Should 'Mark to Market' Meet Its Maker?
Featured Blog Comments
" Dear Prof Carroll: My eyes have indeed glazed over every time I saw a reference to mark-to-market, but I knew it was important to understanding whats... more "
By Eve 10-04-2008
" Hi Chris, A great post. Repealing of "mark to market" rule is exactly what happened in Japan. Well, they didn't have mark to market, but they were in... more "
By Takeo Hoshi 10-03-2008
" Chris, Fully agreed. It's been said that we are in the first of the five stages of grief. I agree that the end of the market to market will not solve... more "
By Vitoria Saddi 10-03-2008
Journalists probably have a secret rule of thumb that says you lose half your readers every time the phrase 'accounting rule' appears in an article.
For the half of you who are still with me, let me try to inoculate you against this natural human inclination by pointing out that this week may be the only time in your life that a debate about an accounting rule is a front-page issue: The revised version of the financial market revivification bill being considered in Congress instructs the Securities and Exchange Commission to think very hard about relaxing its rule requiring certain financial institutions to 'mark to market' all of the assets on their books. So, if there is any moment in your life to exercise your willpower and force glazing eyes to unglaze, this should be it.
The quarter of my initial readers who are still with me will be relieved to hear that the debate is actually more interesting than they might imagine. The question at issue, fundamentally, is whether markets can be trusted to always set a rational price for an asset.
The wise assumption of the 'mark to market' rule is that the banks themselves cannot be trusted (I use 'banks' loosely, as a substitute for 'financial institutions subject to the SEC rules discussed above'). The rule requires banks, whenever possible, to count an asset's value as being the same as the value of any similar asset that has recently been traded between two arms-length players in the market. So, if party A just paid party B $100 for a given asset, then an identical asset owned by party C must be marked as also being worth $100, even if the original sticker price was, say, $1000.
Our front-page controversy right now is about what to do when the market for an asset has largely or entirely collapsed, as has happened for the 'toxic waste' mortgage-backed securities that are now a lively part of our national discourse.
The question is undeniably complex, because there are several potential explanations for the market collapse.
One explanation is reminiscent of Groucho Marx's remark that he wouldn't want to be a member of any club that would accept him as a member. If a bank that is holding several mortgage-backed securities ('mortgage pools') knows that mortgage pool A consists of mortgages that were made to people who definitely won't pay them back, and pool B is mortgages to people who definitely will repay, then it wants to keep pool B and dump pool A. So the very fact that it is offering A for sale is ipso facto proof of A's toxicity. (Two Nobel prizes have been awarded, to George Akerlof and to Joseph Stiglitz, for figuring out how to make this point mathematically. Sadly, Marx never received the economics Nobel he deserved, which is perhaps just as well given the endless confusion this might have caused for the political left).
Another possible reason for the market to have collapsed is (slightly) more benign. Maybe the problem is simply that, to continue with the cinematic allusions, 'nobody knows anything.' In the end, each of these securities will turn out in fact to yield some stream (trickle?) of revenues, as the borrowers either make their payments, refinance, or default. But perhaps no information in anybody's hands right now can yield a believable prediction about the proportion of borrowers who will choose each strategy. 'Knightian' uncertainty (after the economist Frank Knight) was recognized as a difficult problem in economics long before Donald Rumsfeld started making oracular pronouncements about 'unknown unknowns.'
The reason the 'mark to market' rule is suddenly headline material is that the collapse of the market for asset-backed securities threatens to force banks to write down some of their assets to much lower prices than they were bought at. Since banks are required to have a certain minimum amount of capital (assets minus liabilities) before they can lend, if their assets are marked down sharply then they may be forced to stop lending.
Secretary Paulson's plan fundamentally asserts that if only we can force a large proportion of these assets to be publicly traded, they will find a price that is much higher than the low valuations at which consenting adults have exchanged them in recent weeks and months. This might turn out to be true; but it requires a considerable leap of faith.
Repealing the 'mark-to-market' rule might seem to be a much more predictable way of accomplishing the same thing; if, for example, banks were allowed to pretend that their subprime securities were still worth what they paid for them, then those nasty regulations requiring them to have 'assets' that noticeably exceed their liabilities might no longer bite.
This sounds plausible, but it is almost surely a delusion. The reason banks are increasingly unwilling to lend to each other (as indicated by the spike in the suddenly-famous LIBOR rate) is not that they are all deluded by some silly accounting rule whose implications they all perfectly understand (for each other, as well as themselves). They don't want to lend to each other because each bank thinks the other bank's subprime assets might actually, really, truly, be worthless.
In the end, the idea that suspending mark-to-market rules would solve all our problems is probably best interpreted as just part of the 'denial' stage of our grieving process for the capital market conditions of a year ago (or 10 minutes ago).
It is vital that we move beyond this denial stage as soon as possible. Our crisis is truly not very different from those experienced by many other countries (even rich countries) in recent decades (America may be exceptional in other respects, but a bank crisis is a bank crisis is a bank crisis). At the stage of a crisis that we currently inhabit, denial is always deeply appealing, especially to the bankers and their allies. But those countries who have succumbed to this siren's song have paid a very steep price. (Japan is the poster child for denial; it suffered ten years of denial and stagnation after the collapse of its asset bubble in 1990).
A powerful impulse to deny reality may be a natural human emotion in response to an unpleasant shock. But if we don't want to further impoverish ourselves, we need a rational, not an emotional, response to our financial meltdown.
