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What Are Mark-to-Market Rules?

Question: What are mark-to-market rules? And should they be changed?

Paul Solman: When it comes to the current crisis, this is the question (or one major question): To "mark to market" or not to "mark to market"?

Consider a bank. A bank's assets are its loans. Loans are what it makes money from. If the loans are no longer worth as much as the bank invested in making them, the shortfall will eat into the bank's OWN money, its capital. If the loans are worth less than that, so the capital cushion can't even cover the loss, then the bank is torn, ruptured: bankrupt.

So a key question is: what are the loans worth?

"What are they worth?" harrumphs the hardliner. "They're worth what they'll bring on the open market!" Like anything else, they're worth exactly as much as people are willing to pay for them. So if they aren't worth what they were when made, the owner should MARK down their value TO the MARKET price. "Mark to market!"

"But that's crazy!" says the beleaguered banker. "Prices are unrealistically low at the moment. This is a once-in-a-lifetime fire sale. To mark to market would unfairly put us under."

"But that's what got us INTO this mess," sputters the hardliner.

"Think about Enron. It had long-term oil and gas contracts. It valued them as it wished: 'mark to MODEL,' it was called, since the company used its own computer model to come up with the valuation. But it turned out the model was giving ridiculously high prices to the contracts. When that proved true, the company went kaput -- in a heartbeat (its last)."

"Well, perhaps," mutters the banker. (He's trying to keep his voice and profile low these days.) "But Enron argued that mark-to-market rules unfairly devalued its assets in the short-term and caused the company's collapse."

"But you can't allow these crooks wiggle room!" bellows the hardliner, veins protruding at this point. "Without regulation, they'll rig their models into fantasyland. The phrase you began to hear in the wake of Enron, quite legitimately, was 'mark to MYTH.'"

"Well, maybe," whispers the banker. "But remember the banks in the 1980s. They'd made loans to countries like Brazil and Mexico, which couldn't pay back. Had those loans been marked to market, the banks would have gone under. The banks argued that Brazil and Mexico WOULD recover. And they DID. Meanwhile, the regulators were in deliberate denial, and they gave the banks time to let recovery happen and restore the market value of the loans."

Back to me now, in my own voice. The whispering banker has a point. In 1983, I interviewed then-Fed chairman Paul Volcker for a PBS documentary on the issue of bank solvency calmly titled, "Banking at the Brink: A Doomsday Scenario." I asked him, on camera, what would happen if Mexico were to default. He looked at me dismissively.

"That question is not posed," he pronounced (even though I'd just posed it). Willful denial. Wise denial? You be the judge.

-- Posted March 11, 2009 | Comments ( ) | Permalink