I saw this a few days back at Clusterstock and thought the question made a bunch of sense. There are good reasons why accounting hocus pocus (ie banning mark to market accounting) is a bad idea. IMHO we are much better off taking our medicine now.
A key component of successful financial system bailouts in the past has been forced asset writedowns, in which the government makes banks reduce the carrying value of this assets to nuclear-winter levels before the government injects new equity. This move does several important things:
- It removes the fear that banks and bank investors will be hammered by future writedowns
- It turns the banks’ attention 100% to putting the new equity to work
- It attracts private capital (because investors won’t worry about getting sandbagged)
- It eliminates the death-by-a-thousand-cuts scenario that killed Japan.
To put some numbers on this: So far, US financial institutions have taken about $650 billion in asset writedowns. Nouriel Roubini and others have put the total expected writedowns at $1-$2 trillion. This suggests that banks still have $350 billion-$1.350 trillion in losses to take. Losses in this range could wipe out common shareholders, the government, and the financial institutions….unless the banks can easily raise additional equity to offset the losses.
The government may be hoping that 1) the writedowns are done, or 2) the banks can just slowly write off the rest of their crap assets against earnings over the next several years (thanks to the elimination of mark-to-market accounting). Given the magnitude of the projected losses, this seems like wishful thinking.
Alternatively, the government may plan to just keep injecting more and more capital until the writedowns are finally done. If this is the plan, however, other private-market investors are unlikely to follow suit.
So we have one remaining and important question for Messrs. Paulson and Bernanke: What about the future writedowns?
The problem with mark to market is that it brings real time supply and demand issues of pricing to an asset that may not have that much to do with its future income stream.
As an (made up) example, if Wachovia gets in trouble and dumps a bunch of GE preferred stock onto the market to raise cash for its own problems, it doesn’t mean that the expected future income stream of these bond-like products has changed that much. It just means that too many of them hit the market at one time and depressed the price for at least a little while.
But that little while, will cause a cascading sell off in other products by banks that are forced to maintain capital positions.
Nobody believes the banks mark to market numbers much in any case. So I don’t see a huge problem with not believing the accrual accounting numbers.
I think the larger problem with mark to market accounting is people forget limitations inherent in financial reporting.
A balance sheet is a snapshot at a point in time (month end, quater end, year end) where everything a business owns is valued along with everything a business owes. The trend both in the US and internationally is fair market value for both assets and liabilities.
Now it is true that over time an investment may outperform it’s current valuation just as in your example. However what something is worth on a given day is the price a willing buyer and willing seller agree to – and that is true whether the asset in question is an exotic security or your house.
In your example Wachovia’s stock dump would impact price. However, it is also true that in Wachovia’s hands such a massive amount of GE preferred is worth less in a forced liquidation. That is generally true in all forced liquidations.
The problem never was mark to market accounting, rather, in the words of a hedge fund manager whose farewell letter I’ll be featuring in another post:
You’ve seen them Russell, right along side me in the financial blogospehere – young bucks like Skiselev from Chiquita who graduate from top flight business schools thinking they can sustain 20% annual returns.
I have clients without a high school diploma who had more business sense on the day they dropped out of school that those MBA’s ever did.. And you’ll never hear a single one of those guys making excuses for crappy business decisions by blaming accounting rules.
sop