Mismarking of Assets

There is a common thread running through many of the concerns that are currently on the radar screen of investors, economists, regulators and politicians: the issue of marking, that is, estimating the value of assets and liabilities.

It links the debates on sovereign credit crisis, bubbles formation and wealth destruction, bankers’ compensation and the removal of the fiscal stimulus. Here I will not attempt to debate them in details: only indicate how the thread runs through them.

In the macro sphere, investors are concerned by the credit quality of sovereign states. That is now impacted by news that Greece used swap transactions to hide the true extent of its deficit. In this it followed the example set by Italy in the late nineties. These transactions were perfectly legal at the time, as before 2008 a loophole existed in European directives, allowing those swaps to be, effectively, “mismarked”.

The present value of a swap is not rocket science: it is the sum of the present values of future cashflows. Despite such simplicity, it was still possible for the EU to underestimate the potential for obfuscation.

Staying macro: a school of thought maintains that economic growth in the past decade was driven by a series of bubbles.

In the “bubble”, assets are often mismarked: recall how the Imperial Palace in Tokyo could be valued at more than the whole of California. The effect is then multiplied by leveraged borrowing secured on the overvalued asset.

In this broader sense of mismarking, the bubble valuations created “paper” wealth, and hence there was no real wealth destruction in the credit crunch: the wealth did not exist. We note in passing that mismarking was not just in the esoteric financial ivory towers, but in more mundane areas (real estate springs to mind).

An egregious example of those bubbles is the heroically optimistic value attached to the panoply of securitised credit structured products: in spring 2007 we saw some of them issued with AAA rating, yielding libor + 200 basis point.

Contrary to the simple Greece swaps, these products were, indeed, wickedly complex. But surely it is simple to understand that it is a contradiction in terms to have libor+200 and AAA. This common sense analysis can help spot mismarkings even in highly complex products, but alas it has not always been applied.

For many outside the world of banking, the burning issue is the “big bonuses”, the compensation policies of large banks. It is argued that such policies generated an unhealthy risk appetite, because of the asymmetrical risk/rewards.

Where does marking come into it? The annual bonus of a trader, a salesman, a structurer, and of their managers, is paid out of the P&L generated in that year. That P&L, crucially, often depends on the marks of new, long term, trades that are put on the books, recognising “profits” upfront based on the marking policy: “profits” which may fail to materialise.

Though there is still no consensus on the best way to mark these longer term, often complex, trades, it is arguable that using a cash-flow based method of marking to worst-case (or nearly worst) could be desirable. The arguments are beyond our current scope, but one outcome is clear: there would be no need to regulate banking bonuses, if they were paid out of realised profits.

There are several proposals to overhaul the regulatory environment for banks and other financial institutions, including countercyclical reserves, risk adjusted capital ratios, and others. If these measures are not applied to the marking and P&L at a book level, it is doubtful though if they will address the issues of inappropriate risk appetite, asymmetric risk/rewards, and the proper allocations of resources and capital within a large bank.

The discussion on removing the stimulus is the final one in our thread. There are strong, and opposing, opinions (effectively, the Keynesian camp versus the Austrian school) but one interesting point of view comes from Richard Koo, who proposed the paradigm of “balance sheet recession” to describe the Great Depression of the 30’s and the lost decade of Japan – his views are becoming more widespread, and can be read in his recent interviews.

In short, he maintains that most companies have borrowed heavily to purchase assets, at inflated bubble prices, which are now worth much less than the debt still on the balance sheet. If this situation were to be recognised, the company would be declared bankrupt. Instead, companies with solid cash flows pay down their debt over time, and when that is done they can finally write off the impaired assets.

Without discussing the merits and consequences of his theory, but if it is accepted one observation pertinent to our theme is derived: mismarking of legacy assets might have to be accepted, for the next few years at least.

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