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The Republican Mark to Market Mistake

House Republicans seem determined to punish Americans as they punish Wall Street Bankers, and their determined resistance to the bailout bill may result in the Bush administration supporting language that changes the 'mark to market' accounting rules. What this will mean is that bankers will be given permission to lie about their value of their assets to make their balance sheets look better, giving the appearance of stronger financial health.

Get it? It doesn't make banks healthier -- it just makes banks 'appear healthier,' and once you do that there is less of a need to step in and bail out banks Adopting this change would be a major mistake, but its exactly what the resisting House Republicans are calling for.

So how did this particular idea float to the surface?

Until about five years ago banks all over the world worked out the profits they made from lending money to homeowners, businesses and consumers by estimating the likelihood that borrowers would continue to pay interest and ultimately repay these loans. Regulators then determined the bank's solvency on the basis of such long-term assessments.

In recent years, however, accountants and regulators have replaced such probabilistic judgments of economic fundamentals with a principle called 'mark to market'. Under this new approach, promoted passionately by conservative financiers and academics who believe that "the market is always right", banks base their profits not on how much income they expect to receive in the future but on how much money they could raise immediately if they sold all their loans and mortgages in the market at the best price they could fetch.

The viability of the loans, the likelihood of the payments continuing, are adjusted for the real world repayment realities -- as foreclosures increase and fewer mortgage loans are paid on time, the remaining loans held are marked down in value because -- well -- there is a greater likelihood they won't be paid off.

So dropping the 'mark to market' rule is in effect giving the bank permission to lie about the current market value of their assets if those assets had to be liquidated today.

This reform didn't make much difference when markets were working smoothly and financial prices reflected long-term asset values. But in the wildly volatile and panicky conditions of the past 12 months, mark-to-market accounting has contributed hugely to the crisis.

It's been a problem for the last 12 months, and the laissez-faire "regulation-lite" Bush administration was happy to let these banks flounder and fail -- all the way up to the brink of disaster, out of the same "the market is always right" philosophy.

And it's easy to understand why Bush allowed the situation to reach this point -- it's the basic tenet of Republican free-market philosophy to let the market do its worst (and best, but it was worse in this instance) and drive these banks and insurance companies to the brink of failure. The AIG bailout had the same market valuation problem at its core.

So how did this come into play in the bailout vote last Monday, and why do some Republicans now hope to change the mark to market rules?

On Monday several Republican Congressmen who had broken ranks with the Bush Administration were focused mainly on the mark-to-market issue rather than on generalised populist disquiet. One reason for the large vote against the package was a persuasive seminar on Capitol Hill just before the voting. It was held by William Isaac, a prominent financial consultant who formerly ran the federal government's deposit-guarantee fund, and who has long argued that suspension of mark-to-market accounting could save many banks from failure and billions of dollars in taxpayer funds.

Issac's expanded on his reasoning in more detail in a Washington Post Op-Ed piece published two days before Monday's vote.

I have doubts that the $700 billion bailout, if enacted, would work. Would banks really be willing to part with the loans, and would the government be able to sell them in the marketplace on terms that the taxpayers would find acceptable?

To get banks to sell the loans, the government would need to buy them at a price greater than what the private sector would pay today. Many investors are open to purchasing the loans now, but the financial institutions and investors cannot agree on price. Thus private money is sitting on the sidelines until there is clear evidence that we are at the floor in real estate.

Issac theorizes that these loans that have been marked down in value won't be sold by the banks at the current low values because their long-term value is greater than their current market value, and threfore we should drop the 'mark to market' accounting rule and just pretend the value of these loans is greater than it appears today.

Therein lies Issacs' failure in my view, and the reason why suspending the mark to market accounting rules is a bad idea is simply that there are no guarantees that the economy will improve. The IndyMac failure in July and the bailout of insurance giant AIG are an early indication of a possible depression. You won't hear Bush or Paulson, or any politician for that matter, say those words because it can be self-fulfilling prophecy to predict a depression as consumer confidence drops and businesses cut back in defense, but that's the reality. We're in a recession and headed for a depression. IndyMac, AIG< and the current Wall Street wobblies are all acting as "canaries in a mine," signaling a worsening economic situation.

But changing the accounting rules and in effect allowing banks to lie about the value of the loans they are holding to improve their balance sheets is not the answer. It's the equivalent of putting an oxygen mask on the canary.

Sure, the canary won't die, but we'd only be deluding ourselves. The mine isn't safer, and the problem hasn't gone away. We're just ignoring the danger and 'saving the canary' (ie propping up the Bank balance sheets).

That's my view anyway. Maybe the rules can be suspended and some other safeguards put into place so that investors and regulators can recognize the real, current market realities that the "mark to market" rules do provide.

Long term, tighter regulation is called for. If nothing else, the disastrous Republican market philosophies promulgated by the Bush administration have clearly been shown to be at fault here. The $700 billion price tag demonstrates that allowing the predatory lending practices to continue over the last few years was a huge and costly mistake. There resulting crash of the housing market has brought us to this point.

Passing the bailout bill and allowing new capital to be injected into the market will raise the value of those depressed loans, and at the same time inject much needed capital into the credit markets and stabilize the stock market. It's a viable fix. It will work, and its desperately needed to help lift this economy out of the recession, and "growing our way" out of the recession is the right answer.

But putting the canary on life support by suspending the mark to market accounting rules doesn't resolve the root problem, and only makes it possible for things to greatly worsen.


Note: Wizbang Blue is now closed and our authors have moved on. Paul Hooson can now be found at Wizbang Pop!. Please come see him there!

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Comments (1)

Lance Free & Jay Dee:


Market Value Solution, Not Problem!

Simply stated, the mark-to-markdown rule states you must assign the value of your bank's assets according to what the market says they are worth at the time. When the market value of a home drops, the buyer has defaulted on the mortgage, the artificially created demand for homes all across the board has collapsed and years worth of supply has to be worked through, there is no value to the property the bank holds since there are all sellers and no buyers. The value is zero according to the market value. Plain and simple, if you are not willing to make significant concessions to rid yourself of the property in order to keep the defaulting party in the home or find a new buyer (doubtful) at a steep loss, you are required to carry the property at the total loss of mark-to-markdown. Similarly, a third-party will never buy the mortgage which has failed. Banks and investors are not in the business of home ownership and maintenance until the housing supply is exhausted and the mortgage purchaser can recoup the price of the home plus carrying costs on the original mortgage terms acquired by the third-party!

Suspension of the mark-to-markdown rules would be a return to the over leveraging of capital that created the mess in the first place. One, it allows the banks to create a subjective value for an asset (the mortgage and underlying price of the physical asset of the home) which the market says is worthless and the bank has failed to find a buyer at any price. Two, this is the same situation which infected Freddie and Fannie since it encouraged them to by theses assets on the faulty assumption the home market would be climbing, the underlying mortgages were payable on reasonable terms, mortgage payments would be made and values maintained in perpetuity. NOT! Finally, the suspension of the accounting rules would be a market ruse which essentially permits the bank to again over leverage by over valuing assets for more cheap Fed money. And, lacking confidence on how any other bank has subjectively valued its unsaleable assets, no bank is going to loan another bank money or issue new loans into a market which has been artificially created.

As the L.A. Times reported,. "Accounting purists say a rule change would raise the risk that the banks would resort to fantasy accounting -- "mark to make-believe" -- that would overstate the value of their assets to investors. The Center for Audit Quality, an advocacy group for the accounting industry, issued a statement Tuesday urging Congress to reject any suspension of mark-to-market rules, saying that would undermine investor confidence by allowing companies "to mask the actual value of financial assets at a given point in time."

No one can say the investment banks, which effectively started the dominos tumbling, were not part of and fueling the mortgage problem. And yet, it was in 2004 that the same investment banks petitioned an obtained SEC approval to allow them special status to leverage their assets up to 40 times compared to the previous 12 times applicable to themselves and banks. This was known as the "Alternative Net Capital Requirements for Broker-Dealers That Are Part of Consolidated Supervised Entities" and which allowed investment banks, including Goldman Sachs being run by Paulson, to subjectively determine "net capital to include securities for which there is no ready market". Now, the proposal is to allow every financial institution to make its own determination of market value! Talk about not learning from a mistake.

As an relevant aside, everyone should be calling for Paulson to step aside from participation in the execution of this plan - whatever the final terms. In February 2006, at the latest, Paulson's Goldman Sachs Group began using an internal and copyrighted Powerpoint presentation entitled "A Primer on the Sub-Prime Market" by the "Goldman Sachs Structured Products Strategy" division. That document indicates how to sell the securities and then states, "Given the belief that house prices in the U.S. are too high, there are several trades that can be executed to short house prices". In the Spring, Goldman Sachs thereafter sold mortgages tronches, totaling $496 million, to the unwitting clients who lost an estimated 300 million. Goldman however handsomely profited again on the failure of these securities by shorting the market and sales!! See, Sloan article in Washington Post. Instead, notables like PIMCO Investment founder Gross, and David Einhorn of Greenlight Capital, are knowledgeable about the debacle and the house of cards on which it was built. In fact, Mr. Gross stated on CNBC he would run the program for free!

A more appropriate response to the "mark-to-markdown" rule would be allow a limited waiver of the rule for any mortgage renegotiated with the "primary residence" homebuyer which puts them back in the foreclosed or abandoned home. As a result, the home would be sold, the home occupied, a simplified mortgage based upon actual ability to pay in place, renegotiation taking place at the local level with knowledge of local markets, federal intervention avoided, excess supply removed from the market, a bottom up approach utilized and liquidity enhanced. The changed mortgage could the be valued at the new market as reasonably estimated by the bank. The "Plan" would then be buying assets which tend to re-establish the fair market value and others are more likely to step in when the toxicity is removed. Note the proposed rule waiver would only be applicable to a primary residence. Sorry, no help for flippers and speculators.

For any one interested in an examination of the greed in sub-prime mortgage the NY Fed noted the overreaching of the effects of the usurious terms " begs the question why such a loan was made in the first place." Please search, read and digest: "Understanding the Securitization of Subprime Mortgage Credit", Staff Report No, 318, by the Federal Reserve Bank of New York, March 2008

Sorry, we were so rude as to inject a comment on the issue of "mark to market" and its application.

Lance Free & Jay Dee
Lance Free Consulting


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Publisher: Kevin Aylward

Editors: Lee Ward, Larkin, Paul S Hooson, and Steve Crickmore

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