Our politicians are becoming more and more predictable. Last week I said: “My guess is the government will suspend mark to market or try something else that circumvents the real problem.” There are rumblings now that the new bank package will be released on Monday and will include a temporary suspension of mark to market. This is a horribly flawed idea. In fact, it makes the “aggregator bank” plan even worse. The whole problem with the “aggregator bank” plan is that it tries to prop up dead banks. It does not allow the system to function as it should. A capitalist system cannot function properly if you don’t let the weak die and the strong prosper.
The main argument against mark to market is that it forces banks to mark long-term investments in todays dollars. This puts pressure on bank liquidity and forces companies to take write-downs that do not properly value the bank balance sheets. That’s nonsense. An asset is only worth what someone is willing to pay for it today. Why does a bank deserve favorable mark to martket accounting when there are millions of homeowners whose mortgages force them to abide by mark to market rules? I don’t care if you own a 90 day t-bill or a 30 year t-bond. That asset is only worth what someone is willing to pay for it TODAY. Why are illiquid mortgage backed securities any different? There are millions of people out there who would love to mark their homes to 2005 prices.
Everyone seems to forget why mark to market came around. BECAUSE INVESTORS DEMANDED IT! Investors demanded more transparency into corporate balance sheets after Enron and Worldcom. Now we’ve got it and we’re making these toxic banks clean up their acts and now the public is crying out that we are too transparent. One of the biggest problems our system has right now is that our banks are black boxes. No one knows what they have on their balance sheets. No one knows if Bank of America is loaded up with toxic assets or not. And the uncertainty is sinking the market.
Managements knew what they were buying and they knew how to account for these assets. They knew they were getting involved in highly illiquid and difficult to mark assets. If you jump in the deep end of the pool and there isn’t a whole lot of water you better prepared to face the consequences. If you’re a bank and you don’t properly diversify the risks out of your portfolio you can’t come back 3 years later and ask for the rules to change. That’s not a functioning market.
This is more of the Japan syndrome. “If we can just hang on until the market turns we’ll get out of this.” I’ve said this a million times and I’ll say it again: we must assume a worst case scenario. Let’s assume we don’t pull out of this for two or three more years. If that is the case we will suffer the same consequences Japan did. The uncertainty hangs over the market and these toxic assets continue to drag down the banks. The patient has a tumor. We can either operate now (kill the bad banks) or wait and see if things get better. But if things don’t get better we will only be making them far worse with this rule change.
Mr. Roche is the Founder and Chief Investment Officer of Discipline Funds.Discipline Funds is a low fee financial advisory firm with a focus on helping people be more disciplined with their finances.
He is also the author of Pragmatic Capitalism: What Every Investor Needs to Understand About Money and Finance, Understanding the Modern Monetary System and Understanding Modern Portfolio Construction.