In a recent broadcast of the Kudlow Report, two heavy weights Larry Kudlow - someone I deeply admire - disagreed with Henry Paulson - someone with an unflinching track record - when Paulson supported mark to market (MtM) of Level II and Level III assets. Paulson claimed that as a banker, he supported MtM while Larry talked in favor of cash flow accounting and suspension of MtM regime.
For the sake of clarity, accountants regard Level II as assets that are hard to value and Level III as those that are even more difficult to value and therefore require deep assumptions. The discussion on the Kudlow Report mostly centered around Level II and Level III assets of the following type - MBS/RMBS/CREs/CDOs/CMOs etc.
The basic premise of Larry’s argument was that if the mortgages were still being serviced MtM should have been suspended as the mortgage were still ‘alive’ and need not have been marked to an illiquid or overly pessimistic market. To be fair to Larry, he supports suspension of MtM in both bear and bull markets.
I want to put an economist’s argument in favor of Paulson’s stance. As free market proponents, we believe in the hegemony of the markets. Paulson’s argument in favor of MtM is actually in line with a more sophisticated version of Larry’s stance on cash flow accounting. Here’s how.
By supporting MtM, Paulson and those in favor of MtM are supporting ‘expectations based’ cash flow accounting and not static (or worse historical) cash flow accounting. So if you are a free market economist, Paulson was right in opposing suspension of MtM regime and Larry right in a, well say a more, round about way. As an economist, Larry should have been talking about expectations or forward looking cash flows and these can be more appropriately captured in transactions taking place in the market. If the market happens to be illiquid or lacks depth that is simply because market participants are finding it difficult to form rational expectations as the future picture of the proportion of mortgages that will continue to be serviced during the lifetime of those mortgages, simply has a large standard deviation.
So this note is in support of Paulson and his stance. MtM is in fact in line with the rational expectations paradigm of an economist.