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March 13, 2009

Pet Rocks and Mark-to-Market Accounting
by Chris Ciovacco

Below are excerpts from a Marketwatch article dated March 11, 2008.

WASHINGTON (MarketWatch) -- The Republican Study Committee, a group of conservative GOP lawmakers, believe that instead of pumping billions to bail out banks, lawmakers could save the economy by simply eliminating controversial mark-to-market accounting rules, which require daily revaluing of assets [based on market prices]. The first step is a hearing Thursday, hosted by House Securities Subcommittee Chairman Paul Kanjorski, D-Penn. Kanjorski argues that the standards have proven "problematic" for banks' illiquid assets...Changing the accounting methodology, even if it is done for a temporary period of time, would restore confidence in banks and result in more lending by financial institutions, they say. In short, a modification of the rules would be the big first step needed for the economy to turn around, those oppose to fair market value say...."Many of these oddball investments are not being traded at all," said Willis Riccio, senior counsel at Looney & Grossman LLP in Boston.

Valuation Methods and Illiquid Markets Became Problematic For "Pet Rocks"

Allowing for the fact all analogies limp to some degree and mark-to-market accounting is not purely a black or white issue, assume we are running a small chain of department stores in the 1970's. The chain experiences a great run selling pet rocks. Pet rocks have become so popular banks are willing to loan money to private investors for the purpose of buying them (leverage). The profits are coming in and bonuses are big. The department store's crack due diligence team assures management their elaborate forecasting models say the price of pet rocks will never go down. Even the general public knows the price of pet rocks "always goes up over time". Pet rocks are tangible assets - at least "you own something". The department store's management team gets a little too excited about the pet rock's staying power and places an order for one million pet rocks. Like most fads or bubbles, the run for the pet rock comes to an end just after we (department store management) order a million of them. Since the market already has an enormous supply of pet rocks (they were very popular), we have a great deal of difficulty finding even so much as a bid from a potential buyer. With prices falling, it is no longer possible to get loans to buy pet rocks - as a result demand drops. The market for pet rocks has become "illiquid" and "ceases to function". The lack of "liquidity" in the pet rock market becomes "problematic" for our department store. In fact, carrying one million pet rocks in our inventory has investors questioning the impact on our entire business model. Our stock price suffers. Our bonuses are much smaller! The department store management team decides the market for pet rocks must be fixed! We hire lobbyists to ask Congress to change the accounting rules for valuing pet rocks. We have friends in Washington who can help us out of this jam. The market has already decided our pet rocks are effectively worthless, based on the glut of supply and the greatly diminished demand. Changing an accounting rule will not magically create demand for pet rocks, it will simply allow us to keep fooling ourselves rather than admitting to our mistakes and moving on. Even if the accounting rule is changed and we are allowed to "assign a value" to the pet rocks in our inventory, the investing public will know what the rocks are worth - nothing or next to nothing. After the craze was over in the 1970's, people used pet rocks as doorstops. In 2009, maybe we can use some of these "oddball" mortgage-backed securities as bookmarks or cabinet liners.

Yes, we understand that pet rocks do not produce any cash flow - as stated, it is not a perfect analogy.

Making Significant Changes to Mark-to-Market is a Big Mistake

Banks and financial services firms are hoping they can cover up years of incompetent risk management with a simple change of an accounting rule. It is ironic that no one complained about mark-to-market accounting when asset prices were soaring and firms happily marked up the value of their assets. Mark-to-market accounting allowed business leaders to claim gigantic bonuses for years. Suddenly, now that times are tough, mark-to-market accounting, rather than incompetence, is to blame. Do not believe it. Do our leaders in Washington really think the general public is dumb enough to believe we can fix this whole mess by changing an accounting rule? Are you kidding me? Let's call this what it is - an attempt to cover up serious lapses in judgment and managerial mistakes.

Some Changes May Be Warranted

Since mark-to-market rules are complex, some changes may be helpful given current circumstances. However, any suspension of mark-to-market rules or radical changes to the basic concepts would do nothing but undermine the already weak confidence of private investors. Since many mortgage-backed securities are producing positive cash flow, there is obviously some value in owning them. The question is how much value.

Mark-to-Market, The Lost Decade, and Zombie Banks

Two administrations (Bush and Obama) have attempted to craft a plan to buy bad assets to spur lending and restore confidence. The idea sounds good on paper. The recurring problem is determining how much to pay for the bad assets. Overpay and the taxpayers are left holding the bag. Pay what the market is willing to bear or fair market value and the banks will have to take a loss. If the taxpayers or private parties pay what the market will bear it creates "accounting problems for the banks". "Accounting problems" is the politically correct way of saying "solvency problems" for many banks. If a buyer pays what the market will bear for the securities, then it will become clear many banks are indeed insolvent or lack sufficient capital. If that were not the case, then the government would have started buying bad assets a long time ago. The banks now want to change fair market value accounting rules to hide their insolvency and/or lack of capital from the public. Changing accounting rules will put us in the express lane to the Japanese "lost decade" scenario. Changing accounting rules will give us banks that appear solvent and well capitalized on paper, but will be insolvent and/or undercapitalized in reality (a.k.a. "zombie banks").

More Transparency Needed, Not Less

Changing market-to-market will greatly reduce transparency (a big problem already). Lack of transparency is a major reason private capital wants no part of banks. If banks are allowed to assign hypothetical values to assets, is that going to somehow magically make the bad assets go away? Investors will know the bad assets are still there. If mark-to-market is suspended, investors and private equity firms will be even less willing to supply capital to banks, which will place an even greater burden on U.S. taxpayers to supply capital. The level of distrust of both political and business leaders is already at a high level. Changing mark-to-market will only increase the anger concerning bailouts and poor leadership.

Asset Values: Facts vs. Fiction

The value of any asset (a car, a home, or a mortgage-backed security) is what the market is willing to pay for it at any given time. In most cases, we assign any other value to any asset then we are guilty of self-delusion. Admittedly, assets which produce positive cash flows do have some intrinsic value above and beyond what the market is willing to pay. This is an area where changes to mark-to-market do make some sense. However, if these asset-backed securities are worth so much more than fair market value then why is no one willing to pay that price for them? If these securities were worth more than current market prices, demand would exist based purely on greed and the motive for profits. There is a reason "many of these oddball investments are not being traded at all" - nobody wants them. There is no demand for them.....no demand equals no bid...no bid means potential buyers and sellers are significantly far apart on their perception of price - based on the state of affairs, we believe the benefit of the doubt goes to the uninterested buyers on the perception of value. Use of leverage in the free market to buy these assets is not coming back anytime soon, which means demand has been permanently reduced. Lower demand leads to lower prices regardless of various states of denial in boardrooms. The financial naiveté of our leaders in Washington could hit an all time high with mark-to-market. The financial markets have known for some time changes to mark-to-market may be forthcoming. The S&P 500 is down 20.13% YTD. The market does not like the government's approach to much of anything, including "restoring confidence" with accounting tricks. If mark-to-market is suspended or altered significantly, we can expect to see financial stocks move higher. However, once the initial reaction fades, the market may decide changing mark-to-market was not such a good idea after all. Let's hope cooler and wiser heads prevail.

Chris Ciovacco
Ciovacco Capital Management

Chris Ciovacco is the Chief Investment Officer for Ciovacco Capital Management, LLC. More on the web at www.ciovaccocapital.com.

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Ciovacco Capital Management, LLC is an independent money management firm based in Atlanta, Georgia. CCM helps individual investors and businesses, large & small; achieve improved investment results via research and globally diversified investment portfolios. Since we are a fee-based firm, our only objective is to help you protect and grow your assets. Our long-term, theme-oriented, buy-and-hold approach allows for portfolio rebalancing from time to time to adjust to new opportunities or changing market conditions.