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There are certainly companies whose cash flows were positive, but were driven into bankruptcy because the value of their assets crashed.

We were trying to raise money for a fixed rate subprime mortgage company in 2007. They had remarkably good underwriting and very low defaults. But the value of their assets kept on plummeting, and they were forced to meet margin calls by their creditors. That firm no longer exists.

However, the cash coming in from their assets could have paid their debt and operating expenses indefinitely. If there was no mark-to-market, then I would know a hundred or so extra people in New York with jobs.

One could make a reasonable argument that if their balance sheet was so tied up in sketchy mortgage assets that they were forced to meet margin calls when the market fell, then they weren't as solid as they seemed. Their problems started before they got in the car.

I realize that there's a bit of begging-the-question here, but even so, if you've borrowed a ton of money and secured it with "assets" of questionable value, then you're taking a risky bet. The accounting regulations didn't make the bet better or worse -- they just kicked the losers out of the game before they wanted to quit.


The purpose of mark-to-market exceptions are to allow temporary price volatility not to drastically impact a firm's balance sheet. The FASB rule specifies that it's an acceptable practice to suspend mark-to-market in "fire sale" conditions.

But the real issue is the flawed risk ratings on the MBSs. If your asset is AAA then it really shouldn't matter whether you are marking it to market or not, as it's supposed to be quite liquid, by definition, as there is supposed to be extremely little risk that its price will fall.

The reason the MBSs weren't liquid is because the ratings were incorrect and the market knew that -- perverse incentives from ratings agencies had led to this, as had the widespread belief (taken as an assumption by many foolish risk-managers and codified into pricing formulae) that housing prices could not fall.

If the MBSs had been properly rated, then mark-to-market would not have caused the firms holding them on their books to become insolvent, as capital adequacy requirements are based on the riskiness of the assets.

So while mark-to-market may have sped up the failure of those firms, the firms were already weakened due to their treatment (thanks to bad ratings) of risky debt as AAA.

In fact, a few months before things got really bad the SEC sent out a memo advising that the fire-sale provisions of the FASB rule regarding mark-to-market were not to be used, a decision which suggests either that the SEC was OK with some firms failing in the near future (unlikely) or that it believed that the ratings were generally accurate (even more unlikely). I've been told by some Wall Street experts that everybody knew that the ratings were BS. Hence the SEC's decision to send the memo was probably just intended not to telegraph the possibility of a future problem to avoid spooking the market in hopes that the problem would go away.

A few things to note: The regulatory trend is moving toward BASEL II which relies heavily on both mark-to-market accounting and third party ratings agency ratings. So the big regulatory question is, how can the perverse incentives that arose and led to the inaccurate ratings of MBSs be restrained? So far everyone is talking about banning the trading of x, y, and z and of limiting bonus pay, executive salaries, etc., but nobody is talking about the actual concrete perverse incentives (pressure on ratings firms to issue inaccurate ratings) that fed the whole mess.


I think a requirement for a random subset to be inspected by a real independent group like the SEC would cut down on a lot of this crap. You would see a lot of stuff get through but it would put a dampener effect on bubbles. You would also need to keep track of how the agency rated vs each company.


Why were they forced to meet margin calls if they had enough cash flow to pay their debt and expenses?


Think of it this way: you make $60k a year, but somehow borrow $1M to short a bunch of stock. Unfortunately, the market goes up, and margin calls come in on the $1M you borrowed. It doesn't matter that you can cover your living expenses with your salary (i.e. that you're cash-flow positive); the banks want their $1M back, and you don't have it. You're insolvent.

The situation in the banks is similar: there are collateral requirements that have to be met, trades with other banks that have to be honored, etc. A bank can cover its day-to-day operational expenses and be cash-flow positive, but if it suddenly has to pay someone else a big chunk of money that it doesn't have the liquid assets to provide, then it's still insolvent.


Actually, the terminology is a little different for financial firms than private traders.

Say that you take out a mortgage on a new house. The bank lets you borrow up to a certain percentage of the house's value, say 90%. The other 10% is a down payment that you must meet with your own money.

Now lets say the value of your house falls from $100,000 to $90,000. The way your mortgage is written, you probably still owe the bank $90,000 (90% of the original purchase price). However, the way debt contracts are written in the financial world, you would have to PAY the bank $9,000 to reduce your total borrowing to 90% of the CURRENT value of the property, or $81,000. That $9,000 payment is a "margin call" in financial market terminology.

So, financial firms borrow up to a certain amount of the assets that they lend, say 90%. If the value of those assets drops in half, and the value of mortgages plummeted on the open market, they owe their lenders enormous sums (45% of the value of the assets, for a 50% drop in value on 90% leverage).

Those margin calls forced a lot of firms out of business, even though their assets were still performing and still paying enough to meet their debt payments and operating expenses. If the firms could call their mortgages, they would be fine, but they can't because the mortgage money is spent on a house which is a non-liquid asset. The financial firms likely thought that their assets were undervalued on the market because of the panic that set in, but no matter. That's not the way their contracts were written.


So why is this the fault of mark-to-market? The banks knew the rules of the game, and they knew the terms of the contracts. They were speculating on asset appreciation, they got burned, and now they are bankrupt.


I thought about getting into this, but I was trying to keep the metaphor simple. But when you really think about it, the intent of the two systems are pretty similar: a mortgage is backed by a physical asset (a home) that is usually worth about as much as the debt that finances it (if not more), and can be liquidated to guarantee the debt if the borrower defaults. Stock investors have no equivalent physical assets to back their trades, and banks have established the margin-call system to compensate.


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