The Weird World of Mark to Market
"Classics II - Another Investor's Anthology," a new book edited by Charles Ellis, includes Hans Christian Andersen's fable "The Emperor's New Clothes."
That is truly fitting. The more I learn about finance, the more I conclude that the performance reports banks put out are as suspect as the emperor's attire.
Take capital standards. Within limits, a bank can make its capital into anything it wants if it is willing to do gains trading and postpone realizing losses.
However, a bank or thrift taking portfolio losses that reduce tax liabilities must also deduct these losses from capital. Because of the capital impairment, many institutions hesitate to benefit from tax reductions.
Still, it is hard to see how a bank gets stronger by passing up a tax deduction. As hard to see as the king's invisible clothes.
A Guaranteed Return?
I discovered a similarly paradoxical world when trying to advise the trustees of a union's half-billion-dollar pension fund on what to do with their money.
The problem was that the trustees had put it all in insurance companies' guaranteed investment contracts.
Because the return was certain, they were sure they could meet pension obligations. At least, this is what they thought.
When the problems of several insurance companies came to light, however, the trustees realized that they had to diversify. I was to advise them on how.
My basic operating assumption is: There is no such thing as a free lunch. Every investment offers a combination of risk, income, and liquidity, and you can't have them all.
I explained that there is risk even for securities from the Federal National Mortgage Association and Government National Mortgage Association. If interest rates rise, people hold their mortgages - and the worth of securities backed by these fixed-rate mortgages falls. If rates fall, people refinance - leaving the securities holder with cash to reinvest at less attractive yields.
Heads you lose, tails you just get your money back.
I also advised that even Treasury securities pose a risk if inflation eats up the value of an investment faster than interest rate payments add to it.
On the topic of equities, I explained that the combination of capital gain and dividend reinvestment has provided a return of about 9% in stocks through the years. So I was saying a diversified portfolio of equities, guaranteed investment contracts of quality insurance companies, and top-quality bonds would provide the yield to meet pension obligations.
Then one trustee indicated that the emperor had no clothes.
"We can't use stocks or longterm bonds," he said. "Under the Employee Retirement Income Security Act, we must mark them to market.
"What this means is that if we ever have a paper profit on them, we have to record it. Then the unions we represent will want higher benefits, because we will have to raise benefits.
"But then - when interest rates rise and bond prices fall again, or when stocks recede - we will be left with higher profits on our books. And you can't move pension benefits backwards. The result: No new employer will want to join our fund and take on such obligations.
"So we want investments that don't show profits on a mark-to-market basis. That's why we rely on GICs."
Avoiding a Jam
The problem: The trustees want protections from inflation and interest rate risk and to cease relying on one type of investment. But if they succeeded and then bond and stock prices rise, they would end up in a jam - unless these profits remained forever. Which they wouldn't.
My advice included warning the trustees about owning and operating real estate.
I showed them how they could make up and hold for the long term a portfolio of stocks that represented the Standard & Poor's 500 without hiring professional management, since they wanted to keep decision-making in-house and avoid portfolio switching.
And I comforted them on the "prudent man" rule, explaining that without being considered frivolous they could take steps like selling puts against securities on hand, thereby augmenting yields on stocks they planned to sell anyway if the shares reached certain prices.
An Accounting Wonderland
But the accountant's rules on marking to market made the board wary of trying to generate profits, even though that is obviously a basic goal of any money manager.
I left with far more sympathy for the bankers who oppose mark-to-market accounting in banking, as the SEC has proposed it, because they fear it would create heavy volatility in reported bank earnings.
I concluded that maybe "Alice in Wonderland" should be included with "The Emperors New Clothes" in the next edition of the investment anthology.