swaps purchases and has been stunned to learn that the aforementioned banks collected as much as $100 million in excess fees by charging far and above the prevailing rates for the securities.

When our car is running well, we don't visit the mechanic. It's only when strange noises alert our attention to a possible problem, that we hire someone to figure-out what needs to be fixed. When you drive a domestic car, you can generally visit any mechanic and find the services you need at reasonable rates. When you drive an exotic, however, you need to visit specialists who will charge you far more for their expertise. The types of exotic securities being purchased these days require just such specialists and, unfortunately, these experts are taking advantage of their clients in much the same way an unscrupulous mechanic might. Fortunately, unlike mechanics, these financial institutions must answer to their regulators who will penalize them for these acts, but hopefully the buyers will learn from these experiences too. Being able to afford a Ferrari goes well beyond having the funds to pay its sticker price; don't be buy exotics, be it cars or financial instruments, unless you thoroughly understand how they work and have the funds to pay those unexpected bills.