3chordcharlie
Diamond Member
- Mar 30, 2004
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Believe it or not, there are a lot of factors that affect inflation.
There is also no single, correct interest rate, or even 'real rate of return' which you're alluding to in your post.
Believe it or not, there are a lot of factors that affect inflation.
There is also no single, correct interest rate, or even 'real rate of return' which you're alluding to in your post.
While there is lots of good information in here for the statistical type person (LK adds lots of info on that score), the "simpleton" view is all I have, since I don't claim any education on the subject of how bonds are priced.
However, on the M2M thing, one "simpleton" view holds true no matter what mathematics one uses to calculate value: Something is only worth what someone else will pay for it - no more, no less. In my mind that is the essence of M2M - if you had to sell it today, what would someone give you for it? Whatever that value is what your item is worth, no matter how much you think its worth more or how unfair you think their "low-ball" offer is.
By relaxing the M2M rules the FASB has, not completely but to a certain extent, allowed the owners of assets to say "Well WE think its worth $XXX, even though nobody would actually pay us that for it" - which is a fantasyland. While we do no yet know all the ramifications of this change in valuation rules it does seem to bode ill for investors. If BofA can effectively say that a collection of mortgage backed securities is worth $XXX regardless of what the market says and that's what they put down in their financials to pump up the books, how can that be a good thing?
However, on the M2M thing, one "simpleton" view holds true no matter what mathematics one uses to calculate value: Something is only worth what someone else will pay for it - no more, no less. In my mind that is the essence of M2M - if you had to sell it today, what would someone give you for it? Whatever that value is what your item is worth, no matter how much you think its worth more or how unfair you think their "low-ball" offer is.
By relaxing the M2M rules the FASB has, not completely but to a certain extent, allowed the owners of assets to say "Well WE think its worth $XXX, even though nobody would actually pay us that for it" - which is a fantasyland. While we do no yet know all the ramifications of this change in valuation rules it does seem to bode ill for investors. If BofA can effectively say that a collection of mortgage backed securities is worth $XXX regardless of what the market says and that's what they put down in their financials to pump up the books, how can that be a good thing?
Lets say that there are two houses side by side in the Hamptons. Both houses are worth $10mm, both are owned by rich people, but house A has a 8mm mortgage on it while House B only has a 2mm mortgage. In all other respects, the majority of people in the neighborhood of 100 will pay. Perhaps 10 will default, caused by prices going down 20%, but pretty much everybody else is OK. Some banks may take a loss, but considering the spread on the mortgages (8% annually), they will probably get out at par.
House B's owner has significant health problems, causing monetary problems. House B sells his house to get cash. The only person who would buy it is a housing speculator, since nobody else can get financing for that house RIGHT NOW and very few people could afford it even if they wanted it (aka, a highly illiquid asset). So, homeowner B sells it for $4mm, pays off the mortgage, and has $2mm left to fight cancer.
Ok, so then House A's mortgage company sees that House B went for 50% of House A's equity position and demands that House A put up enough cash to bring the mortgage back down to 80% LTV (since the value is now 4mm, he has to put down 800k). So Homeowner A can't come up with 4.8mm (8mm - 3.2mm = 4.8mm).
What does he do?
He goes into foreclosure!
Then his house sells for $2mm, since it is so illiquid and people want 50% of the last price.
What happens to every other house?
They go down.
So, now, you have 100 houses in the neighborhood, 2 houses sold for 60% and 20% of the original value.
What happens? Ohh well, now every other house is now worth 20%. Since that happens the banks call up Homeowner N (through 100) and says "hey, you need to bring your home to 80% LTV".
98 other homeowners go "ohhh fuck...."
Rinse and repeat.
austrian economics depends on removing people and the world they live in from the equation. anyone who believes it deserves the mocking they get, its like believing in santa or the tooth fairy
you act like people are rational or have rational expectations, or the information necessary to have rational expectations; they don't.
Correction, were appraised at $10m at some point.
There are plenty of people who would buy it at a certain price. Its present value is essentially the highest bid. The artificial availability of credit towards consumption is what drove the price so high in the first place. If you expected the home to go up 15% every year, didn't have to prove your income, didn't have to pay much down, you could quit your job and the home's appreciation would eventually pay for itself.
Also, the reason for which the seller wants to sell doesn't affect the buying mechanism, so I don't know why you're giving it.
Yep, that's what happens when bubbles burst. And the banks who conjured up all those loans into existence now take over the depreciated assets.
Here's a question for you: in a normal market where prices were not precipitously falling from being bid up by artificial credit, why is shelter becoming more efficiently built and steadily declining in price any worse than a car steadily declining in price? The cheaper a product becomes relative to wages, the less debt you have to incur to buy it, making the final cost even lower discounting all that interest.
One thing fix income securities like these MBS/Bond/debt that's different from other investment is that these securities actually give you cash flow either every period or at the end of maturity.
That's why fix income securities is valued based on the periodic/maturity cash flow discounted using interest rate yield curve and other factors like convexity and duration. If bank cannot sell the securities, they can hold the security and get payment for each period or until the security matures. The only reason they have to sell the securities on the market is they need cash for operations. It's not like stock where you always have to sell it (dividend give you little percentage of return, if any for most stock) to get the return.
So it makes little sense for bank to value fix income security based on MARKET VALUE because bank does not necessary have to sell their fix income security holdings, they have the option to hold it for the cash flow. There are places for M2M rules, but it should not be applied in every single instance.
3chordcharlie
Diamond Member
- Mar 30, 2004
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Because mortgages take to long to pay off; if houses depreciate, you're always underwater. You guys nearly had another revolution over this
The reasons why housing prices don't fall over time, even without inflation:
Because land is not getting more plentiful.
Because a looked-after house does not deteriorate in the space of a lifetime or two.
While I understand your point here about cash flow over time, I don't see how that changes my point from above. If they want to sell it, its only worth what someone will pay them for it. How the bidder determines what price he's willing to pay isn't really material is it? I mean, if he uses the complex formulas that LK talks about or whether he pulls the number out of his most recent tarot reading, his offer is what it is and the seller can either take it or leave it. If the seller decides to sit on it and scream "but its worth more according to all this cool math stuff" doesn't change the fact that the bidders offer is lower.
From what it sounds like there are two approaches to determine the value of a time-based asset like a bond/MBS/etc:
1) What can I sell it for, right now and get cash?
2) How much will I make if I hold it to maturity myself instead?
What it seems to come down to is whether or not the current owner can afford to sit on it to maturity or do they need cash now (thank you J.G. Wentworth). If they need cash now and "cash is king" then all the fancy valuations of what it should be worth over time don't seem to matter - they can take what they're offered, even if its lo-ball, and that's what the security is worth like it or not.
Have I gone done an incorrect mental path here?
I absolutely agree that if you are selling an asset, the price you can get for it is the price it is valued at. However, Mark to Market values ALL assets, even the ones you aren't going to sell at that price, at that price. Hence, my housing example.
You're assuming that the price was inflated to begin with and now the price of the house is at the correct value. Is 20% correct? This is really the key to mark to market. Are the prices at the correct market value, a rational price, or are they at an irrational price dictated by forced selling (homeowner B who forced homeowner A to sell).
The negative feedback loop caused by M2M is far more damaging than people realize.
Unless I'm mistaken, and I'm certainly open to that, the reason ALL assets were done as M2M is that the future is uncertain - all the calculations of future value don't mean anything since that future may not materialize in the way the formula's say they will. By forcing the companies to take the current liquidation value (isn't that what M2M really is?) the FASB was effectively saying that all the future value equations are well and good and we hope that works out for you. But since that's an unknown, your financial reports of your assets can only be done at what you'd get for them if you had to sell them today/this quarter/etc.
M2M was a way of setting a baseline for asset valuation, since everyone had to do it the same way. Now with the relaxation of those rules, some companies might still to M2M, others might say "well we think its higher because of its longer term possibilities, so this is what we say its worth", even though nobody would ever actually pay them that much. This makes it more difficult for the investor to determine the rubber-meets-the-road valuation doesn't it?
I mean I could go buy a comic book on the stands for say $1.50. I choose to buy that comic book because I happen to like the character/story and its part of my collection. But I also buy an extra copy because its a special edition, done by a particular artist/writer/whatever and I believe that it'll be worth something greater than what I paid for it in the future. Now according to the market, especially while that issue is still on the stands, my item is only worth $1.50, less now that I bought it because its "used". But based on these new rules I could say that I think its worth $50 because by my own valuation scheme for that title, artist, writer combination that it'll be worth more in 5 years. Just because I think its going to be worth more doesn't mean that an investor should allow me to use it as collateral for a loan at that future value does it? Since the future is uncertain it wouldn't be financially prudent to give that sort of value to it would it?
BoberFett
Lifer
- Oct 9, 1999
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Isn't that then a fundamental problem with the concept of securities? How exactly is the value of a portfolio determined if not by current market value of what it contains?
It reminds me of looking through baseball card price guides as a child. I remember getting so excited thinking how much my baseball card collection was worth as I priced each of those rookie cards. Of course the price guides are going to tell me those cards are all worth a fortune, they want me to buy another guide next year which will tell me it's worth even more. Those cards have been sitting in a plastic tote in my basement and haven't been looked at in 25 years. I don't think that makes me a millionaire, despite what Beckett claims.
What do you mean future is uncertain? Most of the fix income security is high grade, with fairly secure cash flow. With all these bash on MBS, average default rate for prime loan is <3% the last time I checked. Sure default rate for sub-prime/alt-A is 15%~20%, but I don't think most institution touch those thing just like they probably don't touch junk bonds unless it's special investment fund with high risk/return strategy.
So with the stable future cash flow, why should government force bank to value their fix income security at market price, especially when market is filled with fear and lack of liquidity? Most of the companies aquire those fix income security at a time when market condition is different, and when those security is valued mostly based on discounted cash flow. Do you know what kind of impact to banks' income statement/balance sheet when they are forced to value those security at market price, regardless if they intend to hold or sell it? Like I said the market is filled with fear and lack of liquidity and those security probably only fetch 20~30 cent on a dollar because of the lack of demand. So banks are force to value their holdings at those market price, and result in huge write off, huge loss on the income statement. Even if banks want to hold those security and keep the cash flow, they are not able to reflect that in their income statement. And the huge write off, huge losses greatly impact the credit worthiness of the banks, causing ran on banks, inflated cost of doing business, and a basic vicious cycle that forced many banks to close their door.
So please keep in mind how those security are valued are not just some game on paper. It has huge impact on how banks do their business. And sure you want to be fair, if bank want to sell their security, value it at market price. If bank want to keep it, let them value at discounted cash flow type valuation. Don't be like some people here in the forum, bashing everything when they have no clue what the heck they are talking about.
This is when you need your foundamental knowledge in finance and security. If you go through CFA certification, you'd see that one big section is equity, and one big totally separate section is fix income security.
Yes equity like stock is meant to be trade and the value is mostly determine by the market. But fix income like MBS/bonds are meant to provide some kind of fix cash flow. Yes they can be traded, and yes banks have been trading them/creating ways to make trading them easily, but they can still provide fixed cash flow in the traditional way. If your baseball card can give you 100 bucks every month, do you want to value it at the market price when people just don't feel like buying baseball card?
BoberFett
Lifer
- Oct 9, 1999
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- 9
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I was really only referring to M2M as a concept, not on the particular issue of bonds. In LKs example those homes aren't providing regular income either, but the same concept applies. How do you place a value on something other than it's market value?
As to your point, yes the interest income on the bond has to be factored into the value, but why completely ignore the projected value? If someone bought a bond from an entity which starts to look like it's going to crater prior to maturity, what is the bond really worth? Without M2M, it's worth full original value plus interest for the remainder of the term even if the issuer will be gone by then. Seems fraudulent to me
Well that depends if you really think market give you perfect valuation of your security all the time. Remember market can be controlled by fear and liquidity, you can have a perfectly good fix income security with very stable cash flow, but other bank just don't have the cash to buy it right now. And for MBS backed by prime mortgage loans with < 3% default rate, does the market accurately reflect that? I'd argue market is over sold because of the fear with all the bad news. Market is not always rational and perfectly efficient, I don't think you can say M2M will always give you the right valuation.
In the case of equity, you have no choice but let market determine the valuation, doesn't matter if market is rational/efficient or not. But for fix income, you do have a choice and it's not a matter of being fraudulent. And remember, unlike stock/equity market, fix income like bond/mbs market is not that big and it's much more likely to suffer from market inefficiency.
rchiu, the fallacy in your argument should be obvious. It doesn't matter whether anyone thinks the fear in the market is rational or irrational, and certainly sellers have a bias towards wanting the highest price possible. Competition between buyers of similar assets will always give a better valuation than mark-to-model by sellers. You can't just wish M2M away the minute you make a bad bet and are left holding the bag.
3chordcharlie
Diamond Member
- Mar 30, 2004
- 9,859
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I'm still waiting for the lightbulb to go on in someone's head in this thread.
You guys are all so close to realizing that accounting is art, not math, and 90% of it is 50% made up.
M2M is forcing everyone to take a worst-case look at their assets right now, because it is hard to believe that things will get substantially worse without the system actually breaking (in which case the accounting won't matter); it's accurate, in a sense, but it's too pessimistic, and is therefore hurting us.
- Mar 20, 2000
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this post brings up so many memories from my mergers and acquisition class.
'hey, paramount, we're willing to pay you double your current share price, an amount your shares have never reached, if you sell all your shares to us.'
paramount board: 'no thanks, your offer undervalues our company'
paramount shareholders: 'wtf, you assholes, of course we want to sell our shares for double the current value, which is way more than the shares have ever been'
paramount board: 'no, just wait, your shares will be worth more'
*lawsuit ensues*
paramount shares never get to that offer price
unocal is another good one
as my corporate finance professor often said: accounting is lying by another name
Just answer this simple question. Why the hell you want to use market to value something that doesn't have to be sold in the market to get the return?
BoberFett
Lifer
- Oct 9, 1999
- 37,562
- 9
- 81
You're viewing only the interest as the return. Does the repayment of principle at maturity never figure into value?
If I borrow a million dollars with no intention to pay it off, use the million to pay the interest and spend the rest on hookers and blow are you saying that the fact that the principle will never be repaid doesn't figure into the value of the loan? I'm paying you your money back and calling it interest. No matter how much interest I pay, you're taking a loss. Sounds like a bad investment to me, but you're saying that it's still worth principle + interest.
3chordcharlie
Diamond Member
- Mar 30, 2004
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The problem is that you're right - but how can we know that the market is valuing these assets correctly? At the moment, it seems almost certain that it is undervaluing some types of debt based on momentum, emotion and instinctive reaction.
Maybe the solution is to have some sort of long-run average value apply to M2M policies. So you get to value these assets at their 2-week average, and never have wild swings.
Any accounting system is, of course, going to be inaccurate, but while your example is concrete, the real world isn't like that.
BTW I was really menaing you previously, I've seen enough of your posts to know you have a better idea about accounting than most (probably better than me).
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