A Simple Alternative to Mark to Market Accounting?
I haven't posted at all on the brouhaha about mark-to-market accounting of derivatives and whether it was a contributor to the recent financial mess. If I had to summarize the issue, I would describe it thus: Investors want something more trustworthy than just management estimates of the value of complex securities -- so they would like an outside market-based reference point -- but the very complexity that makes these contracts hard to value as an outsider also tends to make their markets illiquid and volatile, making it difficult to get a good market value.
Tom Selling addresses the problem of accounting for the value of credit default swaps here. He makes what seems to me to be a common sense suggestion:
Requiring the asset and liability sides of derivatives to be separately
measured and reported seems like an amazingly simple fix that could
simplify regulation of the financial and insurance industries, reduce
the need for the disclosures in financial statements written so as to
discourage one from reading them, and help investors more easily assess
risk.
This certainly seems reasonable to me. When one buys a revenue producing asset with debt financing, the two are listed separately as an asset and a liability, rather than as one "net" asset, even though they may be inextricably linked (say if the asset is collateral for the loan and the loan has high pre-payment penalties). Any thoughts? Does this make sense, or is it naive?
John Moore:
How about running most of that stuff through an exchange. That would standardize it and bring in exchange rules.
Rating agencies (or whoever) would be able to use this as part of their measurement.
October 7, 2008, 10:35 amErikTheRed:
I deal with this personally by not investing in stuff I can't figure out. I figure that if everyone stuck to this rule the problem would eliminate itself. And if other people don't, then they get what they deserve.
October 7, 2008, 10:59 amJeff:
I'm certainly no expert in these contracts, but in reading about them one of the prime problems is they obscure risk and erode confidence in the debt markets. You don't know your counter-party's, counter-party's, counter-party (it could even be yourself), so you don't trust anyone's ability to pay up.
Kind of defeats the purpose of credit default insurance if you ask me.
Jeff
October 7, 2008, 11:20 amJason:
Do you have a Private mortgage insurance (PMI) policy? If you do have one your PMI insurer passes their risk to others by bundling 100 policies together and then they sell them as a credit default swaps (CDS). In doing this they can take 1.7% of the annual policy. They also do this in order to protect themselves from making large cash payments to mortgage providers in the event your home is repossessed. In the mortgage industry this has been the case for decades. If you bought a PMI policy to protect your lender then you are building the CDS market. To avoid this put at least 20% down on your home or pay what it takes now to get rid of the PMI policy. http://nomedals.blogspot.com
October 7, 2008, 1:53 pm