Fair-Value and Mark to Market...The Most Expensive Scam in History?Stock-Markets / Derivatives Jan 11, 2009 - 11:39 AM GMT
Time for "Surprise-Free" Valuation Standards? - Once upon a time accountants used to count beans. But then they realized (a) that's not very complicated and (b) you don't get paid much for jobs that are not very complicated (particularly after "out-sourcing").
So they decided to be management consultants. That can be as complicated as you want it to be, so it's very difficult to see if you did the job properly or not. Which is why there was (is) much more money in it, because if the punter doesn't have a clue what he's buying you can charge him a lot of money...if you get your branding right.
That worked fine for a while until some bean counters worked out that some people (like Enron) would pay a management consultant tons of money for doing nothing at all...if they agreed to make some simple mistakes in the bean counting department.
Once that scam got closed down the accountants started casting around for something else to keep them in business-lunches, fast cars, and loose women, and they latched onto valuations.
Not many people know that valuation is the oldest profession, older in fact than the "other" oldest profession for the simple reason that before that profession could really get going there had to be valuations.
By the way, after that came "markets" and a long time after that came "government". Markets work fine without government (witness Somalia which doesn't have any government but the market for AK-47's is transparent, efficient, and very healthy). But as is currently being (painfully) revealed, governments don't work fine without markets... or proper valuations.
Now the problem was that bean counters are well known to be not very smart, and certainly not very imaginative. So they didn't know how to do valuations. But they managed to solve that problem but introducing the idea of Mark to Market and Fair Value Accounting.
That's pretty simple, even a bean counter can get his head around that idea, you just look up the price of something in the market today (Level 1) or you look up prices of comparables in the market today (Level 2).
Oh...umm, "but what if the market is not working properly?" Like "what happens if the breaks on my car are not working (today), should I drive my kids to school (today)?" And "who's going to tell me if my breaks are working properly or not?"
"Mmm...I dunno. Well darn it, that's too difficult for a simple bean counter like me to work out. Heck!...you think that I know anything more about valuation than I know about management consulting?"
"Tell you what; we will PRETEND that the market is working even when it's blindingly obvious EVEN to a hamster that it's not. And if heaven forbid, a situation occurs so that EVEN a mentally defective hamster can work out that the markets aren't working properly we will declare that the asset must be put in "Level 3":-)"
And how do we value assets in Level 3?
"Simple, we just let people like Kenneth Lay, Richard Fuld and Bernie Madof do the valuations. That ought to be "good enough for government work"".
So the bean counters went out into the market place to sell their great invention. They told the punters, "don't get those hard-assed valuation people to do valuations - we can do valuations much better. I.e. we can give you a more "favorable" valuation, "and it's cheap too".
"We don't really care too much about whether the market is working properly or not (today), or that today assets are priced at twice what the hard-assed valuation people would value them at, so pay us money and give us all your audit business (and now there is a virtual monopoly on that business you will be happy to pay us through the nose), then we will put a "very friendly" valuation on your assets, so that you can go out and borrow huge sums of money secured by those assets, and make lot's of money (so you can pay our bills)".
It was no contest; the bean counters got 100% market share and the valuation profession withered to a couple of old men doing "appraisals" under the supervision of the bean counters, or they threw in the towel and became real estate salesmen.
And everything worked fine when the price of assets was more than the value, because thanks to the bean counters there was lots of money around so that people could buy more assets, which meant that the price of those assets went up. And the bean counters and their customers made unimaginable fortunes.
They had truly discovered a cure for gravity, and they were handsomely rewarded for it!
But sadly they hadn't, and when finally gravity kicked in, a lot of (other) people lost everything they had. Because the valuations that had been used to assess capital adequacy of financial service companies explicitly and implicitly guaranteed by the government turned out to have been "fundamentally flawed and bound to be misleading" (there's a reason why I use those exact words).
In other words when the time came to sell some of the assets that had a big stamp of approval on them, what the sellers could get for those assets was a lot less than what was stamped on the valuation. SURPRISE!!
So then the bean counters got snared by their own scam; because by then even a mentally-defective hamster could see that the markets weren't working...at all.
In fact they were frozen upside-down on their perch like a dead parrot.
What the bean counters hadn't understood is why you do a valuation in the first place?
They thought that the reason you do a valuation is so that people can persuade banks to hand over money, and so the bean counter's can get a piece of the "action".
Sadly it's not. The reason you do a valuation is so that at the time you come to sell an asset you can be pretty sure that the price you will get will be more or less what the valuation says you will get. With the emphasis on WHEN you want to sell it.
If it isn't, then the valuation was wrong.
The fact that the asset might have been worth a lot of money yesterday, doesn't help if it's worth nothing on the day you decide to sell it, or on the day after, or even in two years time.
That's what the bean counters couldn't figure out, or perhaps it was just too difficult and too complicated. Because it's a lot harder to figure out what an asset might be worth on the day you decide to sell it, than it is to figure out what you might have sold it for yesterday. That's why, apart from being the oldest profession, valuation, (done properly), is one of the hardest professions.
Ah well, that's the "Free-Market"...that's what happens when you believe that bean counters could possibly find a cure for gravity, tough cookie!!!
Was this the greatest scam in history ...or what?
Like all great scams, (and this might well go down as one of the greatest; certainly the most expensive for the suckers who were unfortunate enough to get pulled into it), the secret is blindingly simple.
"Even if you have to say, "BLACK IS WHITE"... under all circumstances pretend that the market is working properly".
That's it, nothing more complicated than that. Take for example the housing market which was where the scam really played out; everything stems from that.
All the rest was just bets on the idea that the valuations of housing that were used to create credit were correct, then lunatic gamblers (plenty of those around) took bets on the bets (CDO's) and bets on the bets on the bets (CDS's).
This is how it worked: the bean counters insisted that valuations for housing done for the purpose of assessing capital adequacy (via a couple of three-card tricks), was done Mark to Market, and then they insisted that everything else down the gravy-chain was also valued mark-to-market.
And government and central bankers went along, after all who would want to argue with the bean counters?
"Rock the Boat" and you will get your assets valued "conservatively", you won't get invited to fly out First Class to exotic places to speak at "conferences" (with pretty girls that run slower than you can), and there is no hope of getting any highly paid "soft jobs" after your time of humble "public service" is over. No-way, no one argues with bean counters. That's the system; don't fight it.
The problem was, small problem, "nothing we can't really handle" (said the bean counters), when the time finally came around to sell those assets, they couldn't be sold for the valuation that had been put on them.
I've been around a lot of scams (busting them or avoiding them), the first thing that happens when the scammers get caught is that they go aggressively "super good".
That's what the bean counters are doing now; they are saying "Ah but now none of those assets (which we previously said were worth a fortune) are worth anything today. And no it's nothing to do with us...it's the "markets" you see".
Oh yeah! Heard that one before.
So what about the valuation profession?
Well it's a bit like the story of Microsoft and Netscape. If you have a monopoly and "access", OK you might take some hits, but in the end you win. Particularly when there are trillions of dollars at stake. Right now the valuation profession is about as viable as Netscape.
Remember the Asian Crisis?
That was when assets were valued using book-value, so some clever bean counters rigged up scams so that the book value was a lot more that the underlying value of the assets, particularly assets used as a basis for assessing capital adequacy (easily done).
Then when people came to sell the assets they found out that they could not get what the valuation said that they would be able to get.
And well, when that was revealed, there was a "crisis of capital adequacy", and governments and the IMF had to get out of bed in the middle of the night and run around in their pajamas injecting money into banks to prop up their capital adequacy.
International Valuation Standards
Only a few obscure historians know that after the Asian Crisis the valuation profession had a go at re-writing the rules so that there would not be another Asian Crisis (by-the way, the current crisis is identical to the Asian Crisis just a hundred times bigger).
They did a great job; they made sure there was international buy-in before they started (including of course USA and UK valuation institutes, but wait for it - even the French... imagine that)!!! And they set up a United Nations NGO to prevent political sticky fingering.
Then they huddled in a corner for years devising what is by far the most coherent and robust valuation system that mankind has ever seen. It's called International Valuation Standards (IVS) and it was first published in 2000.
Then what happened?
Apart from practically every valuation institute in the world accepting the standards and recognizing them...absolutely nothing happened.
The bean counters saw this as a threat to their little monopoly and apart from copying some ideas and some big words that they didn't really understand (like Microsoft copied Mac); they just ignored it. And they persuaded the regulators and the central bankers to ignore it too (with the threat of course that if they didn't they wouldn't get invited to "conferences" and easy seats on boards in the future).
Nah...they said, we don't need all this complicated stuff!!
474 pages on how to do a valuation properly, what a waste of paper, we care about the environment, that's why we condensed the whole thing into a couple of paragraphs (we care about trees - we are Green), and we dumbed it down into something that even a hamster (and a bean counter and most important a banking regulator) can understand.
Easy if you know how; the rest is history.
Granted from the onset the International Valuation Standards Committee told everyone who would listen that there was a scam going on.
For example in July 2003 they wrote to the Bank of International Settlements (the central banker's club), to say that "valuations used for the purpose of assessing capital adequacy" (as mandated under US GAAP and IFRS and similar standards), "are fundamentally flawed and bound to be misleading".
But no one paid a blind bit of notice, all that letter-writing and hand wringing was about as effective as Netscape writing to a lobbyist paid off by Microsoft.
So - then what happened? When the time came to sell assets so as to cover the bets, the price that those assets could be sold for was a lot less than the valuation that had been done two or three years before. SURPRISE!!!
OK here is a test:
Question 1: What is the purpose of a valuation? Is it (a) so that you do not get a surprise when you come to sell an asset or (b) so that you and your mates can get rich?
Question 2: What would have happened if International Valuation Standards had been adopted in 2000?
Answer: The housing bubble would not have happened, the mortgaged backed securities would not have defaulted, the CDO's sliced out of those would not have defaulted, and the CDS's insuring those would never have been written. In a word, nothing at all, how boring!!
Question 3: What would happen if International Valuation Standards was adopted now?
Answer: Market participants would have the confidence to be able to easily tell the difference between a toxic asset (no value) and a non-toxic asset (plenty of value), so the market for credit would re-start.
Ever wondered why Hank Pulson's idea to buy Toxic Assets using a reverse auction was such a damp squid, and why he made a quick about-face and decided to re-capitalize instead?
His idea was to re-start the credit market. If he had gone ahead as planned it would have done precisely the opposite, because of mark to market rules. As soon as he bought a tranche of bonds at a low price, the WHOLE market would have been obliged to re-value even the bonds that were not impaired, to the price he paid. That's going backwards not forwards, it would have been a disaster.
Right now the traditional buyers of bonds who used to keep the credit market going, the insurance companies and the pension funds who have cash coming in every month (from contributions and premiums), are not buying bonds; for the simple reason that they are terrified that any bonds they buy will be arbitrarily marked to market.
So they are hoarding cash, terrified that the bonds they hold, many of which are perfectly sound, will be arbitrarily valued down to nothing by some ignorant auditor or regulator, because of some random and totally unforeseen event in the marketplace - like some dumb-ass with more money than sense (thanks to putting his hand in the pocket of every American) who doesn't really know what he is doing, going and buying a whole lot of bonds too cheap.
Sorry to say, Hank Paulson waking up one morning with a bright idea and a pile of cash in his back pocket is not a "market".
So what's happening? The dollar is going through the roof because everyone is pulling cash back to cover the positions that they are exposed to due to mark to market, the bond market is stalled (no one is buying and no one is selling because they know that in the end the bonds they hold are worth more held to maturity than sold in the market today), so that the only way that anyone is going to get a mortgage, a car loan, or a loan for their business, is if the government slaps Fannie on her bottom. Sorry again guys, that's not "markets" working, that a government gone crazy (again), which is another word for Socialism.
The question is this (a) if socialists don't believe in markets and are doing their best to destroy them (b) what is the logic of mark to market?
Think of this, it's a notion for every American who voted for the idea of spending all the money that could have been spent on improving their health system and education, on going and blowing up civilians they don't know in places they never heard of.
If International Valuation Standards were introduced, governments and central bankers would also be able to tell the difference so they could catch people who introduce poisonous assets into the market (which is about as irresponsible as selling poisonous food in a supermarket), and they could rendition them to the brand new facility that George Bush and his psychopathic ex-Attorney General are setting up at a secret location, for a good dose of water-boarding, along with all the other terrorists.
If you didn't get full marks in the test, may I humbly suggest that you go on the International Valuation Standards Committee web-site, and order a copy of International Valuation Standards, and...READ IT.
One of the sad fairy stories in history is the idea that if governments get in a hole they can close their eyes and throw tons of money at the problem and that it will go away.
Sadly, history shows, that when governments start blindly throwing money in the air, all that happens is that they go broke.
And then, like gamblers on a losing streak they start pawning things, first the mother in law, then the wife, then the little condo in Florida where they used to go for a good time (without the wife), then the boat, then the family home, then the dog, then the children (that's always a wrench), then the grandchildren.
USA and UK have about reached the grandchildren stage. What's next?
Time to start using "surprise-free" valuation standards perhaps?
All that has to happen is that accounting rules have to be amended to say "All valuations of assets and liabilities must be done strictly in accordance with International Valuation Standards".
How hard is that? Certainly a lot easier then selling your mother-in-law to a pawn shark (it's difficult to shove her in the boot), but the question is really, is it harder than selling out your children and your grandchildren?
By Andrew Butter
Andrew Butter is managing partner of ABMC, an investment advisory firm, based in Dubai ( email@example.com ), that he setup in 1999, and is has been involved advising on large scale real estate investments, mainly in Dubai.
Copyright © 2009 Andrew Butter
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11 Jan 09, 21:28
This article is an absolute CLASSIC, very funny and down rite hit the nail on the head.
WELL DONE !!!!!!!