Wednesday, January 28, 2009

TARP Version 1 Revisited: Mark-to-Market Back in the Crosshairs

“Senior Wall Street executives said yesterday that they had been sounded out on plans for an “aggregator bank” that would purchase toxic assets from banks. Under one of the plans discussed, toxic assets would be valued by an independent third party. Where assets are purchased at prices below their book values, the government might then inject common equity into the banks to make up for capital wiped out by the sales.”
Financial Times, January 28, 2009

On the surface, mixed signals are emanating out of the US Treasury department. Last week, Treasury Secretary Geithner stated that he was comfortable with mark-to-market accounting. Today, we learn of the above quoted plan, which is a direct assault on mark-to-market – the real villain in turning a recession into potentially a depression. What gives?

To refresh your memory, mark-to-market accounting is rooted in the failed ideology of the efficient market hypothesis, which (in its “strong” form) says that when it comes to determining the fair value of an asset the market knows best. This dogma is so entrenched in the thinking of mainstream economists and many na├»ve investors that even Nobel Laureates such as Paul Krugman ascribe to this fantasy of the “wisdom of the market” (see "More on the bad bank"). Moreover, there is little doubt on these pages that the primary reason why TARP Version 1 went from “price discovery” (code for attacking mark-to-market) to bank capital infusions was due to the intimidation of then Treasury Paulsen by mainstream, non behavioral finance economists.

Investment Strategy Implications

Conspiracy theorist alert: Clever guy this Mr. Geithner. Publicly advocate for free market principles (mark-to-market) while working behind the scenes to exploit it (through the aggregator bank and price discovery (courtesy the "independent third party")).

The significance of keeping mark-to-market intact is the extraordinarily positive impact it will have on bank earnings as assets held at 20 cents on the dollar are written up ("say what?" you say) thereby producing large earnings gains. Moreover, by stabilizing the valuations of “toxic assets”, write ups will thereby alleviate banks’ capital requirements, which is the primary reason why bankers are reluctant to lend. Under the bizarro logic of mark-to-market, they need the cash to remain solvent – hence no lending.

Once mark-to-market is replaced by something like mark-to-maturity (suggested by Bernanke during early days of TARP Version 1), then, miraculously, liquidity will begin to flow through the banking system to the real economy. Sounds too simple? Allow me to refresh your memory on another non real economy factor that wrecked a large amount of unnecessary havoc on the global economy – commodity speculation and the price of oil.