Critics of mark to market accounting rules argue that mortgage backed securities held by banks are under-valued by the rules and fail to reflect the fundamental or underlying value of the assets. Some critics have gone so far as to describe our current financial mess as a “mark to market meltdown” rather than a genuine credit crisis or an asset devaluation.
It would be better, the critics argue, to allow banks to sequester illiquid assets—particularly mortgage backed securities issued in the last five years—into accounts that would be marked according to expected cash flows rather than current market pricing. The problem, however, is that no one really knows what kind of cash flows to expect.
Our great experiment of pushing home ownership to—and beyond—its outer limits combined with massive securitization that made the quality of underlying mortgages difficult to determine, introduced an unprecedented level of risk. The historical data about mortgages—what led to defaults, why foreclosure rates increased—was rendered largely useless because homeownership no longer fit the pattern we had established since the 1960s. It’s not enough to know how low loan-to-value mortgages behaved in the past, and then do the maths to reflect the fact that 43% of loans made to first time home buyers included no down payments. The new class of homeowners we created in the last decade is not paying its mortgages as previous homeowners did. They are defaulting at much higher rates. How do you calculate a discounted cash flow when you have no idea what level of risk discount to use?
One way to calculate the discounted cash flow would be to look at the implied cash flows from market pricing. But this, of course, would just get you to the same place as mark to market rules. What the advocates of suspending mark to market are arguing is that the market is radically inefficient in pricing these assets.
“Here’s a shot at what’s going on: The only way changing mark to market gets us out of this mess is if market psychology is driving it,” law professor Larry Ribstein argues at Ideoblog. “In other words, changing the accounting rule is a bet that (1) markets are inefficient; and (2) we can make them more efficient by eliminating an accounting rule based on real transaction prices.”
Ironically, it may make some sense to start valuing assets on discounted cash flows for assets held to maturity because that’s the price that Hank Paulson and Ben Bernanke have said the government will pay for the assets. But how will the government calculate the cash flows given the historically unprecedented situation? It’s in the same blind spot as the rest of us.
The right way to value illiquid assets, given the likelihood of the bailout, is to attempt to guess the price the government will pay. That is, forget trying to guess actual cash flows and try guessing what the government will conclude about pricing. The key to getting valuation right, then, is trying to think like a Treasury Department bureaucrat.
This has a very strange result of flipping a long-standing critique of socialism on its head. It used to be said that socialist planners were parasitical on free-markets, that they depended on information from profit-driven markets to determine production schedules and prices. Now the markets are left guessing how Treasury Department planners will price mortgage assets.Like Humpty Dumpty telling Alice that his words meant whatever he wanted them to mean, the prices of these assets will be whatever Hank Paulson wants them to be. Humpty Dumpty accounting.
Forget marking to market. Mark to Paulson.
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