Bloomberg reports that "But the accounting change, which incorporated a proposal that would bring about US$ 900 Billion onto the lenders' book....." on the impact of such a change on the top 19 financial institutions in US which includes banks and insurance companies.
For listed assets, the practice seems more objective and transparent after one of the many prescribed valuation method is chosen and applied consistently based on a gambit of open, closing, average etc prices provided by the exchange and we have the valuation of the asset. For other forms of assets, objective 3rd party valuers are called upon to provide a valuation of the asset which seems less objective compared the listed assets. As for off balance sheet items, the valuation becomes more murky for some of the more sophisticated synthetic instruments, it takes a Phd in mathematics to unravel only the basis let alone the value and the counter party risks can go through the roof without a mediating exchange to guarantee and clear the trades and so as to allow market participants to trade on a blind basis as far as counter party risk is concerned.
Now that we have arrived that mark to market is a good discipline to adopt to ensure more transparent financial reporting, we shall now shift the burden of proof the other way round and for those opposing this cause to cast reasonable doubts especially its applicability in a turbulent market like what we are facing now.
Firstly, we have to proof beyond reasonable doubt that market price is a true reflection of value. On the surface, it seems that the battle is won hands down in a capitalistic view of things. Adam Smith's invisible hand and how the selfish pursuits of individuals will result in the overall goodness for everyone has not only been challenged in the communist and socialist camps but has also been quietly questioned in the capitalistic camp on its effectiveness. Chief among them is the recognition that in the short run, market prices might not be a a good indicator of value as the market does goes into a sticky phase at times before converging at a point where supply meets demands. In addition, it also pre-supposes that there are sizable diversified market participants and liquid enough market of both buyers and sellers to prevent the market from being cornered or being illiquid. One example being that it is not uncommon for some ETFs to trade against their underlying index. I believe there are enough evidence to cast reasonable doubt to the jury on this count.
Secondly, we shall examine how mark to market itself can serve as overly strong draft forces that could cause chronic declining markets to suffer a pre-mature self full-filling crash or for a bull market to spin inflation out of control through a inflationary spiral. However, it seems to work just fine when the market is relatively stable. It is liken to the doctor that is always not when needed most. Whether in a bull or bear market, mark to market is needed to have a realistic measure and a compass on where it is headed valuation wise. This is also where on a micro basis, mark to market is likely to become an innocent by stander but on a macro basis, it can be the very pill to poison either a bull or bear market. The practice of cross equity holding amongst companies is a fairly common phenomenon especially in countries like Japan. These mega corporations in Japan known as Zaibatsu are on the the surface competing with each other in the market place but a closer examination of their shareholding is likely to bring us into a spider web of complex cross shareholding which can make their share prices impregnantrable or stabilized in the short term but could grow into a bubble that would burst suddenly either way positively or negatively when valuations defy the most common logic. During the height of the Japanese real estate bubble, it was estimated that the value of the land on which the royal palace sits in Tokyo is equivalent to the value of all properties in the state of California.
There are various versions of this joke on engineers, lawyers and accountants in circulation and here is my recent construct. An engineer, lawyer and an accountant happened to visit an optician for a color test. As the optician use the flip charts which uses varying polka doted colors to form numbers to be deciphered. The first number on the flip chart was supposed to be the number 9. As these 3 gentlemen were no ordinary kinsman but were recognized as being captains in their field with their names on the signboard of their sizable firms and therefore did not give a straight forward answer to the optician like all and sundry. The engineer said that the number appears to more like a 6 instead of a 9. He reasoned that depending on how the optician has angled the flip chart. The optician reaffirm his answer as a 6 and told him that it was actually a 9 and he protested that it was the optician's fault for not positioning the flip chart properly and therefore the reference point was setup wrongly and it was not his fault. Next came the lawyer who said that it can either be a 6 or a 9 depending on whose point of view; yours or mine. The now impatient optician replied it is you who is having the test and not me and the lawyer interjected politely that it is a 9 in that case. The optician nudged him on saying that at least the lawyer is not color blind. The accountant baffled the optician when he told the optician that it can be any number or even an alphabet depending what the optician ordered.
Valuation, pricing and markets are so important for our capital market to function well that we sometimes need very basic commonsense to unravel the highly complex. We should not allow a change in accounting treatment to write US$900 into the books of the top 19 financial institutions in the US nor shall we allow the ancient straight jacketed rules to ruin fortunes and livelihood of many overnight. What we need is a return to good old commonsense.
Safe Harbor. Please note that information contained in these pages are of a personal nature and does not necessarily reflect that of any companies, organizations or individuals. In addition, some of these opinions are of a forward looking nature. Lastly the facts and opinions contained in these pages might not have been verified for correctness, so please use with caution. Happy Reading. Peter Lye