Mark to market rules and efficiency of financial markets

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Mark to market rules and efficiency of financial
markets

• Paul De Grauwe
• University of Leuven
• and CEPS

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• Mark to market rules are based on the view that
  market prices provide the best available
  information about the correct value of underlying
  assets
• This is the same as saying that mark to market
  rules assume markets are efficient
• i.e. market prices reflect all relevant
  information
• Usefulness of mark to market rules depends on
  market efficiency

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Are financial markets efficient?

• Lets look at the stock markets first
• Take US stock market (DJI, SP500)
• (same story can be told in other stock markets)
• And exchange markets

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Dow Jones and SP500
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US stock market 2006-08

• What happened between July 2006 and July 2007 to
  warrant an increase of 30?
• Put differently
• In July 2006 US stock market capitalization was
  11.5 trillion
• One year later it was 15 trillion
• What happened to US economy so that 3.5 trillion
  was added to the value of US corporations in just
  one year?
• While GDP increased by only 5 (650 billion)

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• The answer is almost nothing
• Fundamentals like productivity growth increased
  at their normal rate
• The only reasonable answer is excessive optimism
• Investors were caught by a wave of collective
  madness
• that made them believe that the US was on a new
  and permanent growth path for the indefinite
  future

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• Then came the downturn with the credit crisis
• In one year time stock prices drop 30
• destroying 35 trillion of value
• What happened?
• Investors finally realized that there had been
  excessive optimism
• The wave turned into one of excessive pessimism
• We still do not know where this will end.

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Nasdaq similar story
200
100
0
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Similar story in foreign exchange market
Since 1980 dollar has been involved in bubble and
crash scenarios more than half of the time While
very little happened with underlying
fundamentals Market was driven by periods of
excessive optimism and then pessimism about the
dollar
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Mark to market in a world of market inefficiency

• We are told that mark to market is the right way
  to value assets
• Thus from July 2006 to July 2007 this rule told
  accountants that the massive asset price
  increases corresponded to real profits that
  should be recorded in the books.
• These profits, however, did not correspond to
  something that had happened in the real economy
• They were the result of animal spirits

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• As a result mark to market rules exacerbated the
  sense of euphoria
• and intensified the bubble
• Now the reverse is happening
• Mark to market rules force massive write downs
  correcting for the massive overvaluations
  introduced just a year earlier
• intensifying the sense of gloom
• and the economic downturn

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A note

• Bankers now complain about mark to market rules
• now that the market goes down
• They did not complain during the upturn
• As a result, their credibility is weak

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Conclusion

• Mark to market rules show excessive confidence in
  the efficiency of financial markets
• There is now substantial evidence that financial
  markets are not efficient
• Inefficiency does not lead to just a few
  percentage points of over- or undervaluation of
  assets
• but of massive and systematic misalignment of
  market prices

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• Yet many people continue to believe in the
  markets infallibility
• and impose rules based on an idea that comes
  closer to religion than to science
• As a result, these rules exacerbate financial and
  macroeconomic instability

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• New rules should be designed
• They should not eliminate market prices
  altogether
• But they should bring some inertia in these
  prices
• Throw some sand in the wheels of financial
  markets.