Tuesday, September 30, 2008

Thirsty for Changes to Mark to Market?

Would suspending mark-to-market rule solve the financial crisis?
Kevin Kersten at bloggingstocks provides this amusing example:

Let me give a silly but simple illustration. If you have 20 one dollar bills in your wallet, we would all agree you have a net worth of $20. Thirsty Bob also has one dollar bill in his wallet and walks into the break room and wants to buy a Coke. Soda in the machine costs 50 cents, but it only takes quarters. Thirsty Bob asks if anyone has change and they all say no. Sam says he has only two quarters and will trade Thirsty Bob -- who is really thirsty -- two quarters for a dollar. Thirsty Bob quickly agrees to take Sam up one his offer in order to get the Coke now. Bob knows that two quarters for a dollar is a bad deal, but he is takes the deal anyway.

According to mark-to-market accounting, you, with your 20 dollar bills, now have a net worth of $10. Even though you are still holding the exact same 20 one dollar bills you held in your hand when you entered the room and even though you did not trade with anyone else in the room, the current public market in the room for $1 bills is 50 cents. If each of those $1 bills is worth two quarters, your net worth is only 40 quarters, or $10. You must evaluate your net worth based on the current market. You are smart enough to know that the one dollar bills are really worth four quarters at the bank down the road, but mark-to-market accounting will not allow you to use this "long term" evaluation method.

This, in essence, captures the problem of the current loans crisis. One dollar bills are the mortgages nobody is willing to buy. Banks must evaluate them at the depressed rates they occasionally trade at and everyone is feeling poorer.

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