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I agree with John Mauldin's comments on asset valuation; however his
suggestion to suspend mark-to-market accounting is wrong.
It does not help investors, depositors or regulators to allow
financial institutions to overvalue their assets and therefore
overstate their capital reserves. And to make matters worse,
re-jigging reported asset values only when it is convenient to prevent
an institution from failing is just insanity.
Here's an example. I buy a house for $1 million and finance it with a
$900,000 loan. Let's say its value goes up to $1.2 million, so I
report that value on my credit application to the bank and borrow an
additional $180,000. A year later, the value of my house declines to
$600,000. Mark-to-market accounting says I must report a deficit of
($600,000 - $900,000 - $180,000) $480,000. Suspending mark-to-market
accounting says I continue to report $120,000 of equity. Which paints
the true picture? Oh, and following the suspension of mark-to-market
accounting, with my $120,000 of "equity," I convince you, an investor,
to put up $60,000 for an equity interest in my house.
An interesting benefit of Goldman Sachs and Morgan Stanley's recent
switch to bank holding companies was that certain assets no longer get
marked to market. They avoid reporting the decline in value of
billions of dollars of certain assets.
From: Pete Holt <peteholt@xxxxxxx>
To: realtraders@xxxxxxxxxxxxxxx
Date: Monday, September 29, 2008, 9:36:52 PM
Subject: [RT] Paulson Plan
This (from John Mauldin's Outside the Box) would seem to be the key
deficiency in the Paulson Plan. Don't see how this can be fixed in
the short run.
There is one practical problem that will plague the Paulson Plan and
any plan that involves the government purchasing distressed assets
from financial institutions. These assets are NOT(!!!) accurately
valued on the books of financial institutions.5 Accordingly, these
institutions are not in a position to sell them to the government at
current fair market value. Any sales at current market value would
inflict huge losses on these institutions. The alternative is for the
government to grossly overpay for these assets, which would constitute
a disguised capital infusion into these firms that would short-change
the American taxpayer. This flaw in the plan is why members of
Congress from both sides of the aisle insisted on some kind of
profit-sharing structure that would compensate taxpayers in the event
the government pays above-market prices for assets. HCM fears that
very little of the $700 billion is going to be spent in the near
future because of the reluctance of banks to part with assets at
anywhere near their current value, and the government's reluctance to
overpay for these assets.
5 Although in fairness all the blame for this can't be placed on these
institutions. There is currently no market for many of these assets
and placing a value on them would be an arbitrary exercise. This is
why mark-to-market accounting should be suspended for an indefinite
period of time.
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