Kessler may be crazy. But mark-to-market’s absurd.

Of the Treasury’s long-awaited non-plan bank plan, Andy Kessler writes, “Mr. Geithner should instead use his ‘stress test’ and nationalize the dead banks via the FDIC — but only for a day or so.”


strip out all the toxic assets and put them into a holding tank inside the Treasury. . . .  inject $300 billion in fresh equity for both Citi and Bank of America. Create 10 billion new shares of each of the companies to replace the old ones. The book value of each share could be $30. Very quickly, a new board of directors should be created and a new management team hired. Here’s the tricky part: Who owns the shares? Politics will kill a nationalized bank. So spin them out immediately.

Some $6 trillion in income taxes were paid by individuals in 2006, 2007 and 2008. On a pro-forma basis, send out those 10 billion shares of each bank to taxpayers. They paid for the recapitalization.

Each taxpayer would get about $100 worth of stock for each $1,000 of taxes paid. Of course, each taxpayer has the ability to sell these shares on the open market, maybe at $40, maybe $20, maybe $80. It depends on management, their vision, how much additional capital they are willing to raise, the dividend they declare, etc. Meanwhile, the toxic assets sitting inside the Treasury will have residual value and the proceeds from their eventual sale, I believe, will more than offset the capital injected. That would benefit all citizens, not the managements and shareholders who blew up the banking system in the first place.

Is Kessler crazy? Well, maybe. In his own creative and boisterous way. But not nearly so crazy as Washington’s fumble-bumble these last few months. I’d much prefer Kessler’s out-of-the-box plan to D.C.’s muddle.

What becomes clearer every day is that all the government’s efforts, from the AIG “bailout” to TARP 1.0 and TARP 2.0 onward, have essentially been efforts to get around the terribly destructive interaction of “mark-to-market” accounting and regulatory capital requirements. A few keen observers — David Malpass (I), Brian Wesbury (I, II, IIIIV), Steve Forbes (I, II) — have made this point from the start. But the government and most economists clung stubbornly to “fair value” in an apparent attempt not to “let the banks off the hook.” 

But what a time for an attack of conscience, a principled stand for supposed accounting purity! We’ll spend trillions and totally alter the nation’s financial landscape, but a minor (though powerful and free!) accounting change — relaxing mark-to-market — is a bridge too far? Explain that one.

Even those who don’t directly target the mark-to-market interplay as the culprit implicitly acknowledge it. As Kessler describes, 

The first iteration of the Troubled Asset Relief Program (TARP) last year was to buy these bad loans and derivatives. It didn’t work. Nothing was bought when it became clear that paying face value was a taxpayer giveaway to banks, but paying market prices for this stuff would cause huge equity write-downs, wiping out banks which would be left with negative equity and effective insolvency.

The next round of TARP injected money onto bank balance sheets first, boosting their equity so they could absorb the write-downs to come when the toxic junk was bought later. It didn’t work. The $45 billion to Citi and Bank of America wasn’t nearly enough. Instead, $306 billion and $118 billion loan guarantees were extended to cover the bad debt, which unfortunately, the market believes still weighs down banks’ balance sheets.

Now with TARP 2.0, renamed a friendly Financial Stability Plan, the idea is to entice private capital to buy these bad loans and derivatives in an effort to set the “market price.” But Mr. Geithner hasn’t solved the dilemma of banks not wanting to sell and become insolvent. Moreover, no one is going to buy these securities ahead of Mr. Geithner’s action with the “full resources of the government” to bring down mortgage payments and reduce mortgage interest rates. Lower mortgage payments means mortgage-backed securities would be worth even less. Six months to a year from now, big banks may still be weak and the ugly “n” word of nationalization will be back.

Look at some very real examples of how mark-to-market sucks the whole banking system down a procyclical vortex.

the Bank of New York Mellon reported that in the fourth quarter, it wrote down its $5 billion investment portfolio of Alt-A residential MBS by $1.4 billion, or about 25%.  If the bank had accounted for the securities as loans, it estimates these same assets would have been impaired only $208 million, just 4% of the portfolio’s face value. The difference between the two accounting treatments: more than $1 billion.

One Alt-A MBS expert, Thomas Patrick, chairman of New Vernon Capital and a former Merrill Lynch vice chairman, calls mark-to-market accounting a “swamp” in this environment, an “accounting fiction” better reflecting the “financial desperation of sellers than the value of the securities sold.” 

In 3,700 mortgage securitizations he examined, Patrick found that of $1.4 trillion in Alt-A mortgages, $948 billion were current on interest and principal, while $452 billion were delinquent more than 30 days.   Further, banks carried the performingmortgages at an average 50% of par.  Patrick observes that if owned directly as loans, the banks would carry the mortgages closer to par.  He concludes that the mark-to-market fiction has created enormous financial difficulties.

Patrick proposes that these securities be dismantled.  Banks would be allowed to rebook performing mortgages as loans at par less appropriate reserves.  Accounting gains would absorb remaining losses in the non-performing mortgages. 

Similarly, Dutch banking authorities evaluated a $39 billion portfolio of Alt-A MBS owned by ING and marked-to-market at 65% of par.  They subjected the cash flows of the 600,000 loans comprising the securities to severe stresses (principal assumptions were another 10% decline in home prices, and a 50% decline from peak prices in Florida and California) and concluded that the bonds were likely to return 90% of their original value. 

Writing alongside Kessler, Holman Jenkins took mark-to-market head on

regulatory forbearance [to mitigate mark-to-market] is the most important item in the government toolkit, and the giant raspberry Mr. Geithner received from the market yesterday should be his signal that the market understands this and worries he doesn’t . . . .

Dropping mark-to-market is no miracle cure, but it would reduce the pressure on banks and regulators to make irrational choices about the disposition of questionable assets. Banking might even regain some of its appeal for equity investors, who might see an attractive bet that bank-held assets are oversold — that is, if they don’t have to worry about unpredictable regulatory actions. Real confidence is organic: not something that can be conjured from Mr. Geithner’s promise that Mighty Mouse is here to save the day.

The inflationary housing bubble-bust would have caused problems in any case. But the financial crisis that spilled over — crashed over — into the real economy did not have to happen. Rigid mark-to-market and capital enforcement was gasoline poured onto a mostly contained fire. It wouldn’t have cost a penny to alter these guidelines — and probably avoid today’s global inferno.

Comments are closed.