Friday, 3 April 2009

The Fool's Rally

Yesterday, financial stocks went quasi-crazy because of a change to accounting rules which allows some assets to be valued at a theoretical price based on what they would sell for in a hypothetical liquid and orderly market. As a result of this change, balance sheets look a lot better and the banking activity that's based on asset ratios loosens up. Those are both good things, right? If so, why do I call this a fool's rally?

First, there is no hypothetical or real liquid and orderly market for all of the CDO/MBS/alphabet soup of the day crap that's hanging out on balance sheets. The only liquid market for these things was created by speculative value. Once the speculative value left the party, liquidity did too. There simply was never any order to the market. It was either breaking down the doors on the climb up or rushing for the exits on the way down. So the allowance of the provision of a liquid and orderly market is idiocy.

Second, this is an accounting rule change that was transparently designed to produce a result, which it did. That result was to lighten the discipline burden on valuation of assets in order to create seemingly better balance sheets, and thus free up some banking activity. It's not all bad; making credit happen is necessary to the world working. The problem is that no fundamental change occurred. Things are not better than they were on Wednesday, we're just being told that they are.

Imaginary and speculative valuations were the fuel that fed the bubble for so long. I can not be convinced that they are also capable of restoring order and soundness to the economy's fundamentals. "If there were a liquid and orderly market for these assets" sounds a lot to me like something I'd answer by saying "if Grandma had four wheels she'd be a trolley cart."

I did take the opportunity to rebalance some things on what I assume will be a temporary top. Of course I'll be wrong on that but there's always hoping. At one point in the not distant past my account was down as much as 42%, now it's down around 8%. A lot of this is due to putting more money in while things have been down, so cost averaging effects are significantly to blame for my success - the "more" money I've put in hasn't lost value, which dilutes the loss that the money that was in there a year ago took. But some of the positions I'm in are a lot less down than they once were. I'm moving up through the pack somehow. Trying to make sure some knucklehead doesn't crash me out.


Jim said...

Part of the problem with mark-to-market accounting is that it prevents fair valuation of the securitized mortgage portfolios that the govt and various financial houses are attempting to unwind. The vast majority of mortgages around the country are just fine - up to date, producing a steady income stream, and the mortgagors have good credit ratings. But with a default ratio of 15% in 4 or 5 states - the real heart of the mortgage default crisis - there are some bad mortgages in that mix. On these mortgages, somebody is going to lose a lot of money, probably half the money that was lent. As long as the servicing institution takes care of the underlying asset, the foreclosed house, and doesn't neglect them like some of the asshole bankers around here are doing, the asset will still have value.

The problem is, if you have a tranche with 1000 securitized mortgages in it, you have no way to know where the 20 or 50 bad ones are. So there is no market whatsoever for that tranche. Yet even if you zeroed out the bad mortgages and said they were worth nothing, the tranche would still be a worth a shitload of money - it represents an income stream of future mortgage payments from 980 or 950 people who are paying their bills.

The problem is that you won't be able to sell the product until you unwind it a bit, because nobody is going to buy a product knowing that they will have to eat a loss of 5% of the value of it on the front end. They would only buy it if the purchase price represents fairly what the income streams are. Then the gamble isn't (will the mortgagors keep paying + how many bad mortgages do I have to eat), it's only (will the mortgagors keep paying + anything I can salvage from the bad mortgages will be gravy).

Mark to market accounting says that tranche is worth nothing because nobody is willing to pay for it given the unknown risk. Because it's worth nothing under that set of assumptions, the government's bad asset bank can't pay anything for it and start unwinding it, nor will private investors touch it because there's no way they can buy something that, by GAAP for that class of asset, is worth nothing.

The bottom line is mark-to-market accounting sounds good in the same way that Sarbanes-Oxley did. Intuitively it sounds like it should produce good results - the idea that something should only be valued at the price ready buyers in the market would pay for it - sounds smart, but it's maybe a bad idea where the value of an asset is really hard to figure out.

I don't think banks should have a license to just make shit up, I think they need to do some careful analysis and unpacking of tranches and be prepared to demonstrate why their valuation is good (e.g. (cash flow - servicing fees from good mortgages) + (secured asset value - property rehabilitation costs)) but I am reasonably certain this was a good first step toward straightening out the mess.

A major problem, however, is uncertainty. If I was certain that the government wasn't going to start picking arbitrary winners and losers in a number of economic sectors, I'd dump my retirement fund money out of bonds and into an index fund. I'm not about to do that right now, however, because I'm not sure that the people directing regulation of the markets at the high end have a better grasp on the significance of what they are doing, than I do. It's like they stumbled onto this mark-to-market accounting rule relief by accident, when a number of people who are pretty damn smart have been pushing the idea since last November. Y'know, when the market indexes were 50% higher than they are now.

Chuck Wagon said...

Fair points and well made. My misgivings with the whole thing are slightly akin to the question of "how are things going in the three legged unicorn market?" Holders of 3-legged unicorns, whose economic activity is based on not necessarily the liquidity of said unicorns but an asset ratio predicated on the value of the unicorns, will say that a 3 legged unicorn is indeed a rare and inspiring beast, whose value should reflect that splendour. Would be buyers of 3 legged unicorns see a damaged example of a niche product with significant liquidity risk. Holders have tremendous economic incentive to overvalue them, which pushes the other side of the table further away from completing a transaction. Enron having been perhaps the most egregious historical holder of 3 legged unicorns.

Chuck Wagon said...

ps - Bill Gross and the fine folks at PIMCO are duly entrusted with sorting all of this crap out for me. Despite my significant misgivings about treasuries and my particular biggest PIMCO holding being at least theoretically weighted toward them, I'm betting heavily that they can navigate the poo far better than I can.

GamJams said...

I'm thinking about getting new pedals. Do you think the speedplay zero ti are worth the extra cash over the speedplay zero stainless steel?

Sigberto said...

I've learned that any time your blog posts start with a financial rant, I should just scroll straight to the last paragraph for the cycling-related material.

Never fails. Thank god you threw in that last sentence today.

Chuck Wagon said...

Mike - No
Bert - Happy to oblige

Chris said...

hey Jim - i'm not sure where you're getting your info about securitized mortgages...maybe Kudlow? bcz he's saying the same crap.

You are oversimplifying the problem. Most of the securities are not simply pools of mortgages that pay off on a pro-rata basis (pass-thru's). The problem is that they are tranched in many ways that allocate cash flows and losses to different places depending on a number of variables. The further you go down the capital structure/cashflow waterfall the more impact a relatively small number of defaults will have.

Not to mention the leverage...

That's not even getting into the re-securitization of the securities and some of the embedded swaps and options. getting rid of mark to market accounting just keeps the bubble inflated.

Shine some light on that shit and let the market sort it out. Pretending that a bunch of financial companies aren't insolvent is putting your head in the sand.

blah blah blah

hugs and kisses ;-0

Jim said...

Yeah, I know I'm over simplifying, and but I figured a 91,000 word comment was bad enough without adding nuance.

I think that easing mark-to-market rules does possibly help keep the bubble inflated, but I also think that keeping mark-to-market in place prevents the kind of sorting out that you're looking for. Yet I don't know if there's a better way without eliminating the bulk buying and selling of mortgages, or the associated up and downside risk arbitrage. I actually worked on putting together packages of mortgages for securitization, on the buyer end, when I first moved to D.C., it's not glamorous or complicated work (that stuff goes on much later) and I know a little about what a tranche of mortgages looks like, first hand, at least at the point where it's developed. Bulk mortgages are f***in hard to value because you just don't know what the income stream of a mortgage held by a guy with a 675 credit rating, living in Arlington, VA, is going to look like in 10 years, then you multiply that by 300 or 500 or 1000, which is the number of mortgages in the tranche, and consider that valueing these now, with some mortgages that have no income stream, unsure home value due to real estate market fluctuation, and you have a product that's definitely worth something, probably a hell of a lot, but there's no way to value it without relying on a lot of presumptions.

Mark to market ain't the cause of the problems and relief from MTM isn't the solution to the problems, but I sincerely believe it is an obstacle to getting the market to deal with these troubled assets.