Why Mark-to-Market Sucks

ToddSullivan
May 23rd, 2008

While well intended, mark to market accounting in times of stress only serves to exacerbate market dislocations and confuse investors. For instance, check out FGIC’s earnings release today.

From the release:

“In accordance with SFAS No. 157, which the Company adopted effective January 1, 2008, FGIC updated its mark-to-market methodology to take into account the market’s perception of FGIC’s non-performance risk. The adjusted methodology, which resulted in a reduction in the valuation of FGIC’s derivative liabilities, incorporated spreads of FGIC’s credit default swaps. In accordance with SFAS No. 157, the Company recorded a benefit of $1.56 billion in the fair value of credit protection contracts provided by FGIC that are considered credit derivatives, which more than offset the mark-to-market losses of $1.40 billion related to such credit derivatives and resulted in a net unrealized gain of $157.0 million in the fair value of such credit derivatives for the first quarter of 2008.

The first quarter 2008 mark-to-market loss of $1.40 billion consisted of approximately $228 million related to estimated credit impairments and $1.18 billion related to the widening of credit spreads in the structured credit markets. The estimated credit impairment of $228 million represents management’s estimate of future claim payments on certain ABS CDOs and other derivative transactions.”

Got it?

All the numbers being thrown around, billions, yet what did the business actually do?

What mark-to-market has done in many cases is reduce earning for companies from actual earnings based on the functions of the business to “anticipated results”. The credit spreads referenced are what the market feels about the insurance issue by the company. If the market feels good, the spreads contract, if they feel bad they expand.

This caused the “earnings” of FGIC to rise and fall based on these “feelings”. They do not have any actual effect on the actual eps. Yet they are now becoming more powerful than the actual operations, especially for businesses like banks and insurance companies that hold large pools of products. Without selling anything and actually realizing a loss or a gain, they will see wild swings in earnings based on market perception of these products.

It is like Anheuser-Busch (BUD) posting a “loss” for the quarter because the market thinks the selling price of beer will fall casing profits to be affected negatively. What should happen is that the market votes on the stock price by buying or selling and then we wait and see what actually happens. What mark-to-market has done is take that speculation and transferred it from the price of the stock to the earnings of the company. Not right…

The good news is for those with stones, when these spreads contract and the huge write-downs become write-ups, boom go earnings…..

Oh, FGIC, actually had a loss of $279 million based on “reserves for estimated credit losses”. That is what operations actually did irrespective of posted results and write-ups and write-downs.

Disclosure (“none” means no position):None