On the management of financial guarantees - Market Microstructure and Corporate Finance Special Issue

Financial Management (Financial Management Association), Winter, 1992 by Robert C. Merton, Zvi Bodie

Because of the natural tension between the guarantor and the insured intermediary over asset valuation, a key element of a mark-to-market system is that it seeks to minimize the opportunities for manipulation. Especially if its assets are traded infrequently, the intermediary has information about their true values that is not costlessly available to other parties including the guarantor. As indicated, the intermediary's incentives favor biased-high estimates of prices of its assets and biased-low estimates of the prices of its liabilities. Thus, while the intermediary may have information that could improve the accuracy of the valuation, it may be optimal to neglect its inclusion in the mark-to-market estimates, if inclusion of this information requires too much discretion on the part of the intermediary. That is, the accuracy of the valuation procedure is important, but just as important is that the procedure be known, agreed upon by both parties in advance, and difficult to manipulate.(23) In sum, a proper mark-to-market model is one that, specified ex ante, gives the best estimate of market price, using verifiable data.

A word on book values in a monitoring system. It is sometimes suggested that circumstances in which estimates of market prices are "noisy" are ones that favor using book values -- that is, amortized acquisition cost. This seems to us to be a non sequitur. We are not aware of scientific evidence that book values are the best estimates of market prices, especially for financial assets of the kind held by intermediaries. Indeed, since financial assets whose prices are observable fluctuate substantially over time, it is highly unlikely that the best-fitting unbiased, nonmanipulatable model would produce values that remain virtually constant (around predictable amortized acquisition cost) over time. Standard accounting rules for marking down book values of assets, such as creating a reserve for bad loans, are usually subject to considerable management discretion. One would therefore expect that for monitoring purposes, the guarantor would be reluctant to let an insured intermediary use book values for illiquid assets. There is a certain irony that the assets with the most uncertainty about their values would be valued by a book system which produces almost no variation in price.

Just as it is important to mark the assets to market, so guaranteed liabilities must also be marked to market. Otherwise, the exposure or shortfall estimates of the difference between asset value and promised liability payment value are distorted, and the monitoring process can become dysfunctional. In the case of broker margin loans or demand deposits, the guaranteed liability is equal to the original principal plus accrued interest. More generally, as in the case of annuities and other insurance policies, the stream of promised payments can stretch far into the future. The question of how to compute the present value of the payments that are guaranteed is, therefore, an important issue.