Editor's Note: This is Part 2 of a 2-part series. Part 1 can be found here.


Ratings to Collateral to Ratings: A Vicious Cycle

What's a recipe for a perfect financial storm? Let's make a massive amount of bad loans and get them on the books of the major financial institutions. Then let's have the loans start to go bad. Throw in some general panic as everyone tries to sell the loans. Unfortunately, no one is buying.

Let's make a new rule that you have to mark your illiquid securities to the last price paid by someone desperate to sell. That means that many institutions now have to mark down their capital. Then, rating agencies mark down the ratings of the institutions which, of course, means that it costs them more to raise capital at a time when they can't get it which means they get lower ratings and so on. It becomes a vicious cycle.

In the early 80s, every major US bank was bankrupt because they had loaned Latin American countries far more than the capital they had on the books. The Latin American countries defaulted. If the US banks had been forced to mark to market, they would have all gone down, taking the US economy along with them. The Fed simply allowed them to carry the loans at book value, offering liquidity and allowing the banks time to make enough money to eventually write off the loans.

While nice in theory, the current mark to market rule works in normal times. But it has the unintended consequence of making things worse during a crisis. Why should an institution have to write down a security which over time is going to pay back the lion's share of its value just because a severely stressed institution was forced to sell it at a very low price in a time of crisis?

Yes, investors need to know what is on the books of the companies in which we invest. But it’s somewhat like my bank asking me to mark to market my home and pricing my loan daily based on that new price. If my neighbor loses his job and sells his home at auction, does that mean my home is now worth less two years from now? An even better analogy: If I’m renting that home to a very good tenant, does my neighbor's price impair my income?

I’m a fan of mark to market pricing. But we need to think through what a market price is. Not all things can be easily marked to market. This is doubly true when "market price" is a nebulous index of mortgage securities that may or may not have a fundamental relationship with an illiquid security on the books of an institution that has no intention of selling.

It’s one thing to require that you mark your stocks or bonds to market values. It’s another thing entirely to require it of all mortgage backed securities.

FASB 157 needs to be amended this week. If Congress can create a new Resolution Trust Corp in a week, then surely the accounting board, with the suggestion of Treasury, can figure out a better way to price illiquid securities.