Marc-to-Market in Plain English: Is public company accounting really broken?

In this post, I explain the mark-to-market scheme (or accounting mechanism) in plain English.

Marc Andreessen says - That's it, public company accounting is broken - on how public companies including big banks and brokerage houses are claiming profits on their books by marking down their own debt obligations. Here is what he has to say:

One of the dirty little secrets -- or rather, dirty huge non-secrets -- of Wall Street is that public company accounting has been diverging further and further from cash accounting -- which is to say, reality -- over time.

Over the last several years, a whole series of new laws and rules have larded up income statements and balance sheets with all kinds of fictional, non-cash components to the point that you basically can't conclude much about any public company financial statement you see, except that you really better read all the fine print.

Marc then cites a WSJ article but it was rather complicated so I thought I would illustrate it by using a simpler example. (Let me know if you think I got it wrong or complicated it further!)

3 Players: Anshu, Marc and Bank of England


The game begins: Anshu borrows $1 billion from Marc

• Anshu borrows $1 billion from Marc. (I am sure he made as much or near about. ;) )
• On my books - I have a debt obligation of $1 billion - and that is the market value of this debt (since I am totally credit worthy).
• On Marc's books - he can show assets of $1 billion in IOU's from me.
  
• Marc can sell this credit note (from me) to Bank of England for $1 billion, so the market value of the debt is $1 billion. So far, we are all good.

On close of loan:
Anshu: $1 billion (debt owed)
Marc: $1 billion (assets- my IOU)


Didn't Stay in Vegas!

I now go gambling to Vegas with Larry & Bill (you know which ones) and start gambling. I end up loosing lots of money (no one knows how much - kind of, like mortgage companies). So my creditworthiness goes down. (Of course, Moody's will wait for few more quarters before realizing this! ;) )

Marc can no longer sell my IOU to Bank of England for $1 billion, they are not stupid (assumption!). So the value of my debt goes down to say $600 million i.e., the market pegs the value of this IOU at $600 million - in other words, someone like Bank of England would be willing to buy the IOU owned by Marc for $600 million.

In short,

• Anshu's creditworthiness falls.
• The IOU's are worth only $600 million in the market.

Reality:
Anshu: $1 billion (debt owed)
Marc: $600 million (assets - my IOU)

Now, the new accounting rules suggest that I can mark my debt to market i.e., I can claim I only owe $600 million now since that is the value of my debt on the market.

New Rules:
Anshu: $600 million (the value of my IOU, not the debt owed)
Marc: $600 million (assets- my IOU)

Since I have $400 million less debt by new rules, I just made $400 million profit!

The problem is this: I still owe Marc (or the owner of the IOU) $1 billion. A lot of ordinary Americans who have credit card problems are familiar with this- you miss 5 payments on your Citi Card, and the bank sells you to a collection agency for pennies on the dollars. But, you still owe the full amount. Now, in some cases, you can negotiate down the debt but till that happens you still owe the full amount.

Charlie Munger's lessons on life

Just read, Sharad Sharma's excellent blog post on Charlie Munger's commencement speech that summarizes some core principles and ways of being that one should embody for happiness and success. For those who do not know Charlie, he is a close friend and business partner of Warren Buffett (yes, that guy who made & then gave away his billions). Whether you are fascinated by Buffett's money making prowess (materialist) or his charity (spiritualist) - this would be an interesting read. Sadagopan (also an Irregular) has a post on it too. So why am I chiming in?

Because I want everyone that stumbles upon my blog to read this address. Here is an excerpt from the middle:

Another thing, perverse incentives. You do not want to be in a perverse incentive system that’s causing you to behave more and more foolishly or worse and worse - incentives are too powerful a control over human cognition or human behavior. If you’re in one, I don’t have a solution for you. You’ll have to figure it out for yourself, but it’s a significant problem.

Perverse associations, also to be avoided. You particularly want to avoid working under somebody you really don’t admire and don’t want to be like. We’re all subject to control to some extent by authority figures, particularly authority figures that are rewarding us. Getting to work under people we admire requires some talent. The way I solved that is I figured out the people I did admire and I maneuvered cleverly without criticizing anybody so I was working entirely under people I admired. You’re outcome in life will be way more satisfactory and way better if you work under people you really admire. The alternative is not a good idea.

Read full speech here.

I would love to add my comments, my learnings and ideas on what is the right way to live but I know for sure Charlie would advise against it (as he says in the speech 'keep the light under the bushel').

(Update: For the interested reader, read this post by Sharad on Work Life Balance; Another update/correction: I menitioned Sharad is an Irregulars member- that was an error).

Warren Buffett buys into Web2.0 conept with $60 Billion

Warren Buffett may not realize it or even know of web2.0 but he is tapping a core concept of Web2.0 i.e., user-generated content, to figure out how to invest hordes of cash that his company generates every year. Currently, his firm Berkshire Hathaway is sitting on $40 billion and he needs to find places to invest this money. In particular, he is looking to find one large company that he can acquire outright but he is doing it with one key difference. Rather than just talk to corporate bigwigs or hire Wall St. dealmakers, Warren is reaching out to the broader community of investors - in fact, any one that reads his annual letter to shareholders or even a newspaper.

Talking about how he is willing to spend even more than $40 billion by selling some other assets, Warren said today:

``I would hope something would come along where I would have to sell something that I like to buy something huge I like even better,'' Buffett, Berkshire's billionaire chairman, said yesterday at a press conference in Omaha, Nebraska. He would ``love'' to find a $40 billion acquisition and would ``figure out a way'' to come up with $60 billion for the right deal, he said in a later interview.

In fact, he even reached out to attendees from foreign countries at his annual shareholders summit.

``I must have told 30 of the South Africans alone to call me collect if they find anything that fits,'' he said in response to a question from a South African journalist. One of the suggestions makes a ``fair amount of sense,'' he said, calling all of them ``long shots.''

If this is not democratization of ideas and user-generated content- potentially worth billions to Warren - then I don't know what qualifies. And as with MySpace or YouTube, the person that comes up with the idea probably gets no more than some limelight - as opposed to billions that would have to be paid to a Wall St. firm that brings you a deal worth this size.

I know that suggesting names of companies is not same as the 'rich' analysis performed by the Wall St. firms but this is an interesting experiment.

What do you think? Should Bill Gates ask our opinion on Yahoo! next? After all, they are best friends.