The End of Mark-to-Market?

The U.S. stock market's wildest swings since 1929 continued as almost 80 million options expired today:

The Standard & Poor's 500 Index jumped 7 percent from its low to its high today, or more than twice the average gap in 2008. The measure advanced 0.8 percent to 953.62 at 2:41 p.m. in New York as traders grappled with billionaire investor Warren Buffett's advice to buy shares and reports showing the housing slump and consumer confidence worsened.

Owners of the contracts on stocks, indexes and exchange- traded funds have until today's close to take advantage of the rights granted by their calls and puts. Investors are preparing for the possibility that market makers will boost volatility by buying and selling stock to hedge the risk of the option trades they have facilitated.

``I'd expect some fireworks,'' said Herb Kurlan, president of Vtrader Pro LLC, a San Francisco-based options and futures brokerage. ``The unwinding of positions is going to be more pronounced because of the high volatility.''

Fireworks happened as the Dow ended down 127 points on a mixed session. One positive note, however, was that this marked the first weekly gain on the Dow in four weeks (+4.7%). Let's see if the mo-mo guys (momentum players) jump on the bandwagon in the coming weeks.

More importantly, under emergency new accounting rules designed to bring Canada in line with recent changes in the United States and Europe, Canadian banks and other financial institutions will be able to postpone taking profit hits from plunging financial assets on their books.

From the Globe & Mail:

The Accounting Standards Board said Friday it has initiated amendments that will allow companies to shift financial assets out of accounting categories that require changes in fair value to be recognized in net income immediately.

The move away from so-called fair value or mark-to-market accounting is designed to make sure that Canadian rules are consistent with both international and U.S. standards, which have been changed to help financial companies better cope with the global market meltdown, the AcSB said in a news release.

AcSB chairman Paul Cherry sought to counter concerns raised by institutional investors and other parties that the changes would allow companies to conceal damage from investors.

“It must be stressed that assets will remain subject to impairment testing and the amendments involve extensive disclosure requirements” he said. “Transparency will remain for investors.”

Mark-to-market rules require financial institutions to place a value on many of their holdings on the last day of each financial quarter. However, in period of great market turmoil such as the present, the values can fluctuate wildly, and lead to large writeoffs and losses, even if the companies plan to hold the securities until their value rises again.

A number of major Canadian financial companies, including Sun Life Financial Inc., Manulife Financial Corp. and GreatWest Lifeco, for example, have disclosed that they expect to take charges on hundreds of millions of dollars in bonds and other securities issued by troubled or failed U.S. companies, such as Washington Mutual Inc. of Seattle, American International Group Inc. and. failed New York investment bank, Lehman Bros. Holdings Inc.

Manulife chief executive officer Dominic D'Alessandro complained last month that the mark-to-market accounting rules are exacerbating the financial crisis and have exaggerated the tendency toward greed and short-term thinking in the financial system.

Senior bankers such as Royal Bank of Canada CEO Gordon Nixon and Rick Waugh, his counterpart at Bank of Nova Scotia, also have blamed these rules for prolonging and worsening the global financial crisis, arguing that they have led to a higher degree of hard-to-predict writedowns at the world's banks.

There is no question that mark-to-market rules exacerbated the moves to the downside but as someone pointed out to me today, they also exacerbated them to the upside.

For years, financial institutions were valuing their illiquid holdings using 'mark-to-model' or generous valuations methodologies that padded values to make it seem as if illiquid assets grew exponentially.

A few "sophisticated" public pension funds were some of the worst abusers of generously valuing their illiquid securities and assets like real estate or private equity. But nobody ever questioned them as long as they kept posting solid gains, handily beating their composite benchmark.

I will state this once again: the biggest scam in the public pension system was how a few public pension funds were able to convince their stakeholders to "diversify" away from liquid bonds and stocks into all sorts of illiquid securities and private asset classes.

They then persuaded their board of directors to use bogus benchmarks that did not reflect the underlying risks of these investments, allowing them to reap huge bonuses as they kept repeating "we added significant value in private equity, real estate, hedge funds and infrastructure." And they shamelessly peddled this as alpha!

But when the crisis hit, all these sophisticated pension funds soon realized that in a bubble all asset classes are correlated to one and there simply is nowhere to hide when waves of deleveraging lead to savage selloffs.

Today, Reuters reported that according to RBC Dexia, Canadian pension funds with combined assets of C$340 billion have lost 10.1 percent so far this year. This last quarter marked their biggest quarterly decline in a decade with an 8.6 percent drop in the third quarter:

"It hasn't been pretty - and judging by the performance in October so far, the situation is not getting any better," Don McDougall, the company's director of advisory services, said in a press release.

Canadian equities was the hardest-hit asset class in the quarter, plunging 18.2 percent, RBC Dexia said. Falling commodity prices dragged down energy and material stocks on the resource-dominated Toronto Stock Exchange.

"Fortunately, most Canadian funds had already trimmed their exposure to resources," McDougall said, and this enabled them to outperform the stock index.

As for domestic bonds, Canadian pension funds saw their bond performance slip 1.5 per cent in the quarter, it said.

All major asset classes declined in the third quarter, consulting firm Mercer said last week. But Canadian fixed income securities and U.S. equities in Canadian-dollar terms put in the best performance.

The S&P 500 index fell more than 8 percent, but only 4 percent in Canadian dollar terms, as the Canadian currency weakened sharply, Mercer noted.

Mercer's pension health index, which shows the ratio of assets to liabilities for a model pension plan, dropped 6 percent in the third quarter, and is down about 10 percent for the year.

The pension fund time bomb is ticking. Keep in mind my "vested interests" theory as you read the losses coming in from pension funds.

Also, I am eagerly anticipating Canada Pension Plan's Investment Board's Q3 results, due any day now so we can get an idea of how the larger public pension funds that invest in private markets are holding up (CPPIB should have already posted their Q3 results).

Back to mark-to-market.

You can change all the accounting rules in the world, but all you are doing is postponing the inevitable. Moreover, you need to introduce more transparency and better regulation into the financial system.

I am glad to see our Prime Minister, Stephen Harper, has teamed up with French President Nicolas Sarkozy to seek an overhaul of the financial system:

The two men, along with European Commission President Jose Manuel Barroso, agreed on the need to hold an international summit before the end of the year "to restore confidence and the normal functioning of the financial system".

They met a day ahead of talks that Sarkozy and Barroso will hold with U.S. President George W. Bush at Camp David in Maryland.

"Clearly in the world of globalization, our institutions and our capacity to act have not kept up with other developments, and we're seeing some of the consequences of that, and we have to have new infrastructure," Harper told a news conference with Sarkozy and Barroso.

"It's not to say capitalism is flawed, it's to say that governments have a responsibility to create a better infrastructure for the establishment of markets internationally," he said.

Sarkozy said a summit is needed to launch an overhaul or "refoundation" of capitalism to become "a capitalism of entrepreneurs, not speculators". The president rejected the idea that regulation somehow clashed with freedom.

"There is no freedom without a minimum of regulation and supervision," the conservative leader said, adding the world must ensure the same causes do not produce the same effects.

That $62 trillion credit derivatives iceberg will take years to thaw out. Worse still, we are likely going to experience the worst consumer recession in the post-war era and debt deflation will wreak more havoc on financial institutions over the next few years.

But as most people hunker down for the upcoming economic upheaval, Comrade Paulson and his buddies on Wall Street are feverishly working on a new plan to turn losses into gains.

Call this "trickle-up economics" where the restless many bail out the prosperous few.