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I have heard several politicians, including John Culbertson, banty around "mark to market", in conjunction with an increase in insured limits (to $2.5 million) on bank deposits as a solution to the current financial crisis.

I am here to completely debunk that idea as a workable solution. While it will alleviate some pressure on banks, it will definitely not start them lending again. It will not turn on the spigot of credit, only new capital will solve that problem -- and new capital will only invest in financial institutions when the "toxic assets" are removed from the balance sheets.

First, let me describe their alternative solution for anyone that may not be familiar (and I apologize for writing to a 6th grade level but that appears to be the level many of our politicians topped out in school). Under the Culbertson alternative, we would increase deposit insurance to $2.5 million to limit withdrawals of corporate deposits from banks and then we would freeze the daily mark to market rules. Banks are required to mark their assets down to market prices on a daily basis so when a transaction occurs at fire sale prices it results in capital reductions at other banks holding similar securities. While I agree that this freeze is a healthy practice in times of extreme distress, it will not solve our current credit and liquidity crisis.

Imagine that you are the President of a local bank with $100 million in total assets. You have 6% tangible equity to assets, or $6.0 million. This is your cushion against potential bad assets. The FDIC requires you to have less than this and the actual minimum calculation depends on the risk level of your assets. For simplicity, lets assume you will start to get in trouble with the FDIC and the markets if your capital falls under 4.0%.

Now your revenue is based on the interest and dividends you earn off your assets. Some of those assets are mortgages to people in your community, some are mortgage backed securities (because there were not enough borrowers to lend out all your assets) and some are marketable securities (treasuries, money-market funds, etc). We will assume you make a blended 5.5% yield on your assets, so revenue of $5.5 million. Your expenses (payroll, branch rent, marketing costs, costs of your deposits, etc) is about $4.5 million, so you net a nice little profit of $1.0 million per year, or a 1.0% return on assets.

Now the housing crisis hits and home values start to drop. Some of your borrowers lose their job, others are "underwater" on their house and decide to walk away, still others can't afford the reset pricing when their adjustable rate comes due. As a result of this problem, your non performing loans skyrockets to 1.5% of total assets and suddenly wipes out $500,000 of your revenue. You are still profitable, but net income has been cut in half to $500,000.

In addition, your costs are rising because now you have to process foreclosures, manage and resell real estate owned (property taken over) and you have more audit costs with the FDIC. In total your costs have increased by $300,000 annually and now you are left with only $200,000 of annual net income.

During this same time, you have to write-down most of your non-performing loans, which was 1.5% of total assets or $1.5 million. We will assume only $1.0 million of those loans need to be written off under FDIC guidelines. That erases $1.0 million of tangible equity which drops our ratio to 5.05% of total assets (assets dropped to $99 million and equity dropped to $5.0 million).

You are still okay with regulators but the markets aren't happy and take your stock down by 25%. You breath a sigh of relief though because on the same day you see that one of the largest thrifts in US, SHAMU, has been sold at firesale prices to another bank.

Because of the drop in housing prices, several highly leveraged lenders are in trouble and they are selling assets to increase capital. As they sell some mortgage backed securities at prices below "rational market levels", you realize that you also have some of these assets in your portfolio. Given the new market pricing that was set by the transaction, you now have to mark your portfolio of MBS down by $500,000, which reduces your tangible equity down to 4.56% ($4.5mm/$98.5mm).

Now the markets are really starting to worry about you and your stock drops another 25% in one day. The FDIC has increased their audits of your bank and the ratings agencies are reviewing your short-term debt (that you sell to the markets to fund your growth). Several large corporate customers decide to pull their deposits out of your bank and your deposits shrink by $400,000. Deposits are a liability, your funding source, and they can be replaced by Fed borrowings or public market debt but it is more expensive and will further reduce your profitability.

As the President of the Bank, you are under siege. You tell your credit department to stop making new loans because you need to protect your capital base. If you need to make more writedowns, it will take you into dangerous territory with the FDIC and the markets. What you desperately need is more capital, but you don't want to sell more capital because your price is 50% and 60% off its highs.

Oh, by the way even if you wanted to sell stock to raise capital -- there are no buyers right now. Remember that large thrift, SHAMU, that was sold at a firesale prices a few days ago -- it turns out that a large private equity investor bought stock in SHAMU just 4 months ago -- and all of its equity investment was wiped out in the transaction. They did their due diligence, but the market changed and assets that had been worth X were now worth Y and the equity in SHAMU was wiped out. Without knowing that the bad assets are gone from the balance sheet, no equity investors are interested in buying equity in your bank or any other bank.

Then Congress comes to the rescue and decides to raise the deposit insurance limit to $2.5 million and puts a moratorium on mark to market rules so that we will not have to mark all of our assets down as other banks sell MBS at fire sale prices. Great, we get back the $500,000 MBS writedown we previously took and we are back up to 5.05% tangible equity to assets -- we have a little bit more breathing room.

And maybe no more corporate customers will pull out "cheap" deposit money now that the insured limit was increased. However, that is not likely because of the "hassle factor". If I have $100,000 to keep in a bank, I still prefer to keep in a "safe" institution where I have 100% access. If a "risky" bank goes under -- yes, my money is insured but I will have to complete paperwork and endure a waiting period to get my capital -- why bother?

Okay, President, you now have 5.05% of tangible equity to assets, your non-performing assets are still growing and you know that there are some assets in your portfolio that are not worth their "stated value", are you ready to loosen up your lending standards and start lending again? Absolutely not! Nothing has changed at your bank, your profit margins are almost non-existent, non-performing assets are rising (so revenue is falling), some customers are pulling deposits out of the bank and your portfolio value is uncertain. The lending FREEZE continues, your bank needs to hunker down and try to weather this storm.

The only way we are going to get the banks lending again is by purchasing the bad assets from their balance sheet (at some price between fire sale and fair value). Once those assets are gone, they can raise capital from market sources. Then and only then will troubled bank presidents be willing to lend money again.

Our country is at a standstill until we realize that Paulson's plan is the only short-term plan that will work.

Disclosure: none

Source: The Lunacy of the 'Mark to Market Solution'