Sunday, February 1, 2009

Mark to Market? Yes . . . But How?

Today's "Naked Capitalism" addresses in a direct and important way the core of the financial crisis, in the post "Fix the Accounting, Then Fix the System".

Your humble blogger has been saying for some time that efforts to prop up bank asset values are prolonging the financial crisis, and the the various incarnations of "bad bank" plans inevitably entail buying dud assets at above market prices. That has the ugly side effect, which some no doubt see as a virtue, of letting banks that hold similar assets mark them at phony prices. The mechanism is different, but failing to write down bad assets is straight out of the Japan playbook.

The financial system grew too large by lending money to people and businesses who could not afford them (at least, if anything remotely bad happened, and bad things happening is part of the human condition). That means it CANNOT be restored to status quo ante (unless you are willing to see it fall apart again in short order). But the plans in motion seem to be an effort to do just that.

Instead, we need a program for shrinking and rationalizing the financial system.

These comments by Yves Smith are sentiments that have been echoed here many times. The post then goes on to quote extensively from a post from Roger Ehrenberg's blog "Information Arbitrage". This blog has a number of recent posts with opinions on the ongoing and proposed plans for the financial bailout hat find complete agreement here. Yesterday's IA post, Fix the Accounting, Then Fix the System, quoted extensively in the NC post from today, would also find complete agreement if the implementation could be clarified. Here is the operative part of this post:

What needs to happen, right now, is to make EVERY financial institution apply mark-to-market accounting to their portfolios. No readily observable market? Have an administrator apply an independent third-party valuation that takes into account polling possible buyers. . .

On Monday, President Obama should get together with Mary Schapiro of the SEC and insist on a clean accounting of all financial institution balance sheets - IMMEDIATELY. We can then truly put a good bank/bad bank plan into motion . . .

DoctoRx here. Full agreement on the concept of mark-to-market. Yet how can an unknown, unnamed administrator come up with a market price? Which possible buyers of which quantity of inventory does one poll? How does polling produce a reliable market price? Here are certain points and questions in more detail:

1. Consider, for example, John Paulson's Year-End Letter to clients, which was leaked to the New York Times and which can be found at Paul Kedrosky's Infectious Greed website at the hyperlink above. This letter makes it clear how research-intensive is the process of valuing each individual CDO and similar security; it states that of similar-seeming securities, some might be currently undervalued and be expected to pay off at par, whereas others might truly be valueless.

The house is burning; the time taken to value these securities could be lengthy, and the values may change rapidly.

2. A specific question is whether the securities would be valued as if they were parceled out in sections, let us say monthly, or whether they would all be placed on the market simultaneously.
The price can vary greatly depending on how much inventory is for sale.

3. Another specific point is that fair value is in the eye of the buyer or seller. Fair value to "sharks" such as Mr. Paulson's company may not be fair value to a financial institution that might be a buyer of the security but also holds some similar securities, and in no way wants the estimated market value of the currently-owned security marked down just so cheaper inventory can be acquired.

4. Another question is who would pay for all the administrative/valuation work. If the cost is dumped on the financial institution, then one ends up with a similar problem to the rating agencies being paid by the issuer of the security and coming up with a favorable rating.

Given the reality-based, taxpayer-friendly orientation of Mr. Ehrenberg, it would be valuable if he could flesh out his thinking regarding the implementation of his proposal. (It would also be interesting if he could comment on a somewhat different proposal, as follows.)

Econblog Review proposal:

Background: The Government is "all over" the troubled financial institutions and knows more than it can say about which are the most troubled. Treasury and the Fed currently have good knowledge of the approximate solvency of these institutions under a mark to market system.

Proposal: The Government should take into receivership or nationalize any probably insolvent institution that is too systemically important to go into an unsupervised bankruptcy. It should then expeditiously sell off the assets. The stock and bond-holders of these institutions will suffer the first losses (except for recent purchasers of Government-guaranteed securities, of course).

This proposal avoids the need for the Government to have a "bad bank" containing devalued securities come into existence. If, for example, an institution thought to be insolvent actually was shown to be solvent after sales of the Tier 3, difficult-to-value assets, great! Those that are insolvent can be shut down in an organized way and enter bankruptcy.

This proposal here is offered humbly, as the blogger is not a financial person by training. However, it perhaps is worthy of consideration. It relies on the principle that the only value for a security is an actual price when it is put up for sale, not estimates of value by possible buyers which have no money actually at risk. This plan perhaps can be implemented more-or-less immediately, perhaps by Executive/regulatory action, without waiting for a potentially lengthy valuation process that may be no better than current "estimates". Government has fiddled too long whilst Rome has been burning.

Copyright (C) Long Lake LLC 2009

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