Something To Think About … Eliminating Mark To Market, Will It Work? Probably Not!
April 8, 2009Written by Harvey A. Goldstein, CPA
President & CEO of GoHagit, Inc.
Maybe I’m crazy, but I’m sure you’ll let me know after reading this. It seems as if, for all the “brilliant” people in DC, they don’t have a definitive solution to the banking problem. They keep pouring money into the system and hope the banking and other economic problems go away.
Now they’ve convinced the world and the FASB that eliminating the “mark to market” accounting standards will help reduce the problem. They think that a simple accounting entry (a book entry with no real economic substance) may be part of the solution. I don’t think so.
I know that lack of money is part of the banking problem, but I believe that accounting rules are also at fault. I contacted Congressman Elton Gallegly, a Republican friend of over 20 years, spoke with his staff, explained my thoughts, and was asked to send a memo to them. In my fantasy I thought that, because of my solution, I’d be the talk of DC. I wasn’t.
Here’s a summary of what I told the Congressman’s staff. If I’m miles off base, please let me know.
Mark to market means that the assets of the bank are reduced to market value. Example: Bank raises $2 million from investors so has equity (capital) of $2 million and $2 million in cash. Balance sheet looks like this:
Cash $2,000,000
Equity $2,000,000
Regulators say, (I simplified this), the bank can lend the $2 million because they have $2 million in equity (capital). Bank lends $1 million for mortgages. Balance sheet now looks like this:
Cash $1,000,000 (original $2 million less the $1,000,000 they loaned)
Mortgage asset 1,000,000
Equity $2,000,000
Bank can still lend an additional $1 million because capital will allow it to loan $2 million and it has loaned only $1 million.
Accountants say the market value (mark to market) of the mortgages are only $500,000, so the bank must now record a write off — take a paper loss (no impact on cash) of $500,000. Balance sheet now looks like this:
Cash $1,000,000
Mortgages 500,000 (Original $1 million less $500,000 write off)
Total assets $1,500,000
Equity $2,000,000
Less loss (500,000)
Net equity $1,500,000
Regulators now say the bank no longer has $2 million in equity, therefore it can loan only $1.5 million (again simplified) because that’s all the equity it has remaining. But the bank has already loaned a million (the original mortgages). So it has only a half million left ($2 million original equity less half million loss, less $1 million already loaned).
Notice that the bank still has $1 million in cash (liquidity), but can lend only one-half million.
The bank now lends the remaining half million allowed. Balance sheet looks like this:
Cash $ 500,000
Mortgages 1,000,000 (original million less half million write off plus half million new loans)
Total assets $1,500,000
Equity $2,000,000
Less loss (500,000)
Net equity $1,500,000
Note that the bank still has a half million in cash but can’t lend any more.
They were limited to equity (capital):
Original equity $ 2,000,000
Actually Loaned $(1,500,00)
Reduced by paper loss $ ( 500,000)
Lending left $ 0
So what to do:
1. Have the government invest more money to increase equity (they already did this), therefore the bank can lend more. This costs taxpayers a whole lot of money.
2. Let the bank add the paper losses back to their capital calculation which would allow it the ability to lend the additional half million in my example above with no use of taxpayer funds.
I realize the example is very simplified, but my simple mind says why not? Explain to me why it wouldn’t work.
Now they want to buy the “toxic assets” of the bank. Well that’s OK if the bank needs cash. However, rather then buy the “toxic assets,” let other banks or the FED make the banks loans with a government guarantee instead of government funds.
Are we creating another problem buy selling the “toxic assets”? Maybe! It seems to me that if the government buys the “toxic assets” for less then their book value, the bank will show losses on the sale of the “toxic assets” and impair their capital even more. Of course the solution to this is would be more government bailout money to cover the reduced capital resulting from the sale of “toxic assets.” A circular equation?
Eliminating marking to market is not going to be helpful. What will help? Easing, for a period of time, the capital requirements for lending. Government stops putting up the bucks and just guarantees inter-bank lending activities and other lending activities. This could stop the treasury printing presses.
But it seems to me that giving the money is what the government wants to do. Why? How about de facto nationalizing of the banks.
Something to think about!
Harvey,
I just happened to read your blog this morning about the “Will Mark to Market Work?” I too have my doubts about the leaders in Washington. Perhaps you may know the answer to this comment better than I. I think the reason why we get some decisions from Congress that just leave us stunned is because the people that sit on these finance related committees have little or no financial background. If there were CPAs like you sitting on these committees and that one involving the bailout monies, we wouldn’t have had those controversial ING bonus payouts.
I certainly think that we could use you in Sacramento. During a time when California is suffering from double-digit unemployment, Californians receive a sales and income tax increases. That makes no sense! The governor and state senators and assembly people need lessons in understanding finance.
Good luck to you in your new endeavor. I’ve read all your books over the years, from “122 minutes a month” to “Don’t bust the budget, toss it.” I’ve enjoyed every one and found them quite useful in my practice. By the way, I also use the software. Unfortunately, I too run into responses similar to Ernie Houseman and Tom Winters when in it comes to the use of financial statements and cash flow projections as powerful decision making tools. But, I still keep trying.
Best wishes, and I will follow your new blog closely.
Joe
Harvey, we met a Carl Terzian-sponsored lunch about a year ago. I’m with you on the ‘nationalization’ idea. Buying the toxic assets at above-market prices (what the current PPIF plan entails so there is no further degradation of the banks’ balance sheets)seems just as foolish as making loans against hugely inflated appraisals of 2005 – 2007. Prudent lending standards were thrown out the window in the rush to capture subprime and alt-A market share. As someone who toils in the investment arena daily (with no exposure to money center banks), I have read a ton of conspiracy theories about why the bailout plan was structured this way – the answer may be as simple as lack of lending and investment experience on the part of those drafting it.