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09/30/08
On the Bailout
Filed under: Politics and Economics
Posted by: site admin @ 7:29 pm

The current economic crisis and no vote by the US House on the bailout package is on a lot of minds. There is the belief that if something isn’t done, the economy will go into a death spiral or something close to it. And all of this is due to “toxic loans” and the resulting impact they have under mark-to-market accounting standards.

There is obvious benefit in mark-to-market accounting which is why some stakeholders, including the major accounting firms, are opposed to changes in the current rules1. In that particular case, the concern is that a lack of mark-to-market accounting will result in a return to the days of the S & L crisis of the 1980’s. In the meantime, some legislators, concerned with complete market failure, see changing the rules as a way to help alleviate the current pricing problems. The problem, of course, with mark-to-market is that when there’s no market, there’s nothing to mark against - the asset then has no value.

Both sides of this debate seem to be making a fundamentally flawed assumption - they both seem to be assuming that this is an either-or choice. Who says it has to be that way? Why can’t we have a both/and approach?

I would like to propose the following:

In addition to valuing assets under mark-to-market rules, each institution could also value assets under a net present value model based on the cash flow from the asset. For fixed rate mortgages, this is a straightforward process. Obviously, for ARMs, interest rates will vary. In those cases, it is still possible to value the mortgages conservatively using the minimum interest rate of each loan.

Of course, not everyone will pay their mortgage, so conservatively estimate the performance characteristics of mortgages based on current national foreclosure rates - with some added margin for safety. So, for example, if 15% of mortgages fail nationally, then each mortgage holder would estimate their portfolio performance based on a 20% failure rate. Additional limiting factors could be added to insure that the resulting estimate is conservative. This value will still fluctuate, but it will be less subject to market whims. While some firms might complain that this unfairly punishes them when their performance is better, the goal here is to provide a floor valuation that people can trust - not come as close to the perfect number as possible.

If both values (mark-to-market and conservative performance based numbers) are made available on a daily basis, investors will be able to better determine what to believe. These are both present values of the assets - just calculated in different ways. Between them, they should give some idea of the actual worth of the asset. If there are legal requirements based on the valuation of one or the other, picking the higher of the two values should still give a conservative result.

There may be many other approaches that might yield usable results as well without whipsawing us from one accounting peril to another. The more different valuations investors and regulators have, the better. We live in an age of spreadsheets and databases - we can handle all the information that can be made available. And the more we get, the better able we’ll be to understand what each company is really worth.

1. For example, see Auditors Resist Effort To Change Mark-to-Market

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