Mark to Market

There are plenty of charlatans who are to blame for our current financial crisis – such as Barney Frank, Franklin Raines, Chris Dodd, Jamie Gorelick, and Jim Johnson. But there is one overweening reason that, combined with the loopy notion that the U.S. taxpayer should buy everyone (of whatever means and morality) a house. This naive idea has brought this country, like Monica Lewinsky, to its knees. This reason is poorly understood by most and, thus, needs to be explained further. This precipitating event was the FASB’s (Financial Accounting Standards Board) change of accounting rules a year ago (FASB 157) that decreed that companies must daily “mark to market” any balance-sheet assets. Mark to market means that any asset, such as a mortgage must be valued at what a willing buyer and a willing seller would agree to in order to affect a transfer.

Now, when financial panics occur, such transactions become very sticky and thus marking to market becomes degenerative. For instance, if a bank’s asset’s value (such as a mortgage) sinks by $50,000, this means that required capital rations cause a bank to reduce it’s lending by $500,000. This puts the pressure on the bank to raise additional capital to justify its current lending portfolio … and, if unsuccessful, further reduces the pool of willing buyers and the mark-to-market price of its mortgages. A vicious cycle is initiated which, as we have seen, can wipe out a financial institution in a matter of days.

Secretary of the Treasury, Henry Paulson, started his testimony to the Senate on Monday with an explanation of this toxic process. He suggested that we might consider changing this rule to permit a less onerous way of valuing such assets, basically a discounted stream of future income. Thus, if a mortgage is to return so much per month for the next 25 years, one could apply a discount cash flow rate of say 5%. If such a mortgage is in default, then the discount rate would be higher, say 10% and the resultant discounted value substantially lower. But, this is a lot less punishing than what is currently required by FASB 157 … yet far better than what Japan did years ago when banks kept mortgages on their books at full value and it took over a decade for Japan’s financial stability to return.

An interesting twist to this dilemma is that Chris Cox, the head of the SEC, could, with the stroke of a pen, change this “mark to market” accounting requirement … to a discounted cash flow calculation and, thus, possibly eliminate the need for the $700 billion bailout now being debated in Congress. Perhaps, McCain’s calling for Cox’s dismissal had some legs after all.