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a quick note on mark to market accounting

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August 03, 2009 – Comments (10)

Mark to market accounting has been at the core of the thesis behind my bullish perspective for some time.  Basically, it works like this:

Imagine you had a business that made $100,000 every year.  But in addition to that,the business invested $2 million worth of corporate bonds at 7.5%. That would bring in an additional $150,000 each year. 

Then imagine that one year - the companies weren't broke, they were still paying interest on the bonds - the bond market crashed.  So your $2 mil of bonds were now worth $1.5 mil.

That year you would report a loss of $250k.  You actually made $250k, nothing about your situation changed, but you'd report a loss of $250k.  Because the market value of your assets fell, so you "mark" them to market and in doing so lose $500k.  You make $100k from the business and $150k in interest, you mark down $500k and that adds up to a loss of a quarter mil.

Then imagine that the next year the bond market settled down and your bonds were worth par again... (or $2 mil market value).  Then you would theoretically report $750k of income the next year ($100k from running the business + $150k of interest + $500k marked up to market).

Well here on Wall Street, mark to market in all of its sweeping, epic glory, doesn't work that way in all cases.

An insurance company like XL or HIG or GNW or CNO (4 of my 8 biggest holdings, mostly from earlier in the year and largely from near the march lows) has this fascinating and bizzare reality:

1.  They DO mark losses to market.  If the bond market (insurance companies sell you apolicy, probably make very little off that, then invest the proceeds, and those investments is where they make money) crashes they report a loss as described above.

2.  They DON'T mark gains to market.  If the bond market recovers, they DO NOT rpeort bizzarely large profits as a result.  So, basically, imagine that the bond market crashed one year and recovered the next.  GAAP WOULD report the LOSS, but WOULD NOT, report the gain.  Book value would show this, but earnings would not.

So, in sum, mark to market accounting in its current form permanently reduces GAAP net earnings, making them unrealistically low.  HIGmarked up a couple billion, they did not report earnings of a couple billion.  They DID report losses of a couple billion when those investments dropped in value.

This is perverse, its almost unthinkable, its bizzare, but its reality.  GAAP is bizzarely and epically flawed.  And it will skew earnings DOWN for basically all of time as far as I can tell.  Actual earnings will be > GAAP earnings due to these perversions of reality.

Consider that when someone parades a p/e of an indexin front of you to make a bearish argument.  

We are in the middle or maybe the tail end or maybe just out of a great recession that was caused in no small part by mark to market accounting and its perverse and peculiar realities.  The realities discussed above will be used for a long time as an argument for why stocks are overpriced.

Just FYI

10 Comments – Post Your Own

#1) On August 03, 2009 at 1:05 AM, awallejr (81.59) wrote:

I don't consider mark-to-market accounting rules as the cause of the current crisis, but it can "exaggerate" things.

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#2) On August 03, 2009 at 1:41 AM, checklist34 (99.70) wrote:

i think it sure as hell magnified the current crisis, awall.  and i think the fact that what marks down IS a loss but what markes up ISNT' a profit will fuel furious beras for some time to come.

a shame, all of it.  its a horribly misguided accounting system

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#3) On August 03, 2009 at 1:54 AM, awallejr (81.59) wrote:

Lehman and Bear, Stearns, for example, were destined to collapse as a result of 1999 legislative action (repealing of Glass-Steagall - I say this alot ;p), not because of mark-to-marketing, tho it did add fuel to the fire.

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#4) On August 03, 2009 at 2:19 AM, checklist34 (99.70) wrote:

awall, i'm more ignant than i sound on teusdays.  I'll have to read up on glass-steagall.  But M2M created, in no small part, the radical p/e charts bears love to throw around.  and falling markets creates panic just as rising markets create happy and confidence. 

vicious cycle up and down.  

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#5) On August 03, 2009 at 11:24 AM, davejh23 (< 20) wrote:

Your points may apply to your investments, but there are legitimate concerns about the valuation of assets on banks' books...there are real losses sitting on their books just waiting to be realized.  I agree that this may have magnified the crisis, and that created some opportunities, but I wouldn't rule out a huge blow to the markets from terrible earnings from the financials in the next several quarters.

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#6) On August 03, 2009 at 12:01 PM, bigpeach (27.47) wrote:

Generally agreed, and good to see you posting a bit checklist. Careful with the insurers however. Both HIG and GNW have had large insurance losses. HIG in their variable annuity book, and GNW in their mortgate insurance book. Fixed income asset mark downs were only part of their problems, but both have taken appropriate steps to increase capital and liquidity and seem to be stable now. In the insurance world, I have a bigger problem with things like DAC and the way that is accounted for.

So are you mostly long again, or are you still fussing around with puts?

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#7) On August 03, 2009 at 12:22 PM, Melaschasm (56.85) wrote:

Great post, and it definately gives me something to think about.

If my understanding of GAAP M2M rules is correct, the 'profit' should be realized as the principle is repaid. 

Based upon your example, if this was an interest only bond, with a balloon payment in ten years, then ten years from now the company would realize a $500,000 profit.

If there is both interest and principle included in the payments, then the company would slowly recognize profits from the repayment of principle, over the next 10 years.

 

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#8) On August 03, 2009 at 12:36 PM, rd80 (98.28) wrote:

For those who still like strict mark-to-market, consider how some of the banks reported profits back in the first quarter.  It wasn't from suspending mark-to-market, it was by marking down their own debt.

Take checklist34's example and add in that your company owes $1 million on a bond issue.  The market is trading your bonds at 60 cents on the dollar.  If you mark that debt to market, you just reduced that one million dollar liability to $600k and boosted your profit by $400k.  You still owe the money, you still need to make the payments, but - poof - $400k of 'earnings' appears as if by magic.

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#9) On August 03, 2009 at 7:24 PM, checklist34 (99.70) wrote:

dave, I will confess that while insurance companies aren't exactly transparent or easy to analyze, banks are outright impossible.  I have some C which i'm selling into this strength that I got in an arbitrage play with the C preferred stock, I made a little bit on it but not a whole lot.  And I'm long some WFC, USB,and BAC and GRNB.  BAC is the only big position there. 

My thesis for BAC is any combination of tarp money (its not going bankrupt), Doug Kass's endorsement (he seems competent), Stifel's endorsement (I like their reports), insider buying, and my own assessment of earnings potential in normalized times. 

Banks off balance sheet liabilities are concerning to me (C has some monster number, like 800B, of off balance sheet mess). 

And rd80 is right about mark to market and recent banking profits.  One timers and marking down their own debt have been a fair bit of it all. 

I think that kind of m2m injustice is just as silly as the one I described, its all silly, and frankly I'm not sure anybody really knows what exactly the situation at a company like C is. 

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#10) On August 03, 2009 at 7:27 PM, checklist34 (99.70) wrote:

hey peach, I fully expect the pps of GNW and HIG to never approach their previous levels again.  But GNW is still trading at around 1/4 of ultimate book value and I think it can trade towards 1/2 of book, they've made alot of progress.

I have always been vastly long, and my putzing about with options has been profitable overall, but the results have been mixed.  I'm still extremely long the market today, although i've reduced my longness over the last several days.  I had a big bit of cash, like 30%, but i blew it all at 870ish a few weeks ago which could hve gone either way, but the way it went has turned out well.

I hope to one day become a better options-putzer.  lol 

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