The Perils of Mark to Model

This article was originally published forMorningstar GrowthInvestorsubscribers on March 26, 2008.

So the roller-coaster ride in the equity markets continues. I was on a flight back from Los Angeles on Monday, so I missed all the fun in the wake of  J.P. Morgan's (JPM) new $10 per share bid for  Bear Stearns , and a not-as-bad-as-feared earnings reports from  Goldman Sachs (GS) and  Lehman Brothers . I did catch a few glimpses of CNBC, however, and there were renewed calls of a "bottom" in equity markets by the talking heads. I'm not dogmatic about my bearishness--I try to poke holes in my pessimistic thesis all the time--but all the evidence I have suggests we're still early on in the unwinding of the Great Credit Bubble.

Let's take a look at the "good" news from Goldman and Lehman. I've read more 10-Ks and 10-Qs from financial companies over the past year than I care to remember, and Statement of Financial Accounting Standards No. 157 (SFAS 157) has been a steady companion--it's always there in the background. Large financial institutions hold many different assets on their balance sheets, from the very liquid (like Treasury bills) to the very illiquid (like subprime mortgage securities). All these assets have to be valued, or "marked to market," at the end of each quarter. The problem is that some of these assets are not actively traded, and thus there is no market price to use as a guide. So how are these assets valued? I'm tempted to say, "with made-up numbers," but perhaps that goes too far.

SFAS 157 gives us a hierarchy of assets based on the "quality" of the fair value determination. I'll just cut and paste from Lehman's 10-K because it's a good explanation:

"Level I--Inputs are unadjusted, quoted prices in active markets for identical assets or liabilities at the measurement date.

"The types of assets and liabilities carried at Level I fair value generally are G-7 government and agency securities, equities listed in active markets, investments in publicly traded mutual funds with quoted market prices and listed derivatives.

"Level II--Inputs (other than quoted prices included in Level I) are either directly or indirectly observable for the asset or liability through correlation with market data at the measurement date and for the duration of the instrument's anticipated life.

"Fair valued assets and liabilities that are generally included in this category are non-G-7 government securities, municipal bonds, certain hybrid financial instruments, certain mortgage and asset backed securities, certain corporate debt, certain commitments and guarantees, certain private equity investments and certain derivatives.

"Level III--Inputs reflect management's best estimate of what market participants would use in pricing the asset or liability at the measurement date. Consideration is given to the risk inherent in the valuation technique and the risk inherent in the inputs to the model.

"Generally, assets and liabilities carried at fair value and included in this category are certain mortgage and asset-backed securities, certain corporate debt, certain private equity investments, certain commitments and guarantees and certain derivatives."

As you can see, the values for Level I assets are fairly reliable, while Level III assets are suspect "mark to model" values. I'll quote from  Citigroup's (C) 10-Q: "Level 3--Model derived valuations in which one or more significant inputs or significant value drivers are unobservable" (emphasis in the original).

So what's the game here? Many investment banks, Goldman primary among them, have hedged their exposure to mortgage securities. I suspect the banks are accurately valuing their hedges (because they have gone up in value and there are ascertainable market prices), while taking interesting "mark to model" values on Level III assets. These Level III assets are not a small problem. Goldman holds $55 billion, or 5% of total assets, with shareholders' equity of $42 billion. Lehman holds $42 billion, or 6% of total assets, with shareholders' equity of $22 billion. You can see why the Federal Reserve has undertaken dramatic and unprecedented steps to bail out our financial system. It is effectively insolvent, in my opinion.

I'll end with a quote from the 2006  Berkshire Hathaway (BRK.B) annual letter. In a different context, Warren Buffett had this to say about the "financial models" used on Wall Street. It was easily the single most important paragraph I read last year.

"Over time, markets will do extraordinary, even bizarre, things. A single, big mistake could wipe out a long string of successes. We therefore need someone genetically programmed to recognize and avoid serious risks, including those never before encountered. Certain perils that lurk in investment strategies cannot be spotted by use of the models commonly employed today by financial institutions." 

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