Interest Rate Roundup

Friday, March 06, 2009

The mark to market canard

I keep reading about how the problem with the banking system isn't all the crappy securities and loans it's loaded up with. It's not that they took on too much excessive risk, lending against assets whose value is plunging. It's not that they funded asinine private equity deals, stupid commercial construction deals, and dumb home purchases. It's that they have to mark their securities book to market.

If only they didn't have to mark to these "artificial" prices, everything would be fine. Eureka, the banking crisis would be solved! Even Bob McTeer, the former Dallas Fed president, is chatting about this on CNBC this morning (Of course, if I heard correctly, he also said he bought Citigroup at $15 figuring it couldn't go any lower -- a sure sign of financial savvy considering it traded below a buck yesterday). Steve Forbes is weighing in with a similar viewpoint in the Wall Street Journal today.

My take? The problem isn't that there is no market for these bad securities. The problem isn't that the prices are "artificially" low. The problem is that these institutions don't want to acknowledge that today's prices are the REAL prices. I fail to see how an accounting maneuver would magically make all the underlying markets to which these securities are tied improve.

Look, in the early days of the housing market downturn, sales volume dried up and inventories of homes for sale surged. Yet mysteriously, reported median prices didn't decline. I don't know how many people asked me: If the market is so bad, why aren't prices falling, huh? I answered that fewer and fewer buyers were paying inflated prices, holding up the median, but that the huge build up in supply and dramatic fall off in the sales pace meant that the TRUE market value of U.S. homes was declining. It just wasn't being acknowledged by most sellers yet. The image that came to mind? Those old Road Runner cartoons, where the coyote runs over the cliff but doesn't start plunging until he looks down.

I believe something similar is happening today. Volume is drying up and the inventory of securities for sale is piling up. But sellers don't want to admit reality. Neither does the government for that matter. Why do you think all these vulture funds are raising gobs of cash, but not deploying most of it? Because the sellers are hanging on to the garbage securities, hoping against hope that they won't have to sell at the true market prices, and the government is too busy trying to figure out ways to prop up the price of the garbage. I understand why this is occurring: They're afraid of mass insolvencies. So they're trying to figure out how to do something akin to the early 1980s use of Regulatory Accounting Prinicples (RAP), which papered over insolvencies in the Savings & Loan industry.

Of course, papering over the problem didn't mean it went away (The unofficial nickname for RAP used to be Creative Regulatory Accounting Principles -- and you can figure out what the acronym is there). Meanwhile, many of the S&Ls granted forbearance and permitted to try to grow their way out of insolvency increasingly gambled on new ventures, especially commercial real estate. They eventually blew up anyway -- at a much BIGGER cost to U.S. taxpayers.

Will this time be different? If M2M is suspended, allowing the industry to mark its paper at higher values based on forecasts of future cash flow, will it "work?" I have my doubts. I suspect many institutions (if allowed to suspend M2M) will keep using optimistic model forecasts, based on underestimations of the depth and breadth of the economic downturn and the slump in both residential and commercial real estate. They'll end up kicking the can down the road, and ultimately need to be resolved anyway. In other words, they'll be just like those homeowners who said three years ago: "I'm not going to GIVE this house away. I think it really IS worth a half-million bucks and that the market is wrong" -- and who are now being forced to sell for $250,000.


Post a Comment

<< Home

Site Meter