Howard Marks on the market

In 1990, when high-yield bonds had the brush with difficulty… (meaning spreads widened to 1,100 basis points, and a law was passed that required S&Ls to reflect price declines on their balance sheets), I was asked to brief the board of TCW on the risks. I presented a parable about a regulated financial institution that went bankrupt under the weight of mark-to-market accounting. I joked with Bill Spencer, who was president of Citibank when I worked there, that in the 1980s, that could have been Citibank if it was required to recognize mark-to-market losses on real estate loans.
Guess what: today that’s the rule.
This raises one of my favorite questions: what’s an asset’s price?
• Is it what you could get for it if you wanted to sell it?
• Is it what you would have to pay to buy it?
• Is it the price to buy or sell $1 million worth, or $100 million worth?
• Is it the likely proceeds from the patient sale of an asset in isolation, or what you’d get for it as part of a large portfolio that has to be liquidated in one day?
• Is it the price in today’s chaotic market, or what the price would be in a calmer one?
• And if the latter, who says what that is?
• Is it Goldman’s price or Morgan’s? Or the average of the two?
And what if you find out that Lehman’s is lower than both of them?
• What’s the price if the asset doesn’t trade? Or if you hold the whole thing and have no intention to sell?
I don’t have the answer. Mainly because there is no answer. In short, an asset doesn’t have “a price.” It has many possible prices, and no one can say which is the right one. The ads for a jeweler here in Los Angeles lead with a great headline: “guaranteed to appraise for more.” In other words, either (a) he sells jewelry for less than it’s worth (and, if so, why?), or (b) he sells things for what they’re worth but guarantees they’ll appraise for more, which makes you wonder about the appraisals. The way I see it, the appraisals he touts are just as meaningless as many of the “market prices” being used today to price assets at banks, hedge funds, CDOs and CLOs.
A view has begun to be expressed that mark-to-market accounting – in conjunction with the vicious circle that
prevails today – is causing asset values to be understated, writeoffs to be overstated, and the credit crisis to be exaggerated.
Certainly there’s every reason to believe that:
• Assets are being valued based on what people will pay for them (which is the goal), but with few people in a buying mood, market prices can far understate value.
• Supply and demand have completely supplanted fundamentals in determining prices.
• With little trading taking place, assets are often priced via reference to indices. But those indices fluctuate wildly in connection with speculation and hedging activity, and they may have little relevance to the individual asset being priced.
• Lenders are switching their valuations of collateral from going concern basis to liquidation basis.
• Margin calls are resulting in liquidations, which depress prices, leading to more margin calls.
It’s hard to believe these are really the bases on which financial institutions should value their trillion-dollar balance sheets. But we’re stuck for now with mark-to-market accounting. At minimum, you should expect it to contribute extensively to continued volatility. Believe me, it already has.