A Funny Notion

If you are looking for that next house in the Hamptons, there are two words you need to get your arms around and own. These two simple words can make you wealthy beyond measure. Excess will be yours. You could be a Master of the Universe able to buy, anything and anyone. These words are “financial obfuscation.” It is true. I am talking about the greatest game ever, no not baseball. . .investment banking.

Marking to market works against financial obfuscation. Marking to market is the opposite of notional value and it is a characteristic of the most transparent financial markets.

One of the provisions of the $700 billion dollar bailout bill that was passed by the House of Representatives on October 3, 2008 includes a provision that gives the Securities and Exchange Commission the right to suspend mark-to-market accounting under Statement Number 157 of the Financial Accounting Standards Board. In other words, the SEC would be allowed to suspend the use of mark to market accounting standards whenever it thinks the public’s interest would be best served by its doing so.

Mark-to-market accounting, or “fair-value” accounting, is inaccurately cited as one of the principal reasons for the recent meltdown in the U.S. banking system. This accounting rule, which went into effect Nov. 15, 2007, forces financial institutions to put a fair value on their assets and liabilities each quarter.

This is not a novel regulation. Section 475 of the Internal Revenue Code has mandated the marking to market of securities at the end of each calendar year since 1983. Nonetheless, many pundits and politicians claim that it is this accounting rule and the very principle of marking to market that is to blame for the mortgage meltdown. However, the principle of marking to market has existed in the futures markets since the beginning of price discovery by way of auction and open-outcry. Marking to market is now being held responsible for erasing over $100 billion in assets tied to mortgage related securities. This is tantamount to blaming the scale for your weight problem. Blaming the marking to market of securities for the current credit crisis confuses causation and effect.

Marked to market is more than an accounting rule. Marking to market is a principle that allows a market participant to know the true value, the market value, of a financial instrument. Had the investment houses and counterparties more frequently had to mark the value of the mortgage related securities to market, the current credit crisis could have been averted, or at a minimum, the failing brokerage houses would have accurately accessed their financial situation long before bankruptcy.

All over the world at any given time, the value and the price of an S&P500 futures contract are known. It is arguable that knowing the price of a contract contributes to liquidity-the ability to get in or out of a position held in a contract. The regulated futures market, long a stepchild of the financial markets, is the most liquid and transparent market in the world. It has been remarkably free from systemic financial crisis. . .with the exception of a certain salad oil scandal. Perhaps there is a lesson here.

Transparency refers to the degree of information that is available. In a perfectly transparent market all relevant information about a market transaction from the price, order size, order flow, trading volume, identity of the traders/counterparties, all bids and offers available, etc. would theoretically be discoverable.

The value of transparency in the marketplace is possibly best explained by its absence-opaqueness. The lack of transparency is called opaqueness. The environment that led to the current crisis was opaque. In the current mortgage debacle, few of the players knew what the baskets of mortgages they were packaging, buying and selling were actually worth. The participants in instruments that led to this current crisis operated in a very opaque if not downright murky environment. The mortgage related securities being traded from brokers to banks and between banks were not pegged to the value of anything tangible. One could make the case that they were not even derivatives because their value was effectively not derived from an underlying anything.

But if they were, their value was not discoverable, or perhaps not verifiable. The values of mortgage securities were not marked to market, they were not pegged to an underlying asset and if they were, no reasonable allowance was made for unfavorable movements in the value of the underlying assets.

All market transactions involve a degree of risk. In the law as in the markets, there is a presumption, albeit rebuttable, that the greater the amount of information a market participant has, the better able the participant is to assume and understand the risk behind the transaction. Information is valuable in decision making until such time that too much information leads to diminishing returns because the amount of information incapacitates the decision-maker and prevents him from making a decision.

Price is one of, if not in many instances the single most relevant information provided in a transparent market. “What did you pay for that?” is more than vaguely related to “what is it worth?” While the price paid for a piece of art is not often a precise indicator of what it is worth, it is a good starting point. However, regardless of the price paid for a Monet or a November Soybean contract, the more important question soon becomes, “what is it worth?” Soybean contracts are marked to market. If I owned a bushel of November 2008 soybeans, I could look at the spot or cash market and know immediately what the value is of what I own. A stock portfolio consisting of listed stocks has an immediately discoverable value because listed stocks are marked to market everyday as buyers and sellers determine through the trading market, what listed equities are worth at any given moment. The owner of a financial instrument unlike the owner of a Monet, has an after market to which he can go to instantly determine the value of the instrument and where he can sell it.

As we are now seeing, bad things can happen when the price or value of something is not known. In cases where financial instruments are not commoditized, regulated or listed, their value must often necessarily be determined by the assignation of a notional value. Notional value is an assigned value and there are varying definitions of what notional value means in different contexts. The assigned notional value takes on different meanings in various contexts. The notional value of many of the collateralized debt obligations (“CDO”) have simply been created by one or more of the counterparties to the transactions. What is worse is that the notional value of a CDO or of a mortgage security bears no relation the market value.

It is argued that the notional value of unregulated securities transactions now exceeds $1 quadrillion ($1000 trillion). While CDOs may be collateralized, the market value of the collateral may be much less than the notional value. This begs a larger question, what are CDOs collateralized to? Are they even collateralized?

In the case of Bear Stearns, many of the trading in mortgage related securities involved financial instruments assigned only a notional value. The failure of one of Wall Street’s oldest and most venerated investment houses and the largest bankruptcy in United States history and now threatens to shut down the banking system itself were caused by mortgage backed securities that were assigned notional values.

To figure out how this happened, it is helpful to recall some history and perhaps the observation by George Bernard Shaw that, “If history repeats itself, and the unexpected always happens, how incapable must Man be of learning from experience.”

Shaw might as well have been referring to the November 1999 decision by President Bill Clinton, led by Robert Rubin and Phil Gramm and supported by Alan Greenspan to sign into law the Gramm-Leach-Bliley Bill or the “Financial Modernization Act.” This bill repealed the Glass-Steegall Act and officially removed the prohibition that investment banks and commercial banks must be separate entities. The same prohibition that was enacted into law in 1933 by an overwhelming majority in Congress. Congress enacted Glass-Steegal to prevent a recurrence of the speculative orgy that culminated in the Great Depression. Interestingly many of the banks, like Goldman Sachs and Morgan Stanley, that participated back then are participants in the current crisis.

Glass-Steegal separated the investment banking functions of banks from those of commercial banks. This separation has many arguments in its favor. For one, by definition, a commercial bank is a deposit-taking bank where a person puts money into a checking or savings account for the principal purpose of safe keeping with the expectation that he may get some interest. It is also an institution whose purpose is to loan money. A customer’s expectation that his money will be safe guarded is enhanced by the knowledge that the bank will not use the customer’s money to do deals, or to conduct speculative investment or deal-making that would place the customer’s money at risk.

Customers prepared to take on more risk could invest his money in any number of the financial products offered by an investment bank. But this would be the customer’s choice, not the bank’s.

But the main argument in favor of Glass-Steegal was the need to prevent a few mega banks from accumulating so much power that in the event of a catastrophe or excess, Wall Street would not be plunged into the throes of another depression or credit crisis.

The current credit crisis on Wall Street is reminiscent of the 1929 speculative frenzy, with one crucial difference, there is a lot more money at stake. Also, technology has had an impact on the financial markets and the kind of transactions taking place. Technology has at once increased the speed of transactions and lowered the costs of completing them. In 2008, there are complex derivative transactions whose notional values are in the hundreds of trillions if not quadrillion dollars.

There are several possible reasons for why these transactions, be they mortgage default credit swaps or what are at least in the authors’ opinions, loosely termed, collateralized debt obligations have become so popular. Perhaps they are the product of what has become known as financialization from the late 1980s to the present. Financialization, has been alternatively defined as the shift in the engines of economic growth away from manufacturing, production or even the service sector, to finance. Finance now accounts for the largest component of private sector GDP. GM and Ford make more from their financial services than from making cars, they have been losing money on making cars for some time. It is the financial firms that are considered too big to fail. Many people point to the growth in private and public debt that occurred concurrently with financialization. During this same period, the profits of investment banks have grown tremendously. Arguably, (though well outside the scope of this paper) wealth has become more concentrated in a smaller percentage of the population.

However, a simpler explanation is self-interest. Trading in futures is a zero-sum game. That is for every penny made by someone, someone else has lost a penny. The total losses equal the total amount of the gains. Futures are derivatives and there are some that would argue, wrongly, that trading in derivatives is also a zero-sum game. This is not true.

Trading in mortgage related securities has proven that in theory, on paper and with the use of notional value, each counterparty wins, at least for a while. Assume for example that a trader at investment house A is able to repackage and sell a package of mortgage related securities that he just bought to a trader at investment house B. Trader at investment house A has not marked to market the value of what he just bought and then sold. He cannot because he would have to assess each and every component of underlying collateral for each and every mortgage included or underlying the collection of mortgage related securities to determine the actual market value of what he first bought. Perhaps he should also have looked at the FICA score of each of the mortgagers if he were further interested in determining the value of the mortgage related securities. But this was not the case. The trader at investment house A reached into the air and assigned a notional value. Presumably in many cases, because the trader wanted to receive a bonus at the end of the year and show how much money he was making, the notional value he assigned to the securities he sold to the trader at investment house B was greater than the notional value he paid to buy them. In turn the trader at investment house B would have bought this basket of mortgage securities, repackaged them and sold them at a profit (a notional profit) to a trader at investment house C. And so on. Presumably one or more these traders was able to add another house in the Hamptons.

Warren Buffet remarked on the perils of marking derivatives according to the models of the counterparties that buy or sell them as opposed to having to mark them to market in Berkshire Hathaway’s 2002 Annual Report,

“Those who trade derivatives are usually paid, in whole or part, on “earnings” calculated by mark-to-market accounting. But often there is no real market, and “mark-to-model” is utilized. This substitution can bring on large-scale mischief. As a general rule, contracts involving multiple reference items and distant settlement dates increase the opportunities for counter-parties to use fanciful assumptions. The two parties to the contract might well use differing models allowing both to show substantial profits for many years. In extreme cases, mark-to-model degenerates into what I would call mark-to-myth.

I can assure you that the marking errors in the derivatives business have not been symmetrical. Almost invariably, they have favored either the trader who was eyeing a multi-million dollar bonus or the CEO who wanted to report impressive “earnings” (or both). The bonuses were paid, and the CEO profited from his options. Only much later did shareholders learn that the reported earnings were a sham.”

Few people understand that the real fortunes on Wall Street are made between the wall and the wallpaper. This is a very fortunate place to find oneself because fortunes are made in fees. With each transaction, each counterparty booked a profit (albeit notional, but the reader should be getting used to the idea by now) but more importantly, each bank charged a fee, or many fees attached to each buy and to each sell, as the case may be. The investment banks made fees because every time a transaction is conducted on Wall Street, there is a fee to be made. An incentive is created to produce transactions for their own sake. New products or repackaged old ones, generate profit from fees. Everyone was winning until now.

But how, one may ask, was this allowed to happen? Was anyone minding the risk? It would be like an inveterate gambler who kept losing money but was able to determine his own limits with the house until one day he brought the house down.

Risk is a funny notion. By the way, risk is not a notional notion either. It is real. However, between the time we have bubbles and financial debacles, talking about risk is a little like talking to a teenage about death. Or like mentioning you have a foot fungus when sitting down to dinner at a black tie formal. In a go-go atmosphere of notional value and financial obfuscation, the environment that bred the current credit crisis, risk was never a polite topic of conversation.

But there is a silver lining here, a lesson for Wall Street to learn. If you cannot mark to market, then trade at your peril, because you are in every way, trading in the dark. Perhaps the Legislature ought to enact regulations that prohibit trades that cannot be marked to market. Perhaps transparency should be encouraged. After all regulation is not possible without transparency. Perhaps the Legislature should institute some regulatory scheme that would enforce the same regulations on the essentially hundreds of trillions (if not one quadrillion dollars worth) of securities out there that are presently and effectively completely unregulated vis a vis all listed and regulated equity and derivatives products. Alas, that the experts and legislators keep talking about the evils of marking to market and attribute marking to market as a culprit in this financial catastrophe. It is almost like they are allowing the table to be set for the next round of crisis, the time when the remainder of the hundreds of trillion dollars in securities with only notional values, come into play.

R. Tamara de Silva

October 4, 2008