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Friday, February 20, 2009

Some Perspective on Marked to Market and the Current Crisis

There is a group of business folks and economists lead by Steve Forbes that believe that the magic bullet in stabilizing the economy starts with reversing the FASB rule of mark to market.

Mark-to-market is an accounting methodology of assigning a value to a position held
in a financial instrument based on the current market price for the instrument or similar instruments. For example, the final value of a futures contract that expires in 9 months will not be known until it expires. If it is marked to market, for accounting purposes it is assigned the value that it would currently fetch in the open market.

I have no opinion about whether or not reversing this rule would be the magic bullet, but mark to market has received little or no attention while its importance in the crisis cannot be understated.

First, in a perfect world, I would favor mark to market. Companies and financial institutions shouldn't be allowed to set an arbitrary value on assets, financial or otherwise. As such, setting their value at current market only makes sense. Yet, in the current market it has had a corrosive effect on our financial system.

Mark to market forces financial institutions to set their assets at current market value. So, how does this contribut to the current crisis? Well, many financial institutions are holding onto Mortgage Backed Securities. With the erosion of real estate, these MBS' have become 1) illiquid and 2)of significantly less value.

Because these assets can't be sold, financial instituions put them away and often have no choice but to use them as part of their asset value for minimum capital requirements. The problem is that these MBS' continue to fall in value. Furthermore, most of these financial institutions took on far too much risk and became far to leveraged. As such, meeting minimum capital requirements becomes a difficult task. With these MBS' continuing to fall in value banks have to constantly scramble just to meet minimum capital requirements.

This brings us to TARP, what banks did with it, and why the credit markets continue to be nearly frozen. Banks sit on Billions of Dollars worth of these MBS'. Their value continues to fall and none of these banks have any idea what they will be worth in the future. Since they can't sell them, their only worth is in contributing to minimum capital requirements. Since they aren't sure how much they will be worth, banks are afraid to lend any new capital they receive, for fear that if they do, they won't have enough capital remaining.

As such, if mark to market were rescinded and these financial institutions were allowed to place one value on these assets, then banks could hold them while the market recovered and they would be less afraid to lend. As this theory, championed by Forbes, goes, this would unfreeze the credit markets, and it would cost us nothing.

1 comment:

Mia Zagora said...

I would think that trying something that would cost us nothing FIRST would be preferrable to getting us into a massive amount of debt that will take years to recover from, if we recover at all.