ARC's 1st Law: As a "progressive" online discussion grows longer, the probability of a nefarious reference to Karl Rove approaches one

Tuesday, September 30, 2008

The Bailout & Mark-To-Market Explained

After yesterday's fracas, it's unlikely that any recovery bill will pass. At least, that's an opinion expressed by co-conspirator Brian offline - and I happen to agree. I'd let him post here, but he either has forgotten his password to the site or breaks out in hives whenever he hits

Anyway, the gist is that as more time passes, the GOP and Democrats who opposed the bill yesterday will only be emboldened to keep their current positions.

The only way that something will get passed is if it gets loaded up with the earmarks and pet projects that have become typical in D.C.

And, if something loaded with pork and pet projects does get passed, it will only strengthen public opinion that D.C. is broken.

There are a number of alternatives that we could employ to solve the problem. One of the main factors in the banking collapse has been the mark-to-market accounting that was instituted after Enron. (Somehow, Fannie / Freddie weren't subject to these rules, yet they still failed.)

I find it completely disingenuous for the Treasury Secretary to say that the federal government could make money on these mortgages (because they are markedly below value) while at the same time force companies to use those below-market values on their financial statements today.

Why is mark-to-market a problem? Well, here's an example most of us could understand.

  1. You buy a car and take out a $20,000 loan to finance it. Total value of the car on the lot is $30,000.

  2. You drive the car off the lot and it drops in value immediately, from $30,000 to $25,000. Does this make you an irresponsible gambler? Were you a sucker? No, you recognized that a new car will immediately depreciate once it's driven off the lot when you bought the car.

  3. After putting 30,000 miles on it, the car now drops to $15,000 in value and you still owe $16,000 on the loan. Are you "in the red" financially? (Perhaps, but only if you sell the car at $15,000.)

  4. Let's say you bought a gas-guzzling SUV (say, like this one I recently purchased) and no one - I mean, no one - is buying these cars because gas has shot up.

    You check the market value of the car on Kelley Blue Book and it's now $1,500 (because of the salvage value).

    (How the market price is determined is one of the big problems with mark-to-market - if other people are selling below market value in order to offload the car, their selling price becomes the value on your books. This is the devaluation death spiral that we're now in which has caused the meltdown....)

    Because of this drastic depreciation, do you close shop, declare bankruptcy, and notify the creditors that you're heading to Mexico?

    No... because you don't have a financial statement which requires you to take the loss now, regardless of whether the value of the car may increase after gas comes back down and regardless of the remaining value (in terms of useful life) that you can get out of the car.
As Brian and I commented a year or two ago, an assets market value isn't truly established until it has been sold - when the buyer and the seller have agreed on a price. Using some other indicator may be helpful in assessing the possible value, but it is not the value of that particular asset.

The Mark-To-Market standard is not helping the situation and should be at least temporarily suspended pending further review.

Mark Levin has an excellent post at The Corner where he objects to the bill and thanks the House GOP for letting it die.
Thank You, House Republicans [Mark R. Levin]

I have read the posts here and elsewhere. Sometimes these things are made to look more complicated than they really are. From an economic perspective, if the problem is liquidity and credit, there simply is no need for the federal government to assume massive amounts of debt on its book by assuming loans in anticipation that their holders or borrowers will default. This seems to me like a brand new expanse of government power that is not justified (if it ever is) by the arguments made on its behalf. The government controls monetary policy through supply and interest rates, among other things. It can further ease money supply and credit, thereby increasing the flow of capital. The government controls tax policy. It can increase liquidity and the flow of new money into the economy both from within the country and from foreign sources by eliminating the corporate income tax and the capital gains tax even on a mid-term basis. No matter what is done, some financial institutions will fail, as they did in the 1981-82 recession and have since. And the Fed and Treasury and other instrumentalities of government will have to determine, on a case-by-case basis, whether to intervene and how to intervene. They will also have to determine whether other policies require modifying, such as the McCain proposal today, in which he suggests increasing federal insurance for individual depositors from $100,000 to $250,000. Other smart suggestions include modifying the mark-to-market rule requiring financial institutions to downgrade the valuation of assets. If the goal is to prevent panic in the economy by investors and depositors, then increase credit, liquidity, and the flow of capital, and deal with problem institutions that are significant enough in size that their demise could resonate to the wider economy. But the Soviet-style, top-down five year plan a la Paulson's proposal, and to a significant extent the proposal that was voted down yesterday, could easily do more damage to both the economy and our governmental structure. So, in this respect, I must depart from NRO's editorial.

Also, count me among those few here who want to thank the House Republicans for taking a bold stand against what had been a stampede on a scale I have never before witnessed on matters of huge consequence. Conservatism is more than a quaint belief-system to be embraced and debated over donuts at Starbucks. It is more than a list of talking points. It is the foundation of the civil society. The liberal uses crises, real or manufactured, to expand the power of government at the expense of the individual and private property. He has spent, in earnest, 70 years evading the Constitution's limits on governmental power. If conservatives don't stand up to this, who will? If they don't offer serious alternatives that address the current circumstances AND defend the founding principles, who will? The House Republicans have done both. And I, for one, thank them.

Incidentally, if you want to buy a home or car today you can. And if your credit is decent, you can get loans at a good rate. Last week we were told that if a deal was not struck by last Friday, our economy would collapse. It has not. That is not to say the evidence of economic troubles or worse should be ignored. It is to say that now is a time for reasoned decisions based on tried and true principles, not for abandoning them. I notice that the socialist, who, for the last 30 years, has insisted that private institutions make risky loans based on non-economic factors, still has not abandoned his policies. Socialism does not work. We shouldn't support more of it.

09/30 11:07 AM

Your Co-Conspirator,
ARC: St Wendeler

Comments (5)
Avatar said...

Even the Financial Accounting Standards Board’s couldn't figure out how to deal with the mark-to-market accounting shortly after the Enron debacle. Even the Arthur Andersen accounting firm had problems with it which led to its failure too. Enron filed for bankruptcy 2001. The Financial Accounting Standards Board’s has had 7 years and they did nothing.

St Wendeler said...

True, FASB couldn't even answer Enron's repeated questions about how to handle Single Purpose Entities (SPEs).... of course, nothing FASB would've said would've allowed for the house of cards that they dreamed up, but keeping Mark-to-market is ludicrous.

Forcing a company to realize a loss while at the same time promising taxpayers that you're going to make money on these distressed assets (because they're really worth much more) is asinine.

Monterey John said...

Newt has been thumping on this since the bottom fell out. Let's hope it is there when this sausage comes out of the grinder.

Andy said...

Great analysis and explanation of this concept! It is going to be a challenge to deal with this rule, but in today's market fear is the driver.

Superb Jon said...

Dude, you need be knowing how this bail out is becoming international and the way the global conspiracy is getting one world governement through one world banking. What we gots to be doing is throw out anyone who visits the same foreign country more than once or who don't speak English at home. Andrew Jackson was right to shut down the central bank. We need to shut down the borders, shut down the air waves and internet and trade and immigration and usury banking and be American first and only again.