Mark to Market: Melee, Irrational Pessimism, or Efficient Markets
Daniel Gross does a nice job of explaining the latest insanity from certain rightwing pseudo-economists:
According to a small but powerful group of America’s financial decision-makers—mostly supply-siders and those in their thrall—the chief cause of the credit market meltdown is not folly, or reckless lending, or the demise of America’s financial management. It’s an accounting rule. “Mark-to-market” is a seemingly innocuous term for the requirement that companies, banks, hedge funds, mutual funds, and the like report the market price of the financial instruments they hold and trade … In the past five years, Wall Street firms created huge volumes of new kinds of complex securities, such as subprime bonds and collateralized debt obligations, which are investment vehicles built out of subprime bond securities. These securities lacked long trading histories or deep markets. To value them, many outfits slipped the surly bonds of mark-to-market and assigned a value to them based on so-called mark-to-market (In other words, educated guesses based on algorithms.) When credit started to go bad, market participants had to write down the value of such assets. For institutions holding onto bank loans—an asset for which there is an active secondary market—marking to market was relatively simple. If markets priced bank debt of companies with a particular credit rating at 85 cents on the dollar, banks had to write down 15 cents of the value of each dollar of the loan. This process helped drive the massive write-downs seen at banks like UBS and Citigroup. But for the complex new financial instruments, the valuations became far more unstable … In some instances, buyers disappeared entirely. The valuations of these new instruments also plummeted because of market psychology … Since those indices are actively traded by investors, they can be driven up and down (mostly down) by speculation and fear.
Hold the phone! This sounds a lot like the Steve Forbes claim that the price of oil should be $35 a barrel but those pesky markets just aren’t efficient as we economist often claim. In this case, market prices fell only because of irrational pessimism. But could it be that market are efficient and that the fundamentals of these instruments are being properly reflected in the market price? But I interrupted Daniel:
Paul Craig Roberts, a veteran supply-sider and former Reagan administration official, wrote on March 11 that the mark-to-market rule “is imploding the U.S. financial system by requiring financial institutions to value subprime mortgages at their current market values.” His solution: Suspend the rule, let financial institutions “keep the troubled instruments at book value, or 85-90 percent of book value, until a market forms that can sort out values, and allow financial institutions to write down the subprime mortgages and other troubled instruments over time.” In other words, let’s assign an imaginary happy value to these assets until the seas grow calmer. Steve Forbes echoed the sentiment in his column in Forbes, calling for a 12-month suspension of mark-to-market in “exotic financial instruments (primarily packages of subprime mortgages).” The reason: “It’s preposterous to try to guess what these new instruments are worth in a time of panic.” This line of thinking quickly wormed its way into McCain’s big economic speech. He put it more anodyne terms: “First, it is time to convene a meeting of the nation’s accounting professionals to discuss the current mark-to-market accounting systems. We are witnessing an unprecedented situation as banks and investors try to determine the appropriate value of the assets they are holding, and there is widespread concern that this approach is exacerbating the credit crunch.”
McCain is relying on accounting advice from Steve Forbes? Do these three understand that trying to infer market values from book values is the height of folly? To suggest that the discount from par should be 15 percent or less is about as stupid as thinking the Iraq War reduced the Al Qaeda threat to the US. But let’s have Daniel finish:
These folks are saying that when markets are volatile and irrationally pessimistic, it’s just not fair to force people to act as if the market prices are real. But you’ll notice that they never made that argument back when markets were irrationally optimistic, as they were from 2003-2006. No hedge fund manager ever told a bank that it should lend him less money because the value of the collateral he was putting up was clearly a product of unwarranted optimism or that he shouldn’t collect management fees based on the assets under management because their value was clearly inflated. Nobody ever complains about the market’s ruthlessness and inefficiency when it’s making them money.