Banking: Is Mark-to-Market a Doomsday Machine?

by: Felix Salmon

John Dizard had a very good column in the FT yesterday, comparing the rules about marking to market in the banking industry to the Doomsday machine in Dr Strangelove. He also has some ideas about how the vicious cycle can be broken:

The capital bases of the major banks and dealers are being reduced by losses on the mark-to-market value of securities faster than they can raise new money. That means that because nobody wants to buy a lot of the structured credit products, credit made available by the entire system could contract. That would lead to more losses, and a further contraction of credit.
We call that a depression...
I have made enquiries in the relevant official circles about the current state of thinking on the enforcement of mark-to-market rules... For structured credits, such as CDOs, where valuations are being done on the basis of illiquid and arguably oversold indices, the accountants would be encouraged to find ways to value the securities that don't result in a cycle of mark-to-illiquid-market followed by liquidation, followed by more marks, and so on.
Also, it has been suggested by some dealers, whose capital bases are getting too stretched to adequately maintain market liquidity, that they be given access to the Federal Reserve's discount window and the generous Term Auction Facility. That would provide enough extra liquidity to keep more securities from being dumped into the capital-eating illiquid valuation "buckets". This idea is likely to be taken seriously by the authorities.

I think the idea of allowing investment banks to access the TAF is a reasonable one: it helps to achieve exactly what the TAF was designed to achieve in the first place.

But what Dizard doesn't mention is that a lot of the looming problem comes not from marking to market, but rather from rules which have meant banks not having to mark to market. I'm talking about all those securities on banks' balance sheets which are rated triple-A thanks to a now-worthless monoline wrap. Since triple-A securities have a zero risk weighting for capital adequacy purposes, banks have to put aside zero capital against them. The minute the monolines get downgraded, the banks suddenly have to mark these highly illiquid bonds to market. The banks then take two simultaneous capital hits: the first because the bonds aren't zero risk-weighted any more and therefore need capital to be held against them, and the second because of the write-downs on the mark-to-market losses.

Is marking banks' assets to market really a Doomsday machine? Remember that in the film the Russians built their machine not just because it was effective, but also because it was cheap. "Our people grumbled for more nylons and washing machines," says the Russian ambassador to the US. "Our doomsday scheme cost us just a small fraction of what we had been spending on defense in a single year." Marking to market is a bit like that: effective and cheap, but also prone to a disastrous blow-up.

There is an alternative: call it the old-fashioned French approach, now adopted by the Chinese. Allow banks to keep assets on their books at par unless or until they're paid off or they are sold at a loss. All manner of losses can be hidden that way for decades if necessary. It's not a system I'd ever want to move to, but it does have one or two advantages.

(Via Alea)