Arnold Kling  

Defending Market-Value Accounting

The Medium and The Message... The Coase Theorem and Divorce;...

Felix Salmon writes,

Krugman's saying they're all wrong, and that Bear Stearns, along with other financial institutions, actually has a negative book value. He's not giving any reasons why he's right and they're wrong, he's just asserting it. And so I'd ask him: what makes you so sure that these institutions are insolvent? Because if you're not sure, it's irresponsible, in the present environment, to start shouting such things from the virtual rooftop of

I don't like to talk about Krugman unless he is saying something halfway reasonable. And although I was put off by the snide tone of Krugman's post that Salmon is talking about, I think that what Krugman was saying was more than half-way reasonable.

The Fed is treating the problems in financial markets as a liquidity crisis. What that means is that the assets that the institutions are holding, such as mortgage-backed securities, are really worth $X, but their current market value is, say, $X times 0.95, and no one will lend the institutions the money to enable them to carry those assets to maturity. If the Fed acts as lender of last resort, then eventually the Fed will get paid back out of the cash flows from those securities--more likely sooner, as investors regain their confidence.

That's if the mortgage-backed securities are really worth $X. But if those securities are actually worth $X times 0.95, then the Fed will take a huge loss on behalf of its owners, the taxpayers.

[UPDATE: Felix Salmon, in his original post and in comments here, says that even on a mark-to-market basis the Fed should have good collateral. In effect, Salmon thinks that securities have to be marked-to-Krugman (their value under Krugman's scenario of a housing market meltdown) for the Fed to lose money.]

Krugman thinks that housing market defaults are going to spread from the subprime segment of the mortgage market to the prime segment in a big way, so that mortgage-backed securities really are worth less than $X. I am less pessimistic than Paul in my outlook for home prices and mortgage defaults, but the probability that his forecast turns out to be approximately true is certainly greater than zero. So I don't see how you can say he is irresponsible for speaking out, even if it turns out that his forecast is wrong.

But the title of this post isn't "defending Paul Krugman." I am seeing a lot of people argue that the investment banks should not have to mark down the value of their mortgage-backed securities to the market value of less than $X. But the alternative of historical-value accounting (what the assets were worth before the market turned sour on them) is worse.

To make a long story short, the reason that the U.S. taxpayers took such a big hit in the S&L crisis of the early 1980's is that S&L's claimed to be solvent using historical-value accounting, and so they kept borrowing more money even though they were actually insolvent. Market-value accounting provides better protection against insolvency.

I can think of a lot of arguments that mortgage-backed securities are being priced correctly. As I've said before, when a security contains embedded short options positions, an increase in volatility lowers value, and we have certainly seen an increase in uncertainty for home prices and interest rates.

The argument that we're in a liquidity crisis is that there are lots of anomalies. If interest-rate volatility is being priced into MBS, why isn't it being priced into long-term Treasuries? Why are tax-exempt bonds so cheap?

On balance, I like the case for a liquidity crisis better than I like the case that we're in a solvency crisis. But raising questions of solvency is entirely fair. And going back to historical-value accounting commits you to the position that this is a liquidity crisis. It will certainly lead to the wrong outcome if it is a solvency crisis.

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COMMENTS (7 to date)
Bill Stepp writes:

Krugman will write a "first generation" paper on the subprime bear market/Fed "rescue"/market recovery (latter still in the future). Second and third generation papers will follow in a few years from other authors.

In fifteen years Krugman will give a talk at the next Google and announce that he invented the field of subprime mortgage crises. No one in the audience, composed of non-economists, will call him on it. His balloon will continue to float and never land.

Edgardo writes:

You make the mistake of distinguishing between liquidity and solvency as if they were clear cut concepts that could be applied easily. Your attempt to distinguish between them ("But if those securities are actually worth $X times 0.95...") makes clear how irrelevant they are. What do you mean by "actually"? If you refer to the "actually" observed price of securities tomorrow or at any time in the future, I hope you agree that it's irrelevant. What matters is the expected price of securities today over the relevant period of time. This poses a problem of expectations--either decision-makers expect prices to remain lower than $X for most of that period, or they expect prices to recover soon enough to justify buying and holding them. So it is not a question of what case you like but of what decision-makers expect about the speed at which prices will recover. Unfortunately this question has no simple answer (and therefore the distinction between liquidity and solvency is irrelevant).

You're right about historical-value accounting but we all know that it is used by debtors to support their bargaining positions.

Marcus writes:


I'd like to get your opinion on the role inflation plays in this. Inflation certainly has its own costs but can't the Fed devalue the dollar to the point that home prices are 'solvent' relative to the loans against them?

Home prices will still drop relative to other goods of course, no escaping that, and bond holders take a big hit in real yields but perhaps defaults would slow.

Of course, inflation has its own problems. It spreads the costs across everybody and presents serious problems for bond holders.

Still, maybe the idea is that the Fed just has to bide time for inflation to do its 'magic' and deal with its consequences later.

Just a thought.

James A. Donald writes:

You say:

On balance, I like the case for a liquidity crisis better than I like the case that we're in a solvency crisis.

Check your 2006 spam folder: It is full of ads saying
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It is a solvency crisis. A stupendous number of bad loans were made and then resold to suckers. These loans are not going to be repaid. The Fed is going to find itself owning vast amounts of real estate.

Felix writes:

Arnold, if the current market value is 0.95X, then that's where the banks are marking the bonds to. The banks and the Fed are NOT treating any bonds as being worth X if they're trading at less than X. So if the securities are "actually worth" what the market says they're worth, then, contra your assertion, the Fed will NOT take a huge loss; in fact it won't take any loss at all.

eccdogg writes:

Felix I think it is more complicated than that.

In illiquid markets thier will often be a price to mark to, but try to sell all of your position at that price and you will find that there is no way you can do it.

If the Fed allows a borrower to use a market price based on a thinly traded market to set the amount of collateral on a large amount of assets the fed is exposed if that borrower defaults because they may find that if they try to unload such a large position they will not be able to sell anywhere near that price.

The repo market obvioulsly knows this, because they will not allow banks to borrow against assets at nearly as attractive terms as the Fed does. That after all is why the banks are going to the Fed in the first place. The fed is essentially pricing risk lower than the market.

If the fed is right (or just lucky) everything will be fine. If the market is right the fed (and the taxpayer) are taking a lot of risk that the market would never bear.

Felix writes:

We all agree that if the Fed's collateral is worth a lot less than the marks, the Fed could potentially lose money. And yes, if you try to dump a lot of illiquid securities on the market, you're not going to get the kind of prices you marked to.

But I was objecting to Arnold's statement that if securities are "actually" worth what their market value is, then the Fed would be in trouble. That's simply false.

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