What is “mark to market” accounting?
Why is everyone talking about it?
Why does Congress want to eliminate it?
What does it have to do with my municipal bond market values?
These are a few examples of the questions being asked by many of you who are following the progress of the government’s $700 billion rescue plan.
Many economists are suggesting that mark to market accounting is at the heart of the current credit crisis and the root cause of the demise of some of Wall Street’s most powerful investment firms and banking institutions.
An accounting rule
“Marking to the market” is an accounting rule that requires financial institutions, on a monthly basis, to price securities they hold on their books at a value that represents what they would be paid if they were forced to liquidate those assets immediately.
It is now well known that the institutions who hold these famous “toxic mortgage securities” are forced to exhaust their capital by valuing these securities at fire sale prices, in a market that has no buyers.
These fire sale prices are thought to be well below what Treasury Secretary Henry Paulson and others in the know assert is their true intrinsic value. That’s why the treasury rescue plan entails buying these risky assets at prices that better reflect their true value with the objective of returning the flow of capital to the financial system.
Highly regarded investors such as Bill Gross and Warren Buffett have suggested that the government will later profit from the sale of these securities to private investors, when the credit markets return to some degree of normalcy.
So what does this have to do with municipal bondholders?
As we have explained before, the lack of institutional participation in our market creates a “half-full/half-empty” situation. (A Tale of Two Investors)
Muni investors have the ability to purchase high quality bonds at rates that far exceed expectations in the current interest rate environment (5.75% to 6.00%), while 30-year Treasury bonds are in the neighborhood of 4.25% to 4.50%.
The half-empty side, however, is that your municipal holdings, for the sake of full disclosure, are “marked to the market” on your monthly statement by a matrix pricing service. Consequently, some of the values on your bonds and bond funds may bear little resemblance to the prices you paid for your securities or their true intrinsic value.
Don’t be alarmed!
There is no reason to assume that these prices reflect a change in the creditworthiness of your investments. The prices are merely a reflection of the current absence of institutional support in the municipal marketplace. This lack of participation is causing unprecedented widening of “spreads” between bid and offering prices.
In essence, your bonds are also being marked to a market that is currently dysfunctional.
Here’s what we see
The good news for investors far outweighs the bad.
Municipal bond buyers are long-term investors and are rarely forced to sell their bonds. In fact, many are feasting on the higher yields available today.
They recognize this as a unique opportunity to purchase high quality assets, which promise a tax equivalent return of over 9.00% for those in the higher tax brackets.
They see a “yield to maturity” value in their bond portfolio that is not available in other investments. More and more new buyers are entering the municipal market, attracted by these higher yields, combined with the security that municipal bonds have always represented.
The last questions investors ask is always, “When will normalcy return to the municipal market?” Frankly, we don’t know. We do feel, however, that the government’s rescue plan is an important and necessary first step toward stabilizing capital markets and restoring confidence to Main Street as well as Wall Street.