To understand what’s roiling the stock and bond markets these days, one must understand an accounting concept known as “marked to market.” It’s an easy concept to grasp—a firm must value its assets based on what the market says they’re worth.
The difficulty comes when there’s no ready market for an asset. Suppose you lend $100,000 to two neighbors secured by mortgages against their homes. Each agrees to pay interest-only for five years, then pay the whole principal balance.
One neighbor, holding an excellent job, makes his payments on time every month. But you must hound the other, who visits the unemployment office every week, to make his payments, although he’s not actually in arrears. Yet.
How much is each loan worth? And does it matter if all payments are being made? Before Enron’s collapse, the ensuing criminal prosecution of its accounting firm, and the requirement under the Sarbanes-Oxley legislation that executives must certify their companies’ financial statements, it didn’t matter so much. But if you’re a public company instead of an individual, it matters a lot, because you must determine a “market” value for those mortgages.
The rub is, there really isn’t a ready market for the mortgages. But to prepare your financial statements, your accountants will insist that values be developed somehow. How much less than its face value is the loan to your out-of-work neighbor worth? Will he be able to pay the principal in five years if he’s still unemployed and cannot get another loan? Should you discount the value of the second loan?
Valuation is only part of the problem. The effect on your financial statements is ugly. In writing the loan down, you don’t simply change its value on your balance sheet. You must also offset the write-down against your income on the income statement. In other words, your financials will show a loss equal to the amount of the write-down, even though the mortgage is still current. This marking of complex and illiquid securities to “market” is what the current financial crisis is all about.
Consider insurance giant American International Group (“AIG”). In 2000, its stock traded above $100 and it sported a market capitalization north of $250 billion, by far the most valuable insurance company in the world. As recently as June 2007, its stock price was still above $70. Now, its stock struggles to stay at $20, and its market cap is barely above $50 billion—still huge, but down 80 percent from earlier this decade.
How have AIG’s insurance businesses fared? Pretty well. Its premium income and investment returns have steadily risen during the past eight years, both more than doubling during the time AIG’s market value has been cut by four-fifths.
How is it possible that the business appears to be firing on all cylinders, but the stock price has been beaten up mercilessly? Thank marked to market.
Around 1990, AIG started a subsidiary called AIG Financial Products (AIGFP). AIGFP was a leader in developing derivatives known as “swaps.” I won’t bother to explain what swaps are, because I probably couldn’t do a very good job. It’s enough to know that they were very profitable for AIG; so much so, that with a relative handful of employees, AIGFP was contributing about 7 percent of its giant parent’s overall profits by early this decade.
You’ve probably guessed by now that earlier this decade, AIGFP got involved in creating and buying complex mortgage-related securities. For the past three quarters, AIG’s accountants have required it write down $25 billion in mortgage-related assets, even though AIGFP left the mortgage business in October 2005, and even though AIG’s actual losses on those assets have been slight. Because write-downs have been charged against its income, AIG has reported operating losses ranging from $5 billion to almost $8 billion in each of the past three quarters.
Given that the AIGFP assets in question are complex securities not readily traded, deciding what they’re worth is far more art than science, bordering on the arbitrary. And since neither AIG’s accountants nor its executives want to go to jail, they have every incentive to understate the “market” values.
As the stock market sees it, AIG continues to lose gobs of money. And nobody knows whether there are more shoes to drop.
AIG’s management, in turn, faces a hard choice. Should they keep an asset—let’s say the second mortgage in our example—or should they sell it for whatever they can get? If they write the mortgage down to $25,000, then they’ll realize $75,000 in income if it gets paid off in full in five years. If they sell it for $25,000 today, they’ll “clean up” their balance sheet and be able to redeploy the cash into other business opportunities. It’s a safe assumption that, with all eyes focused on Wall Street and the credit rating agencies, AIG’s management is under a lot of pressure to offload the troubled assets even though the ultimate returns from keeping them may greatly exceed the returns achieved from investing the proceeds of sale.
In July, Merrill Lynch announced it was selling a package of mortgage-backed securities, which Merrill had originally held on its books at $31 billion, to a private investor group for $7 billion—a 77 percent discount. Unlike Merrill, which has been under intense pressure from its public shareholders to stop the reported losses, the private investors can afford to hold those assets to see how they actually play out.
If you have faith in AIG management and its ability to continue to successfully run its insurance operations, AIG stock may prove to be an extraordinary bargain now. But whether management can hang onto the troubled assets will depend more on what its accountants say than on AIG’s management’s own business judgment about their true value.
