Rafi Mohammed

Want to Resuscitate the Banking System? Focus on Price…

Posted on March 16th, 2009 (0 Comments)

Last night on the CBS news show 60 Minutes, Fed Chief Ben Bernanke was clear: the banking system has to be fixed to navigate our economy out of a recession. I, along with a growing chorus of economists and business leaders, believe that rescinding or modifying mark-to-market accounting is key to revitalizing our banking system.

Mark to market accounting basically means that banks have to value their assets at current market prices. In other words, if a bank had to sell all of its assets today, how much would it be worth? The goal of this accounting rule is to create transparency – instead of basing a bank’s valuation on intricate analyses of exotic financial derivatives developed (and only fully understood) by physics Ph.D.s., the Securities and Exchange Commission is basically saying, “hey, what does the market say it’s worth?”

Sounds reasonable right? We participate in a capitalist market and favor Adam Smith’s invisible hand to drive our economy and value products. The stumbling block to this rationale is the market price of a bank security is subject to many different forces aside from its objective value. Suppose a bank has a financial note from my father, the most trusted person I know, pledging to pay $1.10 in exactly one year. Given a prevailing interest rate of 10%, the objective value of this note to an investor today is $1 ($1 today returns $1.10, 10% interest, in a year). Makes sense, right? That said, there are two other components of value that affect how much the market will pay: subjectivity and demand/supply. Suppose that financial notes from fathers suddenly go out of vogue…this subjectivity depresses the price. Additionally, suppose many institutions are trying to sell notes from fathers – it is a buyers’ market…this demand/supply condition further depresses the price. So the question becomes, if you are trying to evaluate the stability of a bank that plans on holding financial assets for the long term, which price do you use? A strictly objective or the market price?

Many bank assets (e.g., mortgage backed securities) are deeply depressed today due to subjective and demand/supply issues. Mortgage-backed securities have been deemed toxic – this spooks investors. Additionally, since banks want these assets off their books, there’s a lot of supply and not very much demand. The result: market prices that don’t reflect the objective value of securities. For example, according to Time Magazine, the highest rated sub-prime mortgages are trading at 27% of their pre-crunch prices. Do we really believe that 73% of these mortgages will become worthless? Similarly, Paul Krugman recently noted that AAA rated mortgages (the best quality) are selling for 40 cents on the dollar. The Bank of New York Mellon claims that mark to market accounting caused it to write down $1.2 billion in assets in Q4/08 when based on principal and assets, it only expects to lose $200 million.

Mark to market accounting represents the fire sale value of a bank today, not the real prices of assets that banks plan to hold onto. Warren Buffett recently analogized this accounting practice as “gasoline on the fire in terms of financial institutions.” To turn our economy around, a key step will involve setting more realistic prices of banks assets.

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