Besieging the Regulators

Near the end of the Civil War, Union forces besieged Petersburg, VA for 9 months. Confederate forces could barely find food to eat. Starving,  with their numbers dwindling due to desertions, and with Sherman’s forces approaching from the south, Lee attempted a break out.

It failed miserably, and on April 2nd, Union forces soon assaulted the Confederate lines. The Army of Virginia was forced to withdraw from both Petersburg and Richmond.

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In the current shadow war over mark-to-market rules for financial institutions, it is the banks, led by the American Bankers Association (ABA) that are besieging regulators to suspend the rules.

There is an urgency to the siege because financial institutions are in the process of submitting their third quarter accounts to their auditors ahead of publicly filing their results.

Some of the nation’s largest banks like Citigroup (C), Bank of America (BAC), Wachovia (WB) have significant balance sheet liabilities that are illiquid and have seriously deteriorated in value. These assets are MBS and CDOs are generally comprised of mortgages.

The credit markets are frozen. There is a minimal amount of trading for these toxic products.

Some argue that the lack of trading is why prices are depressed while others argue the assets are seriously impaired because the nations housing market is so overvalued and distressed.

All the formerly active market makers for intermediating these products are dealing with their own issues (i.e. Goldman Sachs (GS), Merrill Lynch (ML) and Morgan Stanley (MS)).

Lehman Brothers and Bear Stearns failed because their balance sheets were full of these toxic and overvalued assets.   

There remains an inordinate distrust in the credit ratings assigned by Moody’s (MCO) and S&P (MHP).

This lack of confidence in the evaluation of creditworthiness makes valuing complex credit products very difficult.

And now, the ABA requests that the SEC immediately overrule the Financial Accounting Standards Board on some complex rules related to  valuing these products that have frozen the balance sheets of America’s banks.

What should regulators do?

The danger in suspending mark-to-market is that we freeze all the toxic assets in the banking system.

Investors would then distrust the books of banks and be unwilling to supply capital and lend to them in the interbank markets.

Governments around the world are moving to guarantee interbank lending but cannot undertake this responsibility indefinitely.

Eventually banks will have to open the kimono and expose their dirty linen.

So do we keep mark-to-market rules and air out the system’s dirty linen now?

Or suspend the rules and hope that somewhere down the road the value of all these toxic mortgage assets recovers and their value can be accurately reflected on banks balance sheets?

Japan had a similar problem when their bank’s balance sheets were inflated with overvalued property loans.

For many years Japanese regulators decided that opening the kimono was just too promiscuous. They never made their banks show their dirty laundry.

And the Japanese banking system stayed frozen for years.

It’s a difficult choice for regulators.

But a vital, healthy economy requires a banking system that easily and efficiently allocates capital.

A frozen banking system leads to a frozen economy.

So it’s intense pain now… or slow and protracted pain later. 

C’mon boys… show us your stuff… let the rules stand… open your kimonos… you had plenty to show when things were good… show a little leg when times are tough  … let’s have the pain… let’s get it over with.