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I didn't read anything wrong with either sentence, because I took it for granted that your base of comparison was the height of children outside of Lake Wobegon and that the inhabitants of Lake Wobegon could be indebted to people outside their locality. But your point is well-taken.

Adam: I was wondering whether to make that explicit, and decided against. As long as people see them as parallel, as you did, I think I made the right decision to leave it implicit.

Nick,

Average gross debt is meaningful; average net debt isn’t; average debt is ambiguous.

JKH: yep. This is just a crude post to grab people's attention, and get them thinking. You've already read the original, to which I linked. Average gross debt means something, but we can't be sure what it means (how correlated is it with net debt across agents, and how correlated are the values of individual's debts and credits), and it doesn't mean net debt, which is what people think it means.

By the way, did you read Willem Buiter's latest post on mark-to market accounting of a bank's liabilities? He is shocked (understandably) by the same thing you taught me a few months back.

Nick,

Off-topic:

Be sure to see Buiter's latest on the fair value issue I mentioned previously!

Nick,

That's hilarious. Same thought process, simultaneously.

Sorry to veer way off-topic here, but here's something I posted on several blogs today re the marked to market issue, which is essentially the same as the fair value issue vis a vis potential measurement dysfunction:


The problem with MTM accounting is that most people view it as a necessary condition for transparency (in the usual financial sense of that word).

It isn’t. It is sufficient, but not necessary.

The necessary condition for transparency is MTM disclosure.

The necessary and sufficient condition for transparency is MTM disclosure without MTM accounting.

Disclosure is different than accounting. Accounting affects capital. Disclosure doesn’t necessarily affect capital. Disclosure without MTM allows the matching of time horizons between the life of assets and their effect on capital. And it allows shareholders to make an independent judgement on the effect of MTM disclosure on the market value of equity. In this sense, MTM accounting forces a double-up valuation of MTM in both the book value and market value of equity. This redundancy is absolutely dysfunctional.

As to exactly what the best complementary accounting to MTM disclosure might be, I don’t know precisely.

But the more critical point is to understand at the outset that MTM accounting is not necessary for transparency, and that it is accordingly suboptimal for accounting and capital measurement.

I think this logical imbroglio may be why there is such a division of opinion between two groups of thinking on the issue, both of which include reasonably intelligent and experienced people.

CHINA.

HELLO.

This bit by Delong cracked me up, "The $7.8 trillion extinguished risky debt by taking it onto the U.S. government's books--and thus improved the risky-debt-oversupply situation. The debt that was created was safe U.S. government debt--and until government debt interest rates rise above zero, it is way premature to worry about there being too much of it."

Reminds me of the people who argue against Public Private Partnership infrastructure deals because the government has a lower cost of borrowing so it 'costs more' to have the private sector finance the deals. People don't really understand risk very well. The U.S. government has no magical power to transform risky debt into safe debt. Just because you throw an object into a large bathtub doesn't mean it displaces a smaller volume of water (or no water, as Brad seems to believe). I also like his assertion that it is premature to worry until it is too late.

I find Ferguson's theory that you can reduce the amount of debt by lowering interest rates odd as well. Surely lower interest rates will encourage more debt, not less? Although I agree with him that reducing the total (gross!) debt load is the right objective.

As for your post, I'm not sure what your point is, you want people to say explicitly that they are talking about gross debt when they refer to average household debt? It doesn't really matter that much does it? The burden of interest is less with gross debt than with net debt, but not by that much.

Greg: But the people who talk about average household debt aren't talking about average (net) foreign debt.

Declan: the average burden of debt is zero. Some people pay interest; other people are paid interest. A reduction in the rate of interest does not have an (aggregate) income effect; it has a distribution effect (borrowers richer, and lenders poorer). And it has a substitution effect. I don't see why a cut in the rate of interest should directly affect the distribution of debt one way or the other. It encourages borrowing, but discourages lending. Any effect must come indirectly.

I'm interested in your arguments against Brad DeLong's statement, and PPP. Not sure you're right, but not sure you're wrong either.

The problem with MTM accounting is that most people view it as a necessary condition for transparency (in the usual financial sense of that word).

It isn’t. It is sufficient, but not necessary.

The necessary condition for transparency is MTM disclosure.

The necessary and sufficient condition for transparency is MTM disclosure without MTM accounting.

Disclosure is different than accounting. Accounting affects capital. Disclosure doesn’t necessarily affect capital. Disclosure without MTM allows the matching of time horizons between the life of assets and their effect on capital. And it allows shareholders to make an independent judgement on the effect of MTM disclosure on the market value of equity. In this sense, MTM accounting forces a double-up valuation of MTM in both the book value and market value of equity. This redundancy is absolutely dysfunctional.

As to exactly what the best complementary accounting to MTM disclosure might be, I don’t know precisely.

But the more critical point is to understand at the outset that MTM accounting is not necessary for transparency, and that it is accordingly suboptimal for accounting and capital measurement.

I think this logical imbroglio may be why there is such a division of opinion between two groups of thinking on the issue, both of which include reasonably intelligent and experienced people.

JKH: This is a very interesting point. Would you be interested in elaborating on it and having it appear as a guest post? You can answer by e-mail (from the About link at the top right-hand corner of the page) if you prefer.


There was an interesting post over at nakedcapitalism that kinda dealt with this.

Patrick: I just read the first part of that link, by Steve Keen. It just seems flat out wrong. I'm no great fan of the banking system multiplier story, but even if we believe that story, we certainly do not need to believe either of those 2 statements that he attributes to the story. I don't.

First, the step-by-step iterative story is just something we tell the undergraduates. It does not mean that all changes in the money supply happen that way, and in slow, real time. They don't.

Second, not all debt is created by the banking system. Some, for example can be sold direct by firms to households, not intermediated at all.

In short, Steve Keen seems to be attacking an orthodox straw man.

I admit I didn't read his full post.

Stephen,

Let me get back to you on your idea. I’m slightly leery of framing it further, because it’s a wretchedly difficult subject, one I’ve been around the block on a few times, and one in which I’d say 98 per cent of market participants probably strongly favour MTM accounting. I’ve no problem calling MTM into question and potentially being part of the other 2 per cent, but would like to assure myself that its worthwhile to put something together that will no doubt be slaughtered by all those who’ve made up their mind on the subject. Not that I mind the prospect of such a predictable reaction, but would just want to assure myself any investment of personal time is personally ROI effective. On the other hand, maybe there’s something worth saying here, and investing a little time in.

I’ll either email you or more likely get back to you via this comment section - probably by tomorrow.

(Alternatively, I also have no problem if you just wish to lift what I’ve written so far and use it as you wish at any point.)

Nick,

I don’t know, but Patrick may have intended a different link:

Naked Capitalism also posted on MTM:

http://www.nakedcapitalism.com/2009/02/mark-to-market-rip.html

(One of the other spots where I posted the same comment as above.)

Okay then; no rush.

Aha! Thanks JKH and Patrick.

"I don't see why a cut in the rate of interest should directly affect the distribution of debt one way or the other. It encourages borrowing, but discourages lending."

After 25 years of declining interest rates and vastly expanded lending, do you at all feel the need to reconsider your assumption that lower interest rates discourage lending?

"the average burden of debt is zero. Some people pay interest; other people are paid interest. A reduction in the rate of interest does not have an (aggregate) income effect; it has a distribution effect (borrowers richer, and lenders poorer)."

Imagine I put $100 in the bank and earn 1% interest.
You borrow my $100 from the bank and pay the bank 10% interest.

Total interest burden = $100 x 10% - $100 x 1% = $9

This may be offset by bank dividends and spending but not entirely.

Now imagine that instead of merely lending out my $100 1 time, the bank decides to lend it out 10 times. Now the total interest burden has climbed from $9 to $90 (10 x the original scenario).

As long as they can make a spread on the interest will the bank ever be discouraged from lending? No. You can't run short of money to lend because the banks can manufacture an infinite amount at zero cost. This is the reason your theory that lower interest rates would reduce lending doesn't hold up). Only 2 things constrain the amount of lending - the supply of willing and able borrowers and the bank's capital requirements.

Capital requirements have been largely evaded through government guaranteed lending (which doesn't require capital), through securitization (again, very little capital required), through other off balance sheet transactions and through lending by unregulated institutions that don't need to keep capital at all.

The capacity of people to borrow has been fully exploited through a culture of debt whereby people took on as much debt as they could possibly handle. It was furthered by lower interest rates which increase the debt load people can service. It was further increased by rising asset prices (bubbles) which collateralized greater lending and disguised losses until the collateral markets turned. There is also an element of a bubble in the money supply as well, as the continued creation of money through more lending provided the money to make the interest payments on the debt created so far.

This combination of factors led to a pretty much unrestrained creation of debt throughout society until it finally hit a wall with no more credit worthy borrowers left to lend to and no way to sustain the elevated asset prices. Now asset prices begin to fall, and even though people try to stop borrowing and repay their debt, they become even harder to lend to as the economy deteriorates and the credit/debt money disappears and their collateral is wiped out. Leveraged financial institutions quickly see their capital wiped out further impairing their ability to lend.

The one easy way out of this scenario was applied in 2001, when interest rates were massively reduced. Lower interest rates makes people credit worthy again by reducing their debt service, and supports asset prices by allowing people to borrow to purchase them. Of course this only postpones and enlarges the problem rather than solving it, but if your perspective is short term enough, it is a solution. Sadly, when interest rates hit 0, as they have in the U.S., there is nothing left to do but either print money or let the whole debt bubble collapse.

So interest rates do have an aggregate effect, with lower rates benefitting borrower and lender alike (because they make people able to borrow more) and higher rates hurting borrowers and lenders by making it harder for people to borrow. Why do think interest rate increases trigger recessions and interest rate reductions lead to recoveries?

Finally, the average net burden of debt is not 0, the more debt, the more of society's wealth is pulled into financial institutions. Having society's wealth sucked up by financial intermediaries is indeed a burden, a large one.

See here for a chart showing that in the U.S. the percentage of the economy made up by the financial industry peaked before the great depression and peaked again prior to our current recession/depression.

You can abstract away the role played by the financial industry and make statements about a world where this industry doesn't exist, but I just don't see the relevance, especially under the current circumstances.

Declan: I don't think financial intermediaries affect the argument. Take the simplest example, of a pure FI with no capital of its own. I lend $100 to the FI, and the FI lends $100 to Harry. The FI has both a credit and a debt of $100. So it still all cancels.

If interest rates rise 1%, and the FI spread stays the same, then I am $1 per year richer, and Harry is $1 poorer, and the FI is unaffected. If, instead, the spread rises by 1%, then (assuming my interest rate stays the same), then Harry is $1 poorer, and the owner of the FI is $1 richer. Again, no aggregate income effect, either way.


I think gross debt does matter, even if net debt is zero.

The bigger the gross debt, the greater the risks and potential harm should a vicious circle of de-leveraging taking hold. When/if such a vicious circle does take hold, if the gross debts are very large and the offsetting assets sufficiently impaired then the only choice is to liquefy large amounts of bought and paid for capital to make-up the difference. This destroys productive capacity, creates unemployment, etc ... I've see this in action; it's the dynamic that wiped out the investment supporting the company I worked for.

On the other hand, if gross debt is limited so that it poses relatively little threat should a rush to extinguish it occur, then we limit the risks that productive capital will be obliterated in vicious cycle of de-leveraging.


Patrick: I sort of agree. But I think that gross debt is probably a poor proxy for the underlying things that matter.

I think we should start from the ground up. First decide what it is about the whole distribution of net and gross debts that matters (creates problems), then see if we can capture that in some single aggregate number (if it's possible). Maybe the variance of net debt would be a better proxy? Maybe the lack of correlation between asset and liability values is what matters? What I mean is that if every individual's assets and liabilities were perfectly correlated, so if your assets fall in value so do your liabilities, you won't go bust.

I see your point, I think. The dangers seems to be when there is a large fraction of immediately callable gross debt offset by illiquid assets whose value can fall in a fire sale scenario. If the debts are offset by cash and cash like instruments, all is well. If the debts are offset by MBS of dubious value ... well, we know where that leads.

Not all debt is equal. Debts that have to be re-paid on demand or which can increase while asset prices are falling are much more 'dangerous' - like margin calls, for example. By contrast a typical bond is pretty innocuous. The bondholder can't panic and demand the principle be repaid immediately.

Stephen,

Re MTM post:

I’ll aim to come up with something by Sunday evening, and leave it here – i.e. as a comment under “Lake Wobegon”. You can decide then whether it suits as a guest post, and let me know. I’m OK either way.

JKH

That would be great; looking forward to it.

Patrick: Yes! And I had forgotten the whole liquidity dimension.

" I don't think financial intermediaries affect the argument. Take the simplest example, of a pure FI with no capital of its own. I lend $100 to the FI, and the FI lends $100 to Harry. The FI has both a credit and a debt of $100. So it still all cancels."

OK, let me try to make it clearer:

Start: I have $100, FI has 0, Harry has 0.
1) I deposit $100 in the FI. I have $100, the FI has 0, Harry has 0.
2) The Fi creates a new $100 and lends it to Harry. Now I have $100, the FI has 0, and Harry has $100 (and owes the bank $100).
3) A year passes. FI pays me $1 in interest, Harry pays FI $10 in interest. I have $101, FI has $8, Harry has $92 (paid interest of $10, received interest of $1)
4) FI likes this game, creates a new $2000 and lends $100 each to 20 of Harry's friends.
5) A year passes. I have $102, Harry has $83, Harry's 20 friends have $92 each, and the FI has $175.

Of course, if you mandate that every entry has a debit side and a credit side then it all balances out, but this doesn't signify anything, it is the flows of money that matter. As the pattern I describe above repeats the level of debt expands, the FI's grow ever wealthier until the whole thing collapses on itself someday.


"If interest rates rise 1%, and the FI spread stays the same, then I am $1 per year richer, and Harry is $1 poorer, and the FI is unaffected. If, instead, the spread rises by 1%, then (assuming my interest rate stays the same), then Harry is $1 poorer, and the owner of the FI is $1 richer. Again, no aggregate income effect, either way."

If interest rates rise 1%, more people default and the FI loses money. The contracting money supply causes the economy to shrink. If interest rates drop 1%, people can take on more debt so the bank creates more money (by lending to them) and makes more money by making the same spread on a greater supply of debt. Are you really arguing that interest rates don't affect the economy?

Sorry, Harry should have $91 in step 3) above, not $92 and the same for his friends in step 5). Doesn't really matter though, the point is the same.

I saw Niall Ferguson's article too and had almost exactly the same thoughts a few days ago:

http://www.knowingandmaking.com/2009/02/how-much-debt-is-too-much.html

It sounds attractive that there would be some meaningful measure that at least partly captures the way in which debt influences the economy. We could certainly build models where a large amount of gross debt has almost no effect at all (e.g. A owes B, B owes C and C owes A an identical fixed amount with identical fixed repayments, and each debt secured on the next), so it can't simply be the quantity of gross debt.

To adjust Declan's example, the 10% interest rate should be there to compensate for the fact that one or two of Harry's friends will default on their loan; this reduces the accumulation of money in FI. But without quibbling on the details, there is definitely less "stability" in that system than in one with no debt at all.

Patrick pointed out the issue of liquidity, or more generally the length of maturity of debt; although by the same logic as the original argument, the net amount of debt at any given maturity is also zero.

One could generate a measure reflecting the amount of short-term liabilities held by entities who have lent long. This would be appropriately asymmetrical, because we don't care about those who have borrowed long and lent short (except that their short borrowers may be unable to repay! but that is captured in the original measure anyway).

More precisely, we could draw a maturity graph for each entity, showing the debt they are due to repay in each period net of the assets they are due to collect (including their money holdings). This illiquidity measure (IM) at any given time t would be the integral of that curve between 0 and t.

The appropriate aggregate measure would be the sum of all positive IMs, ignoring negative ones, for a given period. So you could generate an one-year IM for the whole economy, or a one-month IM or a ten-year IM.

What does this tell us? I don't know exactly, but a lot more than "average debt". I imagine it could offer guidance for the appropriate size of central bank liquidity measures such as the Bank of England's SLS and the Fed's money market purchases.

Stephen,

Re suggested MTM post:

Here it is.

You may judge it too long or otherwise for a post. That’s OK. It can remain here in that case.

I’ll check in every so often to see if you have any questions, comments or whatever.

Otherwise, please feel free to use it as a post, in whole, in part, or not at all.

JKH

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MARK TO MARKET

Lurking in the background to the credit crisis and the unfolding policy responses to it has been the issue of mark to market accounting.

Bankers distinguish between two types of accounting, known as accrual (ACC) and mark to market (MTM). Simplified, accrual accounting includes only ongoing interest or yield income in reported earnings. MTM accounting includes the same accrual plus an adjustment for changes in the value of the asset over the period. For example, annual ACC earnings on a 5 year bond would include interest plus any amortization of premium or accretion of discount, based on the original book price. Annual MTM earnings on the same bond would include the same accrual earnings, plus the change in the market value of the bond over the reporting period. Thus, accrual accounting, in addition to being a standalone method, is also a sub-component of MTM accounting. But when people talk about the issue of MTM, they generally refer to the accounting component that differentiates it from accrual accounting; i.e. the adjustment for changes in asset values. Finally, fair value (FV) accounting refers to the formal application of mark to market accounting under specified accounting rules, including the treatment of various types of assets according to their inherent liquidity and marketability characteristics. FV accounting rules are complex, and we won’t explore them in detail here.

Commercial banks use accrual accounting in accordance with the intended hold to maturity nature of their loan books. Broker dealers use MTM accounting due to the liquid nature of their securities sales and trading businesses. So called “universal banks” combine both types of banking and both types of accounting under one roof. Commercial bank deposit taking and lending is captured in the accrual book; broker dealer securities activity in the MTM book. The two segments are also known the “banking book” and the “trading book”, and the resulting accounting combination as the “mixed model”. Citigroup, JP Morgan, and Bank of America are universal banks. Goldman Sachs and Morgan Stanley are broker dealers (although they’ve recently obtained commercial banking licences). All five major Canadian banks are universal banks. (This overall description is generic and simplified.)

Regulators of universal banks have steadily expanded the scope of FV accounting over the past two decades. The motivation has been to increase the “transparency” of financial statements, so that changes in underlying asset values are open to investor scrutiny and evaluation. The result has been an incursion of MTM measures into what were previously accrual banking books, and an FV accounting regime of increasingly wide and complex scope within universal banks.

The issue of MTM accounting as it pertains to the credit crisis has much to do with the resulting ambiguous border-line between the two types of accounting within universal banks. When questioned at last week’s Congressional hearing, Goldman Sachs’ CEO suggested that the MTM problem lay primarily in the reluctance of universal banks to mark down assets properly to market (Goldman is not a universal bank). Citigroup’s CEO on the other hand claimed that assets already marked down to distressed levels on an MTM basis did not reflect true value, and therefore the bank was reluctant to sell them. (Citigroup is the prototype example of a universal bank.) These are different interpretations of the MTM issue. Such different viewpoints are widespread and contribute to the debate on how to solve the credit crisis.

The wisdom of MTM accounting has been debated before and since its original implementation. On the one hand, it “shines a light” on developing asset value problems. On the other, it has the potential to exaggerate volatility in reported earnings, in some cases unnecessarily. As a simple example, a 5 year fixed rate loan or bond that matures in tact may exhibit substantial MTM volatility throughout its lifetime. But such volatility accumulates to zero net effect by the time the bond matures. To the degree that MTM based risk measures such as “value at risk” (Var) and capital measures such as “risk adjusted return on capital” (Raroc) pay attention to this volatility, measured risk and attributed capital are higher than is the case where the bond is assumed to be held to maturity. This capital effect in terms of both risk measures and unrealized losses has been critical to the dynamics of the credit crisis. Unrealized MTM losses create capital shortages, motivating liquidations, creating realized losses, pushing prices lower, feeding back to further unrealized losses. Potential distortions spread from such plain vanilla examples to the wider scope of various credit risk instruments. Much of the credit crisis problem as it pertains to banking revolves around the pricing of so called “toxic” or “troubled” assets, and other assets that are at least guilty by association. The fact that both composition transparency and market liquidity are lacking means that the appropriate MTM treatment for these assets is problematic. Various credit crisis solutions have been proposed, such as MLEC, TARP I, bad bank, good bank, TARP II, and full nationalization. All of these depend on the problem of asset valuation and pricing and MTM, one way or another. Nevertheless, the wisdom of such aggressive MTM application is a question that lingers.

Willem Buiter (see below) has commented recently on one aspect of FV accounting, that being consistent treatment of assets and liabilities. E.g. an increase in market interest rates reduces the value of a fixed rate asset, which reduces FV earnings. The same effect on a similar fixed rate liability reduces its value, which increases FV earnings. The pathological case is that of deterioration in a bank’s credit quality, with a widening of credit spreads that reduces the value of its liabilities and increases its FV earnings. Buiter has noticed what bankers themselves complained about almost 20 years ago when FV accounting was first proposed. Given the broad transparency objective of FV accounting, there is no rationale for applying it to assets alone. This apparent “foolish consistency” is symptomatic of unintended consequences.

Events are rapidly unfolding in the global credit crisis. There is increasing momentum toward the view that governments should urgently nationalize banking systems on a broad scale. The tendency in that context is to assume the MTM issue is increasingly irrelevant. Before allowing this, we should highlight several fallacies about MTM, which are at the conceptual origin of the issue.

The first fallacy is that MTM accounting is necessary in order to produce balance sheet transparency. This is not the case. Given the nature of the information it conveys, we can say more accurately that MTM accounting is a sufficient, but not a necessary condition for transparency. Insofar as asset values are concerned, the necessary condition is MTM disclosure, not MTM accounting. Exactly the same information can be made public through disclosure, without necessarily affecting reported earnings and capital positions. This would still allow the market to incorporate internal MTM information in the stock price. Shareholders could evaluate the impact of illiquid asset markets, uncertain pricing, and the longer term relevance of immediate MTM asset values, and impound all of this in the current stock value. This avoids a compound and to some degree duplicative and arguably inefficient pricing process in which internal assets and external stock value are both subject to an MTM valuation process.

The second fallacy is the contention that choice of accounting has no bearing on the economics of value. This would be conventionally correct if accounting had no bearing on the actual requirement for bank capital. But it is wrong for precisely this reason. And this is of particular importance to the credit crisis.

A relevant and connected analogy exists in the household sector. The housing boom was based on easy credit and an implied belief in MTM accounting for houses, otherwise known as the ATM effect. Current house prices, however inflated, were the basis for many hundreds of billions of dollars of mortgage equity withdrawals (MEW). Those who bet on housing MTM as an indicator of sustainable price appreciation behaved accordingly. So did mortgage lenders. Those who restrained from using MTM as a mental accounting of a sustained trajectory of personal wealth, and who considered such MTM information with more restraint, probably checked their behaviour more wisely in terms of allowing for risk. In order words, behaviour was a function of how households viewed the effect of housing MTM on their personal balance sheets and longer term capital positions. Those who resisted incorporating full MTM into their own capital evaluations were probably more restrained in MEW transactions and related spending. Those who acted aggressively on their housing MTM profile overextended their balance sheets and spent the money from their MEW proceeds. The economist Steven Roach referred to the corresponding macroeconomic effect in terms of the “asset economy”. The trajectory of this economy is tracked in the Federal Reserve’s quarterly computation of US household wealth. Trillions of dollars of wealth have now been eroded from household balance sheets since the credit crisis began.

A number of reputable economists and analysts have judged the US banking system to be insolvent. They conclude this in part by comparing the probable value of bank assets and liabilities with system capital. Forecast loan losses apart from MTM losses are also an important factor. These forecasters may be right. Who would bet strongly against Nouriel Roubini at this stage? President Obama has invoked “catastrophe” as the worst case scenario for the US economy, and positioned the importance of fiscal action accordingly. One could describe the banking problem similarly, and the importance of policy action there. Prescriptions for resolving the banking crisis include permutations and combinations of government intervention and asset reconfigurations such as “bad bank” (MLEC, TARP I, TARP II), “good bank”, and full nationalization. More commentators are pronouncing both US and European banking systems as insolvent, and urging quick nationalization, in order to avoid a Japan style protracted bank balance sheet deflation. Martin Wolf (see below) alleges the new US administration has already failed to recognize that the US banking system is insolvent. In his view the current policy response has already failed; nationalization is required. He makes the point that aggressive action is required to prevent a calamitous consequence that is asymmetric in its severity. All of this may be right. The MTM issue has been overtaken by this momentum. So where does it fit now?

The government assumes asset risk in any of these bail-out mechanisms. But unlike private sector banks, it incurs no additional capital requirements due to unrealized MTM losses on assets that it purchases (not that it guarantees). Neither the Treasury nor the Fed requires more capital funding because of MTM changes in the prices of assets that they hold. (The issue of Fed capital adequacy is really part of the same question for the government as a whole.) In other words, Treasury and the Fed can hold assets to maturity, but the private sector may be inhibited from doing so, given its required response to MTM unrealized losses and capital constraints.

The Treasury and Fed balance sheets offer considerable potential leverage to a financial system that is undergoing massive deleveraging. This is the essence of the requirement for their balance sheet intervention. But they also offer MTM immunization by virtue of their own balance sheet process. Therefore, why not provide MTM immunization (i.e. “relief”) directly to the banks, as part of a broader package of intervention? Indeed, this is what a number of commentators have urged for some time. Among them are Paul Volcker (former Fed chairman), Bill Isaac (former FDIC chairman), and Bob McTeer (former Fed governor; see below). Opposing this general proposition is the purist MTM view, which happens to note correctly that Japan’s banking system failed to recover due to half-way measures. But this doesn’t deny the potential dysfunctional effect of MTM on bank capital requirements in any environment.

TARP II as outlined by US Treasury secretary Geithner envisages a public-private partnership for the purchase of bank assets. The idea is that government will provide the leverage necessary to make these assets attractive to private equity capital. This would presumably also lift current MTM pricing, simply due to financial engineering. The irony is that private capital because of this financing may discover assets worth holding on the basis of underlying cash flow, i.e. on an accrual basis. Thus, the government may move assets out of the banking system that are disabled on an MTM basis to an investment platform where they make sense on an accrual basis. This would include the decomposition of complex assets such as CDOs in order to identity cash flow arising from the underlying assets. So long as these individual assets generate cash flow, they are “worth” something rather than nothing.

In summary, the banking crisis reflects the problem of dealing with so-called “toxic assets” and associated write-downs forced by MTM and FV accounting. Various solutions have been proposed involving different ways of severing toxic and non-toxic portions of a bank balance sheet, including full nationalization. These mechanisms will depend on the price at which these assets can be sold or transferred away, and how MTM accounting will factor into the arrangement. There may also be some scope for meaningful relief on MTM accounting in universal banks. The credit crisis itself reflected an asset bubble that in good times was enabled by aggressive MTM accounting, explicit or implicit, across all sectors of the economy, including banks and households. Universal banks combined and integrated MTM oriented investment bank operations with more staid, accrual accounted commercial operations. Perhaps the financial architecture of the future will feature a return to commercial banks that resemble deposit taking and lending utility functions, with minimal exposure to MTM businesses, and investment banks that are still MTM driven but small enough to fail.


Various opinions on mark to market:

http://www.bob-mcteer-blog.com/mark-to-market-in-the-american-spectator/ (Bob McTeer)
http://www.bob-mcteer-blog.com/volcker-and-greenspan-mark-to-market/ (Bob McTeer)
http://blogs.ft.com/maverecon/2009/02/accounting-according-to-barclays-declining-creditworthiness-as-a-source-of-profits/ (Willem Buiter)
http://www.nakedcapitalism.com/2009/02/mark-to-market-rip.html (Yves Smith)
http://us1.institutionalriskanalytics.com/pub/IRAstory.asp?tag=336 (Chris Whalen)
http://www.ft.com/cms/s/0/9ebea1b8-f794-11dd-81f7-000077b07658.html?nclick_check=1 (Martin Wolf)
http://mises.org/story/3301 (Jesus Huerta de Soto)

Stephen,

I posted this more than an hour ago and it didn't show up. So I'll try again.

Re suggested MTM post:

Here it is.

You may judge it too long or otherwise for a post. That’s OK. It can remain here in that case.

I’ll check in every so often to see if you have any questions, comments or whatever.

Otherwise, please feel free to use it as a post, in whole, in part, or not at all.

JKH

-----------------------------------------------------------------------------------------------------

MARK TO MARKET

Lurking in the background to the credit crisis and the unfolding policy responses to it has been the issue of mark to market accounting.

Bankers distinguish between two types of accounting, known as accrual (ACC) and mark to market (MTM). Simplified, accrual accounting includes only ongoing interest or yield income in reported earnings. MTM accounting includes the same accrual plus an adjustment for changes in the value of the asset over the period. For example, annual ACC earnings on a 5 year bond would include interest plus any amortization of premium or accretion of discount, based on the original book price. Annual MTM earnings on the same bond would include the same accrual earnings, plus the change in the market value of the bond over the reporting period. Thus, accrual accounting, in addition to being a standalone method, is also a sub-component of MTM accounting. But when people talk about the issue of MTM, they generally refer to the accounting component that differentiates it from accrual accounting; i.e. the adjustment for changes in asset values. Finally, fair value (FV) accounting refers to the formal application of mark to market accounting under specified accounting rules, including the treatment of various types of assets according to their inherent liquidity and marketability characteristics. FV accounting rules are complex, and we won’t explore them in detail here.

Commercial banks use accrual accounting in accordance with the intended hold to maturity nature of their loan books. Broker dealers use MTM accounting due to the liquid nature of their securities sales and trading businesses. So called “universal banks” combine both types of banking and both types of accounting under one roof. Commercial bank deposit taking and lending is captured in the accrual book; broker dealer securities activity in the MTM book. The two segments are also known the “banking book” and the “trading book”, and the resulting accounting combination as the “mixed model”. Citigroup, JP Morgan, and Bank of America are universal banks. Goldman Sachs and Morgan Stanley are broker dealers (although they’ve recently obtained commercial banking licences). All five major Canadian banks are universal banks. (This overall description is generic and simplified.)

Regulators of universal banks have steadily expanded the scope of FV accounting over the past two decades. The motivation has been to increase the “transparency” of financial statements, so that changes in underlying asset values are open to investor scrutiny and evaluation. The result has been an incursion of MTM measures into what were previously accrual banking books, and an FV accounting regime of increasingly wide and complex scope within universal banks.

The issue of MTM accounting as it pertains to the credit crisis has much to do with the resulting ambiguous border-line between the two types of accounting within universal banks. When questioned at last week’s Congressional hearing, Goldman Sachs’ CEO suggested that the MTM problem lay primarily in the reluctance of universal banks to mark down assets properly to market (Goldman is not a universal bank). Citigroup’s CEO on the other hand claimed that assets already marked down to distressed levels on an MTM basis did not reflect true value, and therefore the bank was reluctant to sell them. (Citigroup is the prototype example of a universal bank.) These are different interpretations of the MTM issue. Such different viewpoints are widespread and contribute to the debate on how to solve the credit crisis.

The wisdom of MTM accounting has been debated before and since its original implementation. On the one hand, it “shines a light” on developing asset value problems. On the other, it has the potential to exaggerate volatility in reported earnings, in some cases unnecessarily. As a simple example, a 5 year fixed rate loan or bond that matures in tact may exhibit substantial MTM volatility throughout its lifetime. But such volatility accumulates to zero net effect by the time the bond matures. To the degree that MTM based risk measures such as “value at risk” (Var) and capital measures such as “risk adjusted return on capital” (Raroc) pay attention to this volatility, measured risk and attributed capital are higher than is the case where the bond is assumed to be held to maturity. This capital effect in terms of both risk measures and unrealized losses has been critical to the dynamics of the credit crisis. Unrealized MTM losses create capital shortages, motivating liquidations, creating realized losses, pushing prices lower, feeding back to further unrealized losses. Potential distortions spread from such plain vanilla examples to the wider scope of various credit risk instruments. Much of the credit crisis problem as it pertains to banking revolves around the pricing of so called “toxic” or “troubled” assets, and other assets that are at least guilty by association. The fact that both composition transparency and market liquidity are lacking means that the appropriate MTM treatment for these assets is problematic. Various credit crisis solutions have been proposed, such as MLEC, TARP I, bad bank, good bank, TARP II, and full nationalization. All of these depend on the problem of asset valuation and pricing and MTM, one way or another. Nevertheless, the wisdom of such aggressive MTM application is a question that lingers.

Willem Buiter (see below) has commented recently on one aspect of FV accounting, that being consistent treatment of assets and liabilities. E.g. an increase in market interest rates reduces the value of a fixed rate asset, which reduces FV earnings. The same effect on a similar fixed rate liability reduces its value, which increases FV earnings. The pathological case is that of deterioration in a bank’s credit quality, with a widening of credit spreads that reduces the value of its liabilities and increases its FV earnings. Buiter has noticed what bankers themselves complained about almost 20 years ago when FV accounting was first proposed. Given the broad transparency objective of FV accounting, there is no rationale for applying it to assets alone. This apparent “foolish consistency” is symptomatic of unintended consequences.

Events are rapidly unfolding in the global credit crisis. There is increasing momentum toward the view that governments should urgently nationalize banking systems on a broad scale. The tendency in that context is to assume the MTM issue is increasingly irrelevant. Before allowing this, we should highlight several fallacies about MTM, which are at the conceptual origin of the issue.

The first fallacy is that MTM accounting is necessary in order to produce balance sheet transparency. This is not the case. Given the nature of the information it conveys, we can say more accurately that MTM accounting is a sufficient, but not a necessary condition for transparency. Insofar as asset values are concerned, the necessary condition is MTM disclosure, not MTM accounting. Exactly the same information can be made public through disclosure, without necessarily affecting reported earnings and capital positions. This would still allow the market to incorporate internal MTM information in the stock price. Shareholders could evaluate the impact of illiquid asset markets, uncertain pricing, and the longer term relevance of immediate MTM asset values, and impound all of this in the current stock value. This avoids a compound and to some degree duplicative and arguably inefficient pricing process in which internal assets and external stock value are both subject to an MTM valuation process.

The second fallacy is the contention that choice of accounting has no bearing on the economics of value. This would be conventionally correct if accounting had no bearing on the actual requirement for bank capital. But it is wrong for precisely this reason. And this is of particular importance to the credit crisis.

A relevant and connected analogy exists in the household sector. The housing boom was based on easy credit and an implied belief in MTM accounting for houses, otherwise known as the ATM effect. Current house prices, however inflated, were the basis for many hundreds of billions of dollars of mortgage equity withdrawals (MEW). Those who bet on housing MTM as an indicator of sustainable price appreciation behaved accordingly. So did mortgage lenders. Those who restrained from using MTM as a mental accounting of a sustained trajectory of personal wealth, and who considered such MTM information with more restraint, probably checked their behaviour more wisely in terms of allowing for risk. In order words, behaviour was a function of how households viewed the effect of housing MTM on their personal balance sheets and longer term capital positions. Those who resisted incorporating full MTM into their own capital evaluations were probably more restrained in MEW transactions and related spending. Those who acted aggressively on their housing MTM profile overextended their balance sheets and spent the money from their MEW proceeds. The economist Steven Roach referred to the corresponding macroeconomic effect in terms of the “asset economy”. The trajectory of this economy is tracked in the Federal Reserve’s quarterly computation of US household wealth. Trillions of dollars of wealth have now been eroded from household balance sheets since the credit crisis began.

A number of reputable economists and analysts have judged the US banking system to be insolvent. They conclude this in part by comparing the probable value of bank assets and liabilities with system capital. Forecast loan losses apart from MTM losses are also an important factor. These forecasters may be right. Who would bet strongly against Nouriel Roubini at this stage? President Obama has invoked “catastrophe” as the worst case scenario for the US economy, and positioned the importance of fiscal action accordingly. One could describe the banking problem similarly, and the importance of policy action there. Prescriptions for resolving the banking crisis include permutations and combinations of government intervention and asset reconfigurations such as “bad bank” (MLEC, TARP I, TARP II), “good bank”, and full nationalization. More commentators are pronouncing both US and European banking systems as insolvent, and urging quick nationalization, in order to avoid a Japan style protracted bank balance sheet deflation. Martin Wolf (see below) alleges the new US administration has already failed to recognize that the US banking system is insolvent. In his view the current policy response has already failed; nationalization is required. He makes the point that aggressive action is required to prevent a calamitous consequence that is asymmetric in its severity. All of this may be right. The MTM issue has been overtaken by this momentum. So where does it fit now?

The government assumes asset risk in any of these bail-out mechanisms. But unlike private sector banks, it incurs no additional capital requirements due to unrealized MTM losses on assets that it purchases (not that it guarantees). Neither the Treasury nor the Fed requires more capital funding because of MTM changes in the prices of assets that they hold. (The issue of Fed capital adequacy is really part of the same question for the government as a whole.) In other words, Treasury and the Fed can hold assets to maturity, but the private sector may be inhibited from doing so, given its required response to MTM unrealized losses and capital constraints.

The Treasury and Fed balance sheets offer considerable potential leverage to a financial system that is undergoing massive deleveraging. This is the essence of the requirement for their balance sheet intervention. But they also offer MTM immunization by virtue of their own balance sheet process. Therefore, why not provide MTM immunization (i.e. “relief”) directly to the banks, as part of a broader package of intervention? Indeed, this is what a number of commentators have urged for some time. Among them are Paul Volcker (former Fed chairman), Bill Isaac (former FDIC chairman), and Bob McTeer (former Fed governor; see below). Opposing this general proposition is the purist MTM view, which happens to note correctly that Japan’s banking system failed to recover due to half-way measures. But this doesn’t deny the potential dysfunctional effect of MTM on bank capital requirements in any environment.

TARP II as outlined by US Treasury secretary Geithner envisages a public-private partnership for the purchase of bank assets. The idea is that government will provide the leverage necessary to make these assets attractive to private equity capital. This would presumably also lift current MTM pricing, simply due to financial engineering. The irony is that private capital because of this financing may discover assets worth holding on the basis of underlying cash flow, i.e. on an accrual basis. Thus, the government may move assets out of the banking system that are disabled on an MTM basis to an investment platform where they make sense on an accrual basis. This would include the decomposition of complex assets such as CDOs in order to identity cash flow arising from the underlying assets. So long as these individual assets generate cash flow, they are “worth” something rather than nothing.

In summary, the banking crisis reflects the problem of dealing with so-called “toxic assets” and associated write-downs forced by MTM and FV accounting. Various solutions have been proposed involving different ways of severing toxic and non-toxic portions of a bank balance sheet, including full nationalization. These mechanisms will depend on the price at which these assets can be sold or transferred away, and how MTM accounting will factor into the arrangement. There may also be some scope for meaningful relief on MTM accounting in universal banks. The credit crisis itself reflected an asset bubble that in good times was enabled by aggressive MTM accounting, explicit or implicit, across all sectors of the economy, including banks and households. Universal banks combined and integrated MTM oriented investment bank operations with more staid, accrual accounted commercial operations. Perhaps the financial architecture of the future will feature a return to commercial banks that resemble deposit taking and lending utility functions, with minimal exposure to MTM businesses, and investment banks that are still MTM driven but small enough to fail.


Various opinions on mark to market:

http://www.bob-mcteer-blog.com/mark-to-market-in-the-american-spectator/ (Bob McTeer)
http://www.bob-mcteer-blog.com/volcker-and-greenspan-mark-to-market/ (Bob McTeer)
http://blogs.ft.com/maverecon/2009/02/accounting-according-to-barclays-declining-creditworthiness-as-a-source-of-profits/ (Willem Buiter)
http://www.nakedcapitalism.com/2009/02/mark-to-market-rip.html (Yves Smith)
http://us1.institutionalriskanalytics.com/pub/IRAstory.asp?tag=336 (Chris Whalen)
http://www.ft.com/cms/s/0/9ebea1b8-f794-11dd-81f7-000077b07658.html?nclick_check=1 (Martin Wolf)
http://mises.org/story/3301 (Jesus Huerta de Soto)

Stephen,

Re: suggested MTM post.

As promised, I did enter this here on Sunday evening, twice, but it didn’t show up on the blog.

It may be a bit long. Please feel free to use as a post, in whole, in part, or not at all.

I'll check back here if you have any comments.

JKH

-----------------------------------------------------------------------------------------------------

MARK TO MARKET

Lurking in the background to the credit crisis and the unfolding policy responses to it has been the issue of mark to market accounting.

Bankers distinguish between two types of accounting, known as accrual (ACC) and mark to market (MTM). Simplified, accrual accounting includes only ongoing interest or yield income in reported earnings. MTM accounting includes the same accrual plus an adjustment for changes in the value of the asset over the period. For example, annual ACC earnings on a 5 year bond would include interest plus any amortization of premium or accretion of discount, based on the original book price. Annual MTM earnings on the same bond would include the same accrual earnings, plus the change in the market value of the bond over the reporting period. Thus, accrual accounting, in addition to being a standalone method, is also a sub-component of MTM accounting. But when people talk about the issue of MTM, they generally refer to the accounting component that differentiates it from accrual accounting; i.e. the adjustment for changes in asset values. Finally, fair value (FV) accounting refers to the formal application of mark to market accounting under specified accounting rules, including the treatment of various types of assets according to their inherent liquidity and marketability characteristics. FV accounting rules are complex, and we won’t explore them in detail here.

Commercial banks use accrual accounting in accordance with the intended hold to maturity nature of their loan books. Broker dealers use MTM accounting due to the liquid nature of their securities sales and trading businesses. So called “universal banks” combine both types of banking and both types of accounting under one roof. Commercial bank deposit taking and lending is captured in the accrual book; broker dealer securities activity in the MTM book. The two segments are also known the “banking book” and the “trading book”, and the resulting accounting combination as the “mixed model”. Citigroup, JP Morgan, and Bank of America are universal banks. Goldman Sachs and Morgan Stanley are broker dealers (although they’ve recently obtained commercial banking licences). All five major Canadian banks are universal banks. (This overall description is generic and simplified.)

Regulators of universal banks have steadily expanded the scope of FV accounting over the past two decades. The motivation has been to increase the “transparency” of financial statements, so that changes in underlying asset values are open to investor scrutiny and evaluation. The result has been an incursion of MTM measures into what were previously accrual banking books, and an FV accounting regime of increasingly wide and complex scope within universal banks.

The issue of MTM accounting as it pertains to the credit crisis has much to do with the resulting ambiguous border-line between the two types of accounting within universal banks. When questioned at last week’s Congressional hearing, Goldman Sachs’ CEO suggested that the MTM problem lay primarily in the reluctance of universal banks to mark down assets properly to market (Goldman is not a universal bank). Citigroup’s CEO on the other hand claimed that assets already marked down to distressed levels on an MTM basis did not reflect true value, and therefore the bank was reluctant to sell them. (Citigroup is the prototype example of a universal bank.) These are different interpretations of the MTM issue. Such different viewpoints are widespread and contribute to the debate on how to solve the credit crisis.

The wisdom of MTM accounting has been debated before and since its original implementation. On the one hand, it “shines a light” on developing asset value problems. On the other, it has the potential to exaggerate volatility in reported earnings, in some cases unnecessarily. As a simple example, a 5 year fixed rate loan or bond that matures in tact may exhibit substantial MTM volatility throughout its lifetime. But such volatility accumulates to zero net effect by the time the bond matures. To the degree that MTM based risk measures such as “value at risk” (Var) and capital measures such as “risk adjusted return on capital” (Raroc) pay attention to this volatility, measured risk and attributed capital are higher than is the case where the bond is assumed to be held to maturity. This capital effect in terms of both risk measures and unrealized losses has been critical to the dynamics of the credit crisis. Unrealized MTM losses create capital shortages, motivating liquidations, creating realized losses, pushing prices lower, feeding back to further unrealized losses. Potential distortions spread from such plain vanilla examples to the wider scope of various credit risk instruments. Much of the credit crisis problem as it pertains to banking revolves around the pricing of so called “toxic” or “troubled” assets, and other assets that are at least guilty by association. The fact that both composition transparency and market liquidity are lacking means that the appropriate MTM treatment for these assets is problematic. Various credit crisis solutions have been proposed, such as MLEC, TARP I, bad bank, good bank, TARP II, and full nationalization. All of these depend on the problem of asset valuation and pricing and MTM, one way or another. Nevertheless, the wisdom of such aggressive MTM application is a question that lingers.

Willem Buiter (see below) has commented recently on one aspect of FV accounting, that being consistent treatment of assets and liabilities. E.g. an increase in market interest rates reduces the value of a fixed rate asset, which reduces FV earnings. The same effect on a similar fixed rate liability reduces its value, which increases FV earnings. The pathological case is that of deterioration in a bank’s credit quality, with a widening of credit spreads that reduces the value of its liabilities and increases its FV earnings. Buiter has noticed what bankers themselves complained about almost 20 years ago when FV accounting was first proposed. Given the broad transparency objective of FV accounting, there is no rationale for applying it to assets alone. This apparent “foolish consistency” is symptomatic of unintended consequences.

Events are rapidly unfolding in the global credit crisis. There is increasing momentum toward the view that governments should urgently nationalize banking systems on a broad scale. The tendency in that context is to assume the MTM issue is increasingly irrelevant. Before allowing this, we should highlight several fallacies about MTM, which are at the conceptual origin of the issue.

The first fallacy is that MTM accounting is necessary in order to produce balance sheet transparency. This is not the case. Given the nature of the information it conveys, we can say more accurately that MTM accounting is a sufficient, but not a necessary condition for transparency. Insofar as asset values are concerned, the necessary condition is MTM disclosure, not MTM accounting. Exactly the same information can be made public through disclosure, without necessarily affecting reported earnings and capital positions. This would still allow the market to incorporate internal MTM information in the stock price. Shareholders could evaluate the impact of illiquid asset markets, uncertain pricing, and the longer term relevance of immediate MTM asset values, and impound all of this in the current stock value. This avoids a compound and to some degree duplicative and arguably inefficient pricing process in which internal assets and external stock value are both subject to an MTM valuation process.

The second fallacy is the contention that choice of accounting has no bearing on the economics of value. This would be conventionally correct if accounting had no bearing on the actual requirement for bank capital. But it is wrong for precisely this reason. And this is of particular importance to the credit crisis.

A relevant and connected analogy exists in the household sector. The housing boom was based on easy credit and an implied belief in MTM accounting for houses, otherwise known as the ATM effect. Current house prices, however inflated, were the basis for many hundreds of billions of dollars of mortgage equity withdrawals (MEW). Those who bet on housing MTM as an indicator of sustainable price appreciation behaved accordingly. So did mortgage lenders. Those who restrained from using MTM as a mental accounting of a sustained trajectory of personal wealth, and who considered such MTM information with more restraint, probably checked their behaviour more wisely in terms of allowing for risk. In order words, behaviour was a function of how households viewed the effect of housing MTM on their personal balance sheets and longer term capital positions. Those who resisted incorporating full MTM into their own capital evaluations were probably more restrained in MEW transactions and related spending. Those who acted aggressively on their housing MTM profile overextended their balance sheets and spent the money from their MEW proceeds. The economist Steven Roach referred to the corresponding macroeconomic effect in terms of the “asset economy”. The trajectory of this economy is tracked in the Federal Reserve’s quarterly computation of US household wealth. Trillions of dollars of wealth have now been eroded from household balance sheets since the credit crisis began.

A number of reputable economists and analysts have judged the US banking system to be insolvent. They conclude this in part by comparing the probable value of bank assets and liabilities with system capital. Forecast loan losses apart from MTM losses are also an important factor. These forecasters may be right. Who would bet strongly against Nouriel Roubini at this stage? President Obama has invoked “catastrophe” as the worst case scenario for the US economy, and positioned the importance of fiscal action accordingly. One could describe the banking problem similarly, and the importance of policy action there. Prescriptions for resolving the banking crisis include permutations and combinations of government intervention and asset reconfigurations such as “bad bank” (MLEC, TARP I, TARP II), “good bank”, and full nationalization. More commentators are pronouncing both US and European banking systems as insolvent, and urging quick nationalization, in order to avoid a Japan style protracted bank balance sheet deflation. Martin Wolf (see below) alleges the new US administration has already failed to recognize that the US banking system is insolvent. In his view the current policy response has already failed; nationalization is required. He makes the point that aggressive action is required to prevent a calamitous consequence that is asymmetric in its severity. All of this may be right. The MTM issue has been overtaken by this momentum. So where does it fit now?

The government assumes asset risk in any of these bail-out mechanisms. But unlike private sector banks, it incurs no additional capital requirements due to unrealized MTM losses on assets that it purchases (not that it guarantees). Neither the Treasury nor the Fed requires more capital funding because of MTM changes in the prices of assets that they hold. (The issue of Fed capital adequacy is really part of the same question for the government as a whole.) In other words, Treasury and the Fed can hold assets to maturity, but the private sector may be inhibited from doing so, given its required response to MTM unrealized losses and capital constraints.

The Treasury and Fed balance sheets offer considerable potential leverage to a financial system that is undergoing massive deleveraging. This is the essence of the requirement for their balance sheet intervention. But they also offer MTM immunization by virtue of their own balance sheet process. Therefore, why not provide MTM immunization (i.e. “relief”) directly to the banks, as part of a broader package of intervention? Indeed, this is what a number of commentators have urged for some time. Among them are Paul Volcker (former Fed chairman), William Isaac (former FDIC chairman), and Bob McTeer (former Fed governor; see below). Opposing this general proposition is the purist MTM view, which happens to note correctly that Japan’s banking system failed to recover due to half-way measures. But this doesn’t deny the potential dysfunctional effect of MTM on bank capital requirements in any environment.

TARP II as outlined by US Treasury secretary Geithner envisages a public-private partnership for the purchase of bank assets. The idea is that government will provide the leverage necessary to make these assets attractive to private equity capital. This would presumably also lift current MTM pricing, simply due to financial engineering. The irony is that private capital because of this financing may discover assets worth holding on the basis of underlying cash flow, i.e. on an accrual basis. Thus, the government may move assets out of the banking system that are disabled on an MTM basis to an investment platform where they make sense on an accrual basis. This would include the decomposition of complex assets such as CDOs in order to identity cash flow arising from the underlying assets. So long as these individual assets generate cash flow, they are “worth” something rather than nothing.

In summary, the banking crisis reflects the problem of dealing with so-called “toxic assets” and associated write-downs forced by MTM and FV accounting. Various solutions have been proposed involving different ways of severing toxic and non-toxic portions of a bank balance sheet, including full nationalization. These mechanisms will depend on the price at which these assets can be sold or transferred away, and how MTM accounting will factor into the arrangement. There may also be some scope for meaningful relief on MTM accounting in universal banks. The credit crisis itself reflected an asset bubble that in good times was enabled by aggressive MTM accounting, explicit or implicit, across all sectors of the economy, including banks and households. Universal banks combined and integrated MTM oriented investment bank operations with more staid, accrual accounted commercial operations. Perhaps the financial architecture of the future will feature a return to commercial banks that resemble deposit taking and lending utility functions, with minimal exposure to MTM businesses, and investment banks that are still MTM driven but small enough to fail.


Various opinions on mark to market:

http://www.bob-mcteer-blog.com/mark-to-market-in-the-american-spectator/ (Bob McTeer)
http://www.bob-mcteer-blog.com/volcker-and-greenspan-mark-to-market/ (Bob McTeer)
http://blogs.ft.com/maverecon/2009/02/accounting-according-to-barclays-declining-creditworthiness-as-a-source-of-profits/ (Willem Buiter)
http://www.nakedcapitalism.com/2009/02/mark-to-market-rip.html (Yves Smith)
http://us1.institutionalriskanalytics.com/pub/IRAstory.asp?tag=336 (Chris Whalen)
http://www.ft.com/cms/s/0/9ebea1b8-f794-11dd-81f7-000077b07658.html?nclick_check=1 (Martin Wolf)
http://mises.org/story/3301 (Jesus Huerta de Soto)

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