Why is Mark to Market bad???

NEW -> Contingent Buyer Assistance Program
[quote author="Nude" date=1222953813]

I know you attribute the worst motives to their actions, and you may be right. But I don't have any evidence of that, so I am going to withhold judgement.</blockquote>


Rep. Brad Sherman, D California:



Larry I am glad you have a few seconds to talk to someone who voted against this bill. I am not changing my mind. I want to thank my colleagues who stood up to the purveyors of panic and voted against a very bad bill and voted with 400 eminent economists including three Nobel laureates who wrote to us and said don't panic, don't act hastily, hold hearings, work carefully. The fact is Larry if you read this bill, even you would have voted against it.



It provides hundreds of billions of dollars of bailouts to foreign investors. It provides no real control of Paulson's power. There is a critique board but not really a board that can step in and change what he does. It's a $700 billion program run by a part-time temporary employee and there is no limit on million dollar a month salaries.



Larry Kudlow:



Let me just ask you one question. I think you are referring to foreign banks headquartered in the United States. I do not see how foreign investors get bailed out.



Rep. Brad Sherman:



Larry you have to read the bill. It's very clear. The Bank of Shanghai can transfer all of its toxic assets to the Bank of Shanghai of Los Angeles which can then sell them the next day to the Treasury. I had a provision to say if it wasn't owned by an American entity even a subsidiary, but at least an entity in the US, the Treasury can't buy it. It was rejected.



The bill is very clear. Assets now held in China and London can be sold to US entities on Monday and then sold to the Treasury on Tuesday. Paulson has made it clear he will recommend a veto of any bill that contained a clear provision that said if Americans did not own the asset on September 20th that it can't be sold to the Treasury.



Hundreds of billions of dollars are going to bail out foreign investors. They know it, they demanded it and the bill has been carefully written to make sure that can happen.



Resolution Draft



Inquiring minds are verifying the above in the Bailout Bill Resolution Draft. Here is the language under discussion.



3 SEC. 112. COORDINATION WITH FOREIGN AUTHORITIES

4 AND CENTRAL BANKS.

5 The Secretary shall coordinate, as appropriate, with

6 foreign financial authorities and central banks to work to

7 ward the establishment of similar programs by such au

8 thorities and central banks. To the extent that such for

9 eign financial authorities or banks hold troubled assets as

10 a result of extending financing to financial institutions

11 that have failed or defaulted on such financing, such trou

12 bled assets qualify for purchase under section 101.



7 SEC. 101. PURCHASES OF TROUBLED ASSETS.

8 (a) OFFICES; AUTHORITY. --

9 (1) AUTHORITY. -- The Secretary is authorized

10 to establish a troubled asset relief program (or

11 "TARP") to purchase, and to make and fund com

12 mitments to purchase, troubled assets from any fi

13 nancial institution, on such terms and conditions as

14 are determined by the Secretary, and in accordance

15 with this Act and the policies and procedures devel

16 oped and published by the Secretary.



SEC. 112. COORDINATION WITH FOREIGN AUTHORITIES

4 AND CENTRAL BANKS.

5 The Secretary shall coordinate, as appropriate, with

6 foreign financial authorities and central banks to work to

7 ward the establishment of similar programs by such au

8 thorities and central banks. To the extent that such for

9 eign financial authorities or banks hold troubled assets as

10 a result of extending financing to financial institutions

11 that have failed or defaulted on such financing, such trou

12 bled assets qualify for purchase under section 101.
 
[quote author="Nude" date=1222913040]IR, I think the plan is to allow mark-to-fantasy until the Treasury can get it's new facility up and running to purchase the toxic stuff. Then Paulson can pay just enough to ensure survival of just those banks that will cause a systemic crash if they fail. Raising the FDIC insurance limit to $250k keeps the withdrawals down and protects the smaller businesses as the rest of the insolvent banks are allowed to fail.



If that is indeed the plan, then it appears that there is no avoiding a collapse. They seem to be attempting the control the size of the event rather than preventing it.</blockquote>


Please correct me if I am wrong. Seriously.

<p>

But, here goes.

<p>

Mark to market is an SEC rule and only governs investment banks and brokerages.<p>

Commercial banks are governed by the FDIC under the Federal Reserve and are not required to mark to market. Commercial banks are required to value their assets at par, no matter what the market may value them at. They are required to value all assets on their balance sheet as if they hold them to maturity.<p>

Goldman Sachs and Morgan Stanley just recently switched to become commercial banks, so there are no American investment banks left. All the biggies, Citibank, JP Morgan Chase, Wells Fargo, B of A, Goldman Sachs, and Morgan Stanley are commercial banks, and they all mark their assets to par, (100 cents on the dollar). They do not give a ____ what the bailout plan or the SEC say to mark to as they are not governed by the SEC.
 
awgee, as far as I understand it, the change in FAS 157 would apply to "any issuer". As for the FDIC and mark-to-maturity, do the rules apply to all assets owned by the bank holding company or just those held by the commercial bank unit? I think it is just the commercial bank unit, else merging Merrill into BoA seems like a counter-productive idea.
 
awgee - FAS 157 applies to anyone who issues GAAP financial statements (which is all public companies). While the FDIC may govern the operations of banks, since they are public companies, the financial statements they issue and file with the SEC, need to be in accordance with GAAP.
 
[quote author="Nude" date=1222953813][quote author="awgee" date=1222947683][quote author="IrvineRenter" date=1222924282][quote author="Nude" date=1222913040]IR, I think the plan is to allow mark-to-fantasy until the Treasury can get it's new facility up and running to purchase the toxic stuff. Then Paulson can pay just enough to ensure survival of just those banks that will cause a systemic crash if they fail. Raising the FDIC insurance limit to $250k keeps the withdrawals down and protects the smaller businesses as the rest of the insolvent banks are allowed to fail.



If that is indeed the plan, then it appears that there is no avoiding a collapse. They seem to be attempting the control the size of the event rather than preventing it.</blockquote>


I hadn't thought of it that way. If this is simply part of a controlled implosion, perhaps this isn't a bad way to do it.</blockquote>


If that were the intention, would it not be easier, more direct, and less expensive to pass a much simpler piece of legislation saying that all the financial institutions have to open their books to Paulson, Bernanke, et al., for the purposes of finding out who is solvent and who is not? And then shut down the banks that are insolvent. The FDIC already has the authority to do this.</blockquote>


Actually, awgee, no it wouldn't. Forcing everyone to open their books at the same time would only ensure insolvency of every institution, leaving no one behind to fill the void. They don't want a panic that would result in a total destruction of the system.



But creating mega-banks via shotgun weddings, preventing short-sellers from forcing their hand, increasing the FDIC insurance coverage, redefining FAS rules, and passing this bailout bill gives them time to maneuver. If they can make a few key insitutions viable, even if only a skeleton crew, it might prevent the entire system from being taken down by cascading cross defaults. Look at the institutions that have been helped: AIG, WaMu, Countrywide, Wachovia, F&F, and recently both Goldman and General Electric have been endorsed by Warren Buffett. I think Bear Sterns caught them off guard, sent them a wake up call, if you will. I think Lehman was allowed to fail to test the weaknesses, see where the fault lines lay in the overall structure. It's just a theory, I admit, but the actions being taken by a number of different agencies makes me believe it is co-ordinated dismantling. I know you attribute the worst motives to their actions, and you may be right. But I don't have any evidence of that, so I am going to withhold judgement.</blockquote>


That is a well-reasoned and thought-through analysis. It fits all the available data. Kudos.
 
[quote author="awgee" date=1222986780][quote author="Nude" date=1222913040]IR, I think the plan is to allow mark-to-fantasy until the Treasury can get it's new facility up and running to purchase the toxic stuff. Then Paulson can pay just enough to ensure survival of just those banks that will cause a systemic crash if they fail. Raising the FDIC insurance limit to $250k keeps the withdrawals down and protects the smaller businesses as the rest of the insolvent banks are allowed to fail.



If that is indeed the plan, then it appears that there is no avoiding a collapse. They seem to be attempting the control the size of the event rather than preventing it.</blockquote>


Please correct me if I am wrong. Seriously.

<p>

But, here goes.

<p>

Mark to market is an SEC rule and only governs investment banks and brokerages.<p>

Commercial banks are governed by the FDIC under the Federal Reserve and are not required to mark to market. Commercial banks are required to value their assets at par, no matter what the market may value them at. They are required to value all assets on their balance sheet as if they hold them to maturity.<p>

Goldman Sachs and Morgan Stanley just recently switched to become commercial banks, so there are no American investment banks left. All the biggies, Citibank, JP Morgan Chase, Wells Fargo, B of A, Goldman Sachs, and Morgan Stanley are commercial banks, and they all mark their assets to par, (100 cents on the dollar). They do not give a ____ what the bailout plan or the SEC say to mark to as they are not governed by the SEC.</blockquote>
From my understanding as a former CPA, different assets are treated differently. Assets that are traded or "held for sale" should be marked-to-market while assets that are "held to maturity" should not be marked-to-market and should be valued at historic costs while using a "reserve for impairment" for all known losses on the historic value.
 
[quote author="qwerty" date=1223004728]awgee - FAS 157 applies to anyone who issues GAAP financial statements (which is all public companies). While the FDIC may govern the operations of banks, since they are public companies, the financial statements they issue and file with the SEC, need to be in accordance with GAAP.</blockquote>
Qwerty - You are saying that commercial banks are held to the same GAAP as other public companies and the entries on their balance sheets are treated the same? I am not being argumentative, just trying to get to the bottom of this.
 
[quote author="Nude" date=1222989560]awgee, as far as I understand it, the change in FAS 157 would apply to "any issuer". As for the FDIC and mark-to-maturity, do the rules apply to all assets owned by the bank holding company or just those held by the commercial bank unit? I think it is just the commercial bank unit, else merging Merrill into BoA seems like a counter-productive idea.</blockquote>


Heck if I know. I was asking for help in trying to understand this myself.
 
[quote author="usctrojanman29" date=1223008576][quote author="awgee" date=1222986780][quote author="Nude" date=1222913040]IR, I think the plan is to allow mark-to-fantasy until the Treasury can get it's new facility up and running to purchase the toxic stuff. Then Paulson can pay just enough to ensure survival of just those banks that will cause a systemic crash if they fail. Raising the FDIC insurance limit to $250k keeps the withdrawals down and protects the smaller businesses as the rest of the insolvent banks are allowed to fail.



If that is indeed the plan, then it appears that there is no avoiding a collapse. They seem to be attempting the control the size of the event rather than preventing it.</blockquote>


Please correct me if I am wrong. Seriously.

<p>

But, here goes.

<p>

Mark to market is an SEC rule and only governs investment banks and brokerages.<p>

Commercial banks are governed by the FDIC under the Federal Reserve and are not required to mark to market. Commercial banks are required to value their assets at par, no matter what the market may value them at. They are required to value all assets on their balance sheet as if they hold them to maturity.<p>

Goldman Sachs and Morgan Stanley just recently switched to become commercial banks, so there are no American investment banks left. All the biggies, Citibank, JP Morgan Chase, Wells Fargo, B of A, Goldman Sachs, and Morgan Stanley are commercial banks, and they all mark their assets to par, (100 cents on the dollar). They do not give a ____ what the bailout plan or the SEC say to mark to as they are not governed by the SEC.</blockquote>
From my understanding as a former CPA, different assets are treated differently. Assets that are traded or "held for sale" should be marked-to-market while assets that are "held to maturity" should not be marked-to-market and should be valued at historic costs while using a "reserve for impairment" for all known losses on the historic value.</blockquote>


Again, not to be argumentative, but did you ever work with or for a commercial bank? This is not a personal question doubting your expertise, but rather an inquiry to find out if banks are treated differently? Does the "reserve for impairment" show up as a negative to the asset value? The person who told me that commercial bank assets are valued at par is usually an extremely reliable source of information.
 
[quote author="awgee" date=1223016145][quote author="usctrojanman29" date=1223008576][quote author="awgee" date=1222986780][quote author="Nude" date=1222913040]IR, I think the plan is to allow mark-to-fantasy until the Treasury can get it's new facility up and running to purchase the toxic stuff. Then Paulson can pay just enough to ensure survival of just those banks that will cause a systemic crash if they fail. Raising the FDIC insurance limit to $250k keeps the withdrawals down and protects the smaller businesses as the rest of the insolvent banks are allowed to fail.



If that is indeed the plan, then it appears that there is no avoiding a collapse. They seem to be attempting the control the size of the event rather than preventing it.</blockquote>


Please correct me if I am wrong. Seriously.

<p>

But, here goes.

<p>

Mark to market is an SEC rule and only governs investment banks and brokerages.<p>

Commercial banks are governed by the FDIC under the Federal Reserve and are not required to mark to market. Commercial banks are required to value their assets at par, no matter what the market may value them at. They are required to value all assets on their balance sheet as if they hold them to maturity.<p>

Goldman Sachs and Morgan Stanley just recently switched to become commercial banks, so there are no American investment banks left. All the biggies, Citibank, JP Morgan Chase, Wells Fargo, B of A, Goldman Sachs, and Morgan Stanley are commercial banks, and they all mark their assets to par, (100 cents on the dollar). They do not give a ____ what the bailout plan or the SEC say to mark to as they are not governed by the SEC.</blockquote>
From my understanding as a former CPA, different assets are treated differently. Assets that are traded or "held for sale" should be marked-to-market while assets that are "held to maturity" should not be marked-to-market and should be valued at historic costs while using a "reserve for impairment" for all known losses on the historic value.</blockquote>


Again, not to be argumentative, but did you ever work with or for a commercial bank? This is not a personal question doubting your expertise, but rather an inquiry to find out if banks are treated differently? Does the "reserve for impairment" show up as a negative to the asset value? The person who told me that commercial bank assets are valued at par is usually an extremely reliable source of information.</blockquote>


Awgee - i dont work for a bank, but i am a CPA at public company - I handle all of the technical accounting and financial reporting (10Q's, 10K's, etc). Banks are not treated differently, if they are public, they must issue and file financial statements with the SEC that are prepared in accordance with GAAP. FAS 115 covers the accounting for investments, like trojanman said, if investments are trading/available for sale then they have to be reflected on the balance sheet at fair value. If investments are impaired permanently they have to be written down to their fair value and the writedown is recognized as an expense on the P&L. If their is temporary impairment, then the change in fair value due to the temporary impairment is an unrealized loss recognized in the equity section of the balance sheet as other comprehensive income/loss. All of the investments held by the banks that hold foreclosed loans are permanently impaired and therefore have to be written down to the new fair value. In addition since there is no market for MBS (because they are believed to be toxic) it makes it tough to make an argument that the impairment is temporary and therefore have to be written down to the new fair value, which is tough to determine since these are all level 3 assets and there are no observable market inputs. For level 3 assets you are pretty much down to cash flow analysis that include a liquidity discount. Right now other types of investments that are level 3 assets are auction rate securities since there is not much of a market for those either. What FAS 157 does is clarify how to calculate fair value - not force you to value investments at fair value, FAS 115 forces you to value certain types of investments at fair value.
 
[quote author="awgee" date=1223016145][quote author="usctrojanman29" date=1223008576][quote author="awgee" date=1222986780][quote author="Nude" date=1222913040]IR, I think the plan is to allow mark-to-fantasy until the Treasury can get it's new facility up and running to purchase the toxic stuff. Then Paulson can pay just enough to ensure survival of just those banks that will cause a systemic crash if they fail. Raising the FDIC insurance limit to $250k keeps the withdrawals down and protects the smaller businesses as the rest of the insolvent banks are allowed to fail.



If that is indeed the plan, then it appears that there is no avoiding a collapse. They seem to be attempting the control the size of the event rather than preventing it.</blockquote>


Please correct me if I am wrong. Seriously.

<p>

But, here goes.

<p>

Mark to market is an SEC rule and only governs investment banks and brokerages.<p>

Commercial banks are governed by the FDIC under the Federal Reserve and are not required to mark to market. Commercial banks are required to value their assets at par, no matter what the market may value them at. They are required to value all assets on their balance sheet as if they hold them to maturity.<p>

Goldman Sachs and Morgan Stanley just recently switched to become commercial banks, so there are no American investment banks left. All the biggies, Citibank, JP Morgan Chase, Wells Fargo, B of A, Goldman Sachs, and Morgan Stanley are commercial banks, and they all mark their assets to par, (100 cents on the dollar). They do not give a ____ what the bailout plan or the SEC say to mark to as they are not governed by the SEC.</blockquote>
From my understanding as a former CPA, different assets are treated differently. Assets that are traded or "held for sale" should be marked-to-market while assets that are "held to maturity" should not be marked-to-market and should be valued at historic costs while using a "reserve for impairment" for all known losses on the historic value.</blockquote>


Again, not to be argumentative, but did you ever work with or for a commercial bank? This is not a personal question doubting your expertise, but rather an inquiry to find out if banks are treated differently? Does the "reserve for impairment" show up as a negative to the asset value? The person who told me that commercial bank assets are valued at par is usually an extremely reliable source of information.</blockquote>
I work at a regional commercial bank and used to work for the BIG 6 CPA firms (down to 4 today). It's not that banks are treated differently, it's the classification of assets that are treated differently per FASB. I believe that Banks are not allowed to trade in and out of securities (they are only allowed to purchase and hold certain like of assets/investments as mandated by FIDC/OCC/OTS). The investments in MBS and alike on the books of banks are classified as "held to maturity" assets as the banks don't have intent to sell them within the next 12 months. The "reserve for impairment" does show up as a credit or contra asset below the investment like as would reserve for bad debts for A/R. If it's a temp impairment then the other side of the transaction hits the equity section of the balance as a debit (unrealized loss on investments) and never hits the income statement. You only hit the income statement once the impairment is permanent.
 
Maybe you can help me with something else that is on my mind:

I keep on hearing how mark to market is unrealistic. I keep on hearing how the paper that would sell right now for 40 cents on the dollar is "worth" much more, but the market is just too illiquid. And as credit unfreezes or the market becomes more liquid, the 40 cent paper will appreciate.



Well, call me naive or shortsighted or ...

But, it seems to me that if that 40 cent paper is going to be "worth" so much more in the future, the banks would be fighting to buy it. Buffett, Ross, Pimco, Einhorn, Paulson, and the big hedge fund managers would be scraping to get their hands on it.



As it is, they can't seem to run far enough from it.
 
[quote author="awgee" date=1223070689]Maybe you can help me with something else that is on my mind:

I keep on hearing how mark to market is unrealistic. I keep on hearing how the paper that would sell right now for 40 cents on the dollar is "worth" much more, but the market is just too illiquid. And as credit unfreezes or the market becomes more liquid, the 40 cent paper will appreciate.



Well, call me naive or shortsighted or ...

But, it seems to me that if that 40 cent paper is going to be "worth" so much more in the future, the banks would be fighting to buy it. Buffett, Ross, Pimco, Einhorn, Paulson, and the big hedge fund managers would be scraping to get their hands on it.



As it is, they can't seem to run far enough from it.</blockquote>


Yeah, what a deal. Any security that is undervalued will find a buyer. There are plenty of long-term investors that make their money by buying distresses assets. There are no buyers because there is no present or future value in these things. The whole supposition that these assets are temporarily distressed is complete nonsense.
 
i don't get why nobody wants my collection of darryl strawberry baseball cards. some guy told me that drug-addicted, tax-evading criminals who never fulfilled their potential aren't worth much these days. i said, at the time the card was issued -- 37 homers and 108 rbi's! numbers don't lie, bro!



darn that marking to market.
 
[quote author="awgee" date=1223070689]Maybe you can help me with something else that is on my mind:

I keep on hearing how mark to market is unrealistic. I keep on hearing how the paper that would sell right now for 40 cents on the dollar is "worth" much more, but the market is just too illiquid. And as credit unfreezes or the market becomes more liquid, the 40 cent paper will appreciate.



Well, call me naive or shortsighted or ...

But, it seems to me that if that 40 cent paper is going to be "worth" so much more in the future, the banks would be fighting to buy it. Buffett, Ross, Pimco, Einhorn, Paulson, and the big hedge fund managers would be scraping to get their hands on it.



As it is, they can't seem to run far enough from it.</blockquote>


awgee - i think i can help with that as well. there actually are investments that people can pick up at a pretty good value like you mention above. ill give you an example on something that i have researched heavily - auction rate securities (ARS). lets say a company at the end of their quarter has ARS that it has to value at fair value. As many of you, there is no real market right now for ARS (the auctions basically all started to fail in Feb of this year). For the purpose of this example lets assume the following:



- ARS backed by tax exempt muni bonds (the highest quality ARS, ARS backed by student loans and other debt obligations have been hit even worse valuations)

- interest rate is 4% (or 6-7% taxable equivalent) - when the auctions fail, this triggers higher penalty rates

- classified as available for sale, so they have to be presented at fair value

- purchased at par before the auctions started to fail and par equaled fair value

- temporary impairment so the change in fair value runs through the equity section of the balance and not the income statement



Since there is no market or other observable inputs, FAS 157 says these should be level 3 assets. These assets basically have to be valued using a discounted cash flow analysis. The assumptions used by management are very subjective, which is why level 3 assets are incredibly hard to value. So using a discounted cash flow analysis without a liquidity discount actually results in fair value that is greater than the par value the ARS was purchased for due to the interest rate being earned compared to other available rates. Of course it doesnt make sense to not have a liquidity discount because no one is going to buy these things at par. So the liquidity discount causes the fair value to drop below par. After you determine a value, you have to determine if the change is fair value is temporary (runs though the balance sheet) or permanent (runs through the income statement). For the change in fair value to be temporary a company basically has to prove that it can hold on to the ARS until it gets the full value back and that there are no underlying credit concerns with the issuer of the muni bond - this is not a big hurdle to the extent a company has a lot of cash or access to it (other than the ARS itself)



The majority of changes (reduction) in fair value that i saw in 10Q's/10K's for ARS backed by muni bonds was about 2%-5%. These valuations were based on cash flow analysis. So from a pure accounting perspective, the fair value is 2% - 5% lower than what they were purchased for at par. However, if you actually tried to sell these things tomorrow, you would actually have to sell them at 70% to 80% of what you bought them for (that info was provided by our bankers) - so the accounting rules actually let you show a higher value than what you could actually get right now if you tried to sell the ARS. There are investors that are buying ARS backed by muni bonds because all of the municipalities are refinancing the bonds tied to the ARS due to the higher penalty rates they are paying. By refinancing the bonds they can pay a much lower rate on the new debt. Those investors know that it is highly likely that within the next year or so, the refinancing will take place and they will be getting 100% of the par value when they only paid 70% to 80% of the par value. So they end up making a very handsome return. The companys that sell them at this type of discount are those that are strapped for cash and have to liquidate them, which is where the investors are getting the good deals.



This example is not as extreme as 40 cents on the dollar you mentioned but you get the drift. Depending on the assumptions used, a company can value an ARS at 40 cents on the dollar, but their argument that it is really worth more is somewhat valid, because to the extent you can hold out long enough for the municipality to refinance, you will get all of your money back, even though the cash flow analysis says its only worth 40 cents on the dollar. I am not as familiar with mortgage backed securities (MBS), which i assume is what you are referring to since that is what this bailout is for (for the most part) - but the argument the holders of the MBS are making is based on the premise i discussed above. For the MBS to be worth only 40 cents on the dollar the liquidity discount has to be huge since some of the loans that are bundled have to be generating cash flow. I guess part of the difficulty with the MBS is figuring out how much, if any cash flow (or cash recovered from the sale of a foreclosed home), is going to be generated by soon to be bad loans.



Hope this makes sense, if not let me know.
 
[quote author="qwerty" date=1223124617][quote author="awgee" date=1223070689]Maybe you can help me with something else that is on my mind:

I keep on hearing how mark to market is unrealistic. I keep on hearing how the paper that would sell right now for 40 cents on the dollar is "worth" much more, but the market is just too illiquid. And as credit unfreezes or the market becomes more liquid, the 40 cent paper will appreciate.



Well, call me naive or shortsighted or ...

But, it seems to me that if that 40 cent paper is going to be "worth" so much more in the future, the banks would be fighting to buy it. Buffett, Ross, Pimco, Einhorn, Paulson, and the big hedge fund managers would be scraping to get their hands on it.



As it is, they can't seem to run far enough from it.</blockquote>


awgee - i think i can help with that as well. there actually are investments that people can pick up at a pretty good value like you mention above. ill give you an example on something that i have researched heavily - auction rate securities (ARS). lets say a company at the end of their quarter has ARS that it has to value at fair value. As many of you, there is no real market right now for ARS (the auctions basically all started to fail in Feb of this year). For the purpose of this example lets assume the following:



- ARS backed by tax exempt muni bonds (the highest quality ARS, ARS backed by student loans and other debt obligations have been hit even worse valuations)

- interest rate is 4% (or 6-7% taxable equivalent) - when the auctions fail, this triggers higher penalty rates

- classified as available for sale, so they have to be presented at fair value

- purchased at par before the auctions started to fail and par equaled fair value

- temporary impairment so the change in fair value runs through the equity section of the balance and not the income statement



Since there is no market or other observable inputs, FAS 157 says these should be level 3 assets. These assets basically have to be valued using a discounted cash flow analysis. The assumptions used by management are very subjective, which is why level 3 assets are incredibly hard to value. So using a discounted cash flow analysis without a liquidity discount actually results in fair value that is greater than the par value the ARS was purchased for due to the interest rate being earned compared to other available rates. Of course it doesnt make sense to not have a liquidity discount because no one is going to buy these things at par. So the liquidity discount causes the fair value to drop below par. After you determine a value, you have to determine if the change is fair value is temporary (runs though the balance sheet) or permanent (runs through the income statement). For the change in fair value to be temporary a company basically has to prove that it can hold on to the ARS until it gets the full value back and that there are no underlying credit concerns with the issuer of the muni bond - this is not a big hurdle to the extent a company has a lot of cash or access to it (other than the ARS itself)



The majority of changes (reduction) in fair value that i saw in 10Q's/10K's for ARS backed by muni bonds was about 2%-5%. These valuations were based on cash flow analysis. So from a pure accounting perspective, the fair value is 2% - 5% lower than what they were purchased for at par. However, if you actually tried to sell these things tomorrow, you would actually have to sell them at 70% to 80% of what you bought them for (that info was provided by our bankers) - so the accounting rules actually let you show a higher value than what you could actually get right now if you tried to sell the ARS. There are investors that are buying ARS backed by muni bonds because all of the municipalities are refinancing the bonds tied to the ARS due to the higher penalty rates they are paying. By refinancing the bonds they can pay a much lower rate on the new debt. Those investors know that it is highly likely that within the next year or so, the refinancing will take place and they will be getting 100% of the par value when they only paid 70% to 80% of the par value. So they end up making a very handsome return. The companys that sell them at this type of discount are those that are strapped for cash and have to liquidate them, which is where the investors are getting the good deals.



This example is not as extreme as 40 cents on the dollar you mentioned but you get the drift. Depending on the assumptions used, a company can value an ARS at 40 cents on the dollar, but their argument that it is really worth more is somewhat valid, because to the extent you can hold out long enough for the municipality to refinance, you will get all of your money back, even though the cash flow analysis says its only worth 40 cents on the dollar. I am not as familiar with mortgage backed securities (MBS), which i assume is what you are referring to since that is what this bailout is for (for the most part) - but the argument the holders of the MBS are making is based on the premise i discussed above. For the MBS to be worth only 40 cents on the dollar the liquidity discount has to be huge since some of the loans that are bundled have to be generating cash flow.



Hope this makes sense, if not let me know.</blockquote>
That's a great post! Almost felt like I was back in my advanced accounting class in my undergrad days as I was reading your post. haha
 
[quote author="qwerty" date=1223124617][quote author="awgee" date=1223070689]Maybe you can help me with something else that is on my mind:

I keep on hearing how mark to market is unrealistic. I keep on hearing how the paper that would sell right now for 40 cents on the dollar is "worth" much more, but the market is just too illiquid. And as credit unfreezes or the market becomes more liquid, the 40 cent paper will appreciate.



Well, call me naive or shortsighted or ...

But, it seems to me that if that 40 cent paper is going to be "worth" so much more in the future, the banks would be fighting to buy it. Buffett, Ross, Pimco, Einhorn, Paulson, and the big hedge fund managers would be scraping to get their hands on it.



As it is, they can't seem to run far enough from it.</blockquote>


awgee - i think i can help with that as well. there actually are investments that people can pick up at a pretty good value like you mention above. ill give you an example on something that i have researched heavily - auction rate securities (ARS). lets say a company at the end of their quarter has ARS that it has to value at fair value. As many of you, there is no real market right now for ARS </blockquote>


First, thank you so much for thanking the time to explain complicated issues. I feel a bit embarrassed because I do not think my stupid question are worth that much of your time.



You say, "there is no real market right now for ARS". Doesn't that make you wonder if maybe it is the accounting principles that are flawed?



[quote author="qwerty" date=1223124617]



(the auctions basically all started to fail in Feb of this year). For the purpose of this example lets assume the following:



- ARS backed by tax exempt muni bonds (the highest quality ARS, ARS backed by student loans and other debt obligations have been hit even worse valuations)

- interest rate is 4% (or 6-7% taxable equivalent) - when the auctions fail, this triggers higher penalty rates

- classified as available for sale, so they have to be presented at fair value

- purchased at par before the auctions started to fail and par equaled fair value

- temporary impairment so the change in fair value runs through the equity section of the balance and not the income statement



Since there is no market or other observable inputs, FAS 157 says these should be level 3 assets. These assets basically have to be valued using a discounted cash flow analysis. The assumptions used by management are very subjective, which is why level 3 assets are incredibly hard to value. So using a discounted cash flow analysis without a liquidity discount actually results in fair value that is greater than the par value the ARS was purchased for due to the interest rate being earned compared to other available rates. Of course it doesnt make sense to not have a liquidity discount because no one is going to buy these things at par. So the liquidity discount causes the fair value to drop below par. After you determine a value, you have to determine if the change is fair value is temporary (runs though the balance sheet) or permanent (runs through the income statement). For the change in fair value to be temporary a company basically has to prove that it can hold on to the ARS until it gets the full value back and that there are no underlying credit concerns with the issuer of the muni bond - this is not a big hurdle to the extent a company has a lot of cash or access to it (other than the ARS itself)</blockquote>
This is where I see the potential flaw. The company has to prove that it can hold on until it gets full value back. I am skeptical that companies can accurately or honestly show that they can hold on until they can get full value. I am especially skeptical of banks. I think they are holding assets in this manner which in all likelyhood are close to worthless and will be worthless as time goes by. I will explain more later in this post.



[quote author="qwerty" date=1223124617]



The majority of changes (reduction) in fair value that i saw in 10Q's/10K's for ARS backed by muni bonds was about 2%-5%. These valuations were based on cash flow analysis. So from a pure accounting perspective, the fair value is 2% - 5% lower than what they were purchased for at par. However, if you actually tried to sell these things tomorrow, you would actually have to sell them at 70% to 80% of what you bought them for (that info was provided by our bankers) - so the accounting rules actually let you show a higher value than what you could actually get right now if you tried to sell the ARS. There are investors that are buying ARS backed by muni bonds because all of the municipalities are refinancing the bonds tied to the ARS due to the higher penalty rates they are paying. By refinancing the bonds they can pay a much lower rate on the new debt. Those investors know that it is highly likely that within the next year or so, the refinancing will take place and they will be getting 100% of the par value when they only paid 70% to 80% of the par value.

</blockquote>


I think that if this were true, there would be more investors lining up to buy "undervalued" assets.



[quote author="qwerty" date=1223124617]



So they end up making a very handsome return. The companys that sell them at this type of discount are those that are strapped for cash and have to liquidate them, which is where the investors are getting the good deals.



This example is not as extreme as 40 cents on the dollar you mentioned but you get the drift. Depending on the assumptions used, a company can value an ARS at 40 cents on the dollar, but their argument that it is really worth more is somewhat valid, because to the extent you can hold out long enough for the municipality to refinance, you will get all of your money back, even though the cash flow analysis says its only worth 40 cents on the dollar. I am not as familiar with mortgage backed securities (MBS), which i assume is what you are referring to since that is what this bailout is for (for the most part) - but the argument the holders of the MBS are making is based on the premise i discussed above. For the MBS to be worth only 40 cents on the dollar the liquidity discount has to be huge since some of the loans that are bundled have to be generating cash flow. I guess part of the difficulty with the MBS is figuring out how much, if any cash flow (or cash recovered from the sale of a foreclosed home), is going to be generated by soon to be bad loans.



Hope this makes sense, if not let me know.</blockquote>


It makes perfect sense. Again, thank you for taking the time to explain. You make a complicated subject much clearer.



If, and that is a big <strong>IF</strong>, the paper I am referring to could be held to maturity, it will be worth less than now. I do not think Paulson will be buying ARS or MBS of mortgage bundles. I think that is what he is misleading the American public to think. The large banks created collateralized debt obligation, CDOs, which are not bundles of mortgages. They are cash flow contracts based on MBSes. The banks sold the AAA, and AA tranches, and kept the BBB and equity tranches because they could not sell them. The cash flow from the equity tranches makes them worth 10 cents or 20 cents or maybe 40 cents on the dollar. The cash flow on these tranches will not improve and will probably become worse. It is contracted that cash flow from the mortgages and proceeds from foreclosures directs to the AAA and AA tranches and the equity tranches are left with squat.



And it is my guess that the cash flow from ARS will decrease dramatically. Investors, unlike government and the public base their decisions on the future and future probabilities, not on the present. I think investors are overwhelmingly saying that most of this paper is lousy.
 
[quote author="awgee" date=1223158315][quote author="qwerty" date=1223124617][quote author="awgee" date=1223070689]Maybe you can help me with something else that is on my mind:

I keep on hearing how mark to market is unrealistic. I keep on hearing how the paper that would sell right now for 40 cents on the dollar is "worth" much more, but the market is just too illiquid. And as credit unfreezes or the market becomes more liquid, the 40 cent paper will appreciate.



Well, call me naive or shortsighted or ...

But, it seems to me that if that 40 cent paper is going to be "worth" so much more in the future, the banks would be fighting to buy it. Buffett, Ross, Pimco, Einhorn, Paulson, and the big hedge fund managers would be scraping to get their hands on it.



As it is, they can't seem to run far enough from it.</blockquote>


awgee - i think i can help with that as well. there actually are investments that people can pick up at a pretty good value like you mention above. ill give you an example on something that i have researched heavily - auction rate securities (ARS). lets say a company at the end of their quarter has ARS that it has to value at fair value. As many of you, there is no real market right now for ARS </blockquote>


First, thank you so much for thanking the time to explain complicated issues. I feel a bit embarrassed because I do not think my stupid question are worth that much of your time.



You say, "there is no real market right now for ARS". Doesn't that make you wonder if maybe it is the accounting principles that are flawed?



[quote author="qwerty" date=1223124617]



(the auctions basically all started to fail in Feb of this year). For the purpose of this example lets assume the following:



- ARS backed by tax exempt muni bonds (the highest quality ARS, ARS backed by student loans and other debt obligations have been hit even worse valuations)

- interest rate is 4% (or 6-7% taxable equivalent) - when the auctions fail, this triggers higher penalty rates

- classified as available for sale, so they have to be presented at fair value

- purchased at par before the auctions started to fail and par equaled fair value

- temporary impairment so the change in fair value runs through the equity section of the balance and not the income statement



Since there is no market or other observable inputs, FAS 157 says these should be level 3 assets. These assets basically have to be valued using a discounted cash flow analysis. The assumptions used by management are very subjective, which is why level 3 assets are incredibly hard to value. So using a discounted cash flow analysis without a liquidity discount actually results in fair value that is greater than the par value the ARS was purchased for due to the interest rate being earned compared to other available rates. Of course it doesnt make sense to not have a liquidity discount because no one is going to buy these things at par. So the liquidity discount causes the fair value to drop below par. After you determine a value, you have to determine if the change is fair value is temporary (runs though the balance sheet) or permanent (runs through the income statement). For the change in fair value to be temporary a company basically has to prove that it can hold on to the ARS until it gets the full value back and that there are no underlying credit concerns with the issuer of the muni bond - this is not a big hurdle to the extent a company has a lot of cash or access to it (other than the ARS itself)</blockquote>
This is where I see the potential flaw. The company has to prove that it can hold on until it gets full value back. I am skeptical that companies can accurately or honestly show that they can hold on until they can get full value. I am especially skeptical of banks. I think they are holding assets in this manner which in all likelyhood are close to worthless and will be worthless as time goes by. I will explain more later in this post.



[quote author="qwerty" date=1223124617]



The majority of changes (reduction) in fair value that i saw in 10Q's/10K's for ARS backed by muni bonds was about 2%-5%. These valuations were based on cash flow analysis. So from a pure accounting perspective, the fair value is 2% - 5% lower than what they were purchased for at par. However, if you actually tried to sell these things tomorrow, you would actually have to sell them at 70% to 80% of what you bought them for (that info was provided by our bankers) - so the accounting rules actually let you show a higher value than what you could actually get right now if you tried to sell the ARS. There are investors that are buying ARS backed by muni bonds because all of the municipalities are refinancing the bonds tied to the ARS due to the higher penalty rates they are paying. By refinancing the bonds they can pay a much lower rate on the new debt. Those investors know that it is highly likely that within the next year or so, the refinancing will take place and they will be getting 100% of the par value when they only paid 70% to 80% of the par value.

</blockquote>


I think that if this were true, there would be more investors lining up to buy "undervalued" assets.



[quote author="qwerty" date=1223124617]



So they end up making a very handsome return. The companys that sell them at this type of discount are those that are strapped for cash and have to liquidate them, which is where the investors are getting the good deals.



This example is not as extreme as 40 cents on the dollar you mentioned but you get the drift. Depending on the assumptions used, a company can value an ARS at 40 cents on the dollar, but their argument that it is really worth more is somewhat valid, because to the extent you can hold out long enough for the municipality to refinance, you will get all of your money back, even though the cash flow analysis says its only worth 40 cents on the dollar. I am not as familiar with mortgage backed securities (MBS), which i assume is what you are referring to since that is what this bailout is for (for the most part) - but the argument the holders of the MBS are making is based on the premise i discussed above. For the MBS to be worth only 40 cents on the dollar the liquidity discount has to be huge since some of the loans that are bundled have to be generating cash flow. I guess part of the difficulty with the MBS is figuring out how much, if any cash flow (or cash recovered from the sale of a foreclosed home), is going to be generated by soon to be bad loans.



Hope this makes sense, if not let me know.</blockquote>


It makes perfect sense. Again, thank you for taking the time to explain. You make a complicated subject much clearer.



If, and that is a big <strong>IF</strong>, the paper I am referring to could be held to maturity, it will be worth less than now. I do not think Paulson will be buying ARS or MBS of mortgage bundles. I think that is what he is misleading the American public to think. The large banks created collateralized debt obligation, CDOs, which are not bundles of mortgages. They are cash flow contracts based on MBSes. The banks sold the AAA, and AA tranches, and kept the BBB and equity tranches because they could not sell them. The cash flow from the equity tranches makes them worth 10 cents or 20 cents or maybe 40 cents on the dollar. The cash flow on these tranches will not improve and will probably become worse. It is contracted that cash flow from the mortgages and proceeds from foreclosures directs to the AAA and AA tranches and the equity tranches are left with squat.



And it is my guess that the cash flow from ARS will decrease dramatically. Investors, unlike government and the public base their decisions on the future and future probabilities, not on the present. I think investors are overwhelmingly saying that most of this paper is lousy.</blockquote>


I agree, there are many flawed accounting pronouncements. Regarding the purchasing of undervalued assets, the example i cite above is happening with ARS backed by tax exempt muni bonds just not with a lot of frequency (at least according to the investment bank that holds our investments).
 
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