The cheap bailout

Yesterday the FASB and the SEC relieved banks from marking securities to market prices that reflect “fire sale” values. The market rose 500 points, making up two thirds of Monday’s drop, even without a bailout. Holman Jenkins thinks there’s a connection.

But wait: mark-to-market accounting just tells us reality. Shutting our eyes to that just kills the messenger, doesn’t it? Why would killing the messenger send the market up 500 points?

Maybe marking to market isn’t reality if the market price is unrealistic.

But wait: Can’t efficient markets see that, and adjust their expectations accordingly?

Enter regulation, according to Jenkins. Mark to market can put banks below capital requirements, forcing them into closure or forced sale.

[T]he essence of the Paulson plan was to raise the value of bank assets to help banks escape the regulatory equity trap. Does that mean we can change an accounting rule and save Congress from having to appropriate $700 billion?

But wait: if capital regulation is intended to ensure solid capital values, and mark to market gives us this value, why is it a "trap"?

Jenkins suggests the accounting rules can be self-fulfilling – the unrealistic “fire sale” price becomes the highest price at which the bank to sell. So only private equity has been buying subprime securities because they don’t have to mark them to market.

But wait: isn’t the market the market? Why should anybody pay more than that.

Maybe the Paulson plan collides with mark to market if it ends up forcing banks to sell at these fire sale prices. In other words, the federal government would just join private equity as a vulture investor.

But wait: if that’s the value, how can our government justify paying more?

Maybe the short-sellers are making things worse, driving down asset values and making the accounting value a self-fulfilling prophecy.

But wait: aren’t short-sellers betting that shares are over-valued? Mark to market is supposed to get prices to their actual value. If the rule causes unrealism, it’s on the low side, not the high side, isn't it? Short selling is a good thing because it enables bets that help us see what assets are really worth.

As you can see, I’m confused.

Here's a shot at what's going on: The only way changing mark to market gets us out of this mess is if market psychology is driving it. In other words, changing the accounting rule is a bet that (1) markets are inefficient; and (2) we can make them more efficient by eliminating an accounting rule based on real transaction prices. Whoa.

But wait: if all mark to market does is reveal values that the efficient market should know already, then the rule doesn’t make much difference, does it? Jenkins point is that we may as well try this gambit.

Hey, it’s a lot cheaper than 700 billion.

One last point:  if we get rid of short selling, then all bets about the market knowing what's really happening are off. In other words, should we get rid of both mark to market and short selling?

Comments

[Xmas]

The way your describing it, Mark-to-Market is a positive feedback loop. It's inherently destabilizing and it prevents the market from reaching an "actual" price. Once the price of a type of asset starts moving, mark-to-market is going to accelerate it's movement.

One regulated company dump (some, most, all) of one type of assets. Which drives the price lower (more supply on the market), now four other regulated companies see their assets losing value, and they decide to dump. This causes others in the market to start dumping, and so on and so on. Until, at some point, the regulated companies are completely out of owning that asset, the market for the asset breaks completely or you reach a minimum price that's so low that everyone realizes that buying now is a bargain.

On the flip side, is some other asset that the regulated companies are buying into, because it's value is going up and up, and the rising price pulls them back above their regulation requirements for asset levels.

[aynrandgirl]

Mark to market makes a huge difference, because it creates liquidity traps. If I have to continuously revalue my assets, it's likely I will be forced into technical default of my bond covenants even though I can easily make my debt service from operating cash flow. The company becomes brittle, because it will be forced into bankruptcy rather than being allowed to weather a temporary downturn in its equity.

[M.D. Fatwa]

I think you have just proven your subsequent post about public intellectuals and the complexity of modern finance. FASB and the SEC did not "relieve" banks from having to mark to market their assets, but merely pointed out that FAS 157 allows for Level 2 and Level 3 modeling of asset values where a liquid market for distressed assets does not exist. This has always been the rule, it's just that most banks, when investing in subprime mortgage-backed securities, never bothered to build the infrastructure to model cash flows because such infrastructure is expensive. What the SEC and FASB said was not new. If anything, they should be faulted for not making more clear that they are not changing current accounting requirements, but just remindings banks (again) that this avenue exists. (The Senior Supervisors Group report -- http://www.newyorkfed.org/newsevents/news/banking/2008/SSG_Risk_Mgt_doc_final.pdf -- and the IOSCO Subprime Report -- http://www.iosco.org/library/pubdocs/pdf/IOSCOPD273.pdf -- also note this.)

[M.D. Fatwa]

Xmas and ayrandgirl are correct, but this only highlights a capital requirement regulatory issue, not an accounting issue. You can be in favor of mark-to-market accounting and also in favor of decoupling net capital accounting from mark-to-market. One is a disclosure issue for investors, the other a prudential issue for regulators. Two different objectives.