Thursday, December 6, 2007

Mark to value versus mark to liquidity during market crises

There is the song lyric “the darkest hour is just before dawn” which probably was not speaking about liquidity crises, but it could have been. I have written a lot about liquidity crises, both in past blog posts and in my book, A Demon of Our Own Design. In a nutshell, the issue with a liquidity crisis is that there is a market shock that forces investors who are highly leveraged to liquidate. Their liquidation drops prices further – remember the market already had some sort of a shock, so it doesn’t take much to move prices down more – and this causes even more forced selling. You end up with a downward spiral in prices. This is helped along because some of the people who might be natural buyers run for the sidelines. They see the market is in disarray and watch a lot of apparently smart people hanging on by their fingernails, and they don’t want to take the risk. Or they want to take the risk, but their bosses, who are further removed from the scene, will think they are imprudent gamblers if they do.
The end result of this cycle is that prices are determined by liquidity issues, not by value. The value players have by and large been scared away. Once the dust settles and the highly leveraged players are done bailing, everything moves back to normal, where “normal” means that prices are determined more by value again. Granted, on the margin liquidity will still affect the price. If there is a pension fund that has a large position to move, prices will adjust for that in order to find the other side of the market. But in most markets, that sort of thing will move prices a few percent here and there, if that much.
Things are deservedly considered to be bad right now. There are major institutions that have gotten themselves into terrible positions. This is a crisis that has a risk of having systemic repercussions both because of its depth and because of the types of markets that are involved. So my intent is not be sounding an “all clear” siren. But I wonder if some people are confusing the liquidity-driven marks with the value-based marks, and in doing so are making things look even worse than they are. This already was on my mind when I watched the level of write-downs of positions, but the most recent event that really makes this a question to pose is the sale of assets by E-Trade for pennies on the dollar. Is that really a representation of where value is? What is the implied default rate that would make that fair value?
I have seen a number of sources extrapolate the E-Trade transaction, asking what would happen if all the Level 3 positions of banks and investment banks were to be remarked based on this transaction. This seems to be a variation on the game that started a month or so ago of assessing the prospects of a bank staying in business based on the ratio of Level 3 assets to capital. I think this is an exercise that is alarmist. Level 3 positions are not all sub-prime or even all CDO. There may be Level 3 positions that are good as gold, but simply do not have comparables or models that can provide adequate marking. And it is no surprise that these institutions are highly leveraged – they typically might have a balance sheet that is twenty times their capital. So with that sort of leverage, and with the sorts of businesses they are in (remember, they tend to make markets in things that you can’t just run out and buy on an exchange), it is not surprising to me that they will have Level 3 assets that are greater than their capital. But again, “Level 3” does not mean “worthless”.
Granted if you are in a position where you may be forced to liquidate, the mark to liquidity is what you are concerned about, and for E-Trade apparently that was the case. But if you have the ability to weather the storm, what will finally matter is the mark to value.


  1. I think that the 800mm price that's quoted for E-trade's ABS is potentially misleading. Remember, the ABS sale was only part of a more complicated transaction: Citadel paid ~$2.5b to get a basket comprised of E-trade's hard-to-mark ABS portfolio, a 12.5% coupon on hard-to-mark E-trade debt, and a big slug of easy-to-mark E-trade common stock. One can't say that the ABS portfolio traded at 800mm because the trade didn't occur in isolation. And there's a lot of uncertainty as to the yield at which E-trade could have issued a big slug of new debt. It may have been advantageous to either Citadel or E-trade (for tax or other reasons) to ascribe a low price of 800mm to the ABS piece of the transaction and a higher price (lower yield) to the debt part of the deal.

  2. Hmmm.

    Mark-to-Liquidity in this market is mark-to-market and is at least somewhat objective. Mark-to-Value is subjective. Value according to whom? If I have the conviction of a value I should be prepared to own it at the depressed liquidity price because I have faith it will one day be priced at value. The logical extension of what you are advocating is that if I buy an at-the-money call, but believe the price of the underlying will double (for reasons I believe are sound) I should be able to price that call on my balance sheet at the value I perceive. A good way to print money, but it seems to encourage the type of mess we are in. Though the government seems to be in your camp with the Paulson sponsored mortgage mismarking scam.

  3. The reverse side, however, is that mark to liquidity would create its own problems when there is a crunch; you would have the same kinds of fire sales for different reasons, or in even more ugly cases, blow ups.

    Like any other problem worth contemplating, there is obviously not an easy answer here. Too much mark-to-make-believe-values causes blow ups in the same way that mark-to-liquidity would cause the same.

    Though, ultimately, anyone seems less likely to get pinched if they are not highly leveraged...

  4. Rick,
    Thanks for the post in response to my comment on the prior post.

    Alex, I think there is evidence in the E*Trade deal that the ABS transaction stands on its own. Blackrock was a participant (for $100MM) in the senior notes + stock capital infusion, but not in the ABS transaction - only Citadel participated in the ABS transaction. It is not clear what other source of value there is in the deal for Blackrock aside from the straight purchase of those securities. Beyond that, we don't know what the mix of the RMBS securities was between AA and AAA. There could be an enormous difference in value between a super senior AAA and the AA tranches, that may help explain the $800MM price.

  5. Rick, first I would like to say that I thought that your book A Demon... was one of the greatest investing books I have ever read. I learned a lot. I wonder if you could do a piece on CDS and explain how a buyer or a seller of CDS actually gets paid. Do they sell them in an opaque market? Do they have to wait for a default? Do they really need to supply the actual instrument that the CDS is related to in order to get paid off? Etc. I would really like some clarity as what these instruments are and what they are not. Thanks. Dr. Steve