Marking to Myth
Many institutions that publicly report precise market values for their holdings or CDOs and CMOs are in truth reporting fiction. They are marking to model rather than marking to market. The recent meltdown in much of the debt market, moreover, has transformed this process into marking to myth.
Because many of these institutions are highly leveraged, the difference between "model" and "market" could deliver a huge whack to shareholders' equity. Indeed, for a few institutions, the difference in valuations is the difference between what purports to be robust health and insolvency. For these institutions, pinning down market values would not be difficult: They should simply sell 5% of all the large positions they hold. That kind of sale would establish a true value, though one still higher, no doubt, than would be realized for 100% of an oversized and illiquid holding.
In one way, I'm sympathetic to the institutional reluctance to face the music. I'd give a lot to mark my weight to "model" rather than to "market."Warren Buffett
Chairman and CEO, Berkshire Hathaway
(Aug 17,07)
Financial markets provide liquidity for us who hold financial instruments but are in need of money for making payments for goods and services. In the world, only money in your pocket / wallet is the thing that holds perfect liquidity. In general, money earns the lowest rate of return of all assets traded in the financial markets, and its value can be eroded by inflation easily.
Business firms, banks, and thrifts rarely can perfectly match the maturities of their assets and the maturities of their liabilities. In other words, volume of cash flowing in rarely matches flowing out.
Financial institutions use two methods to meet their liquidity requirement:
- Asset Conversion - selling selected assets, such as deposits or government securities, that holds to cover a pending cash need.
- Libability Management - calls for borrowing enough liquidity. The borrowing institution uses interest rates to bid in the financial marketplace for cash it needs. Among the most popular source of borrowing liquidity are selling deposits, borrowing in the money market, or from the central bank.
