Arnold Kling  

Leaning Against the Wind

Afternoon Commentary... What do Financial Intermediari...

Edmund L. Andrews writes,

As recently as last summer, the central bank’s entire vault of reserves — about $800 billion at the time — was in Treasury securities. By last week, the Fed’s holdings of unencumbered Treasuries had dwindled to just over $300 billion. Much of the rest of its assets were in the form of loans to banks and investment banks, which had pledged riskier securities as collateral.

Zachary Karabell writes,

A few years from now, there will be a magazine cover with someone we've never heard of who bought all of those mortgages and derivatives for next to nothing on the correct assumption that they were indeed worth quite a bit

The person who will be on that cover is someone we've all heard of, Ben Bernanke. As Andrews points out, Bernanke is selling treasuries to buy the assets that Karabell thinks are undervalued. Meanwhile, the market is falling all over itself to go in the opposite direction.

The best case scenario is that the U.S. government hedge fund makes a big profit for the taxpayers over the next few years. The worst case scenario is that house prices go into free fall and the taxpayers take a loss. But in that case, you could argue that the Fed's actions were at least countercyclical.

The accounting issue is a tough one. When the market prices are obviously right, then firms that refuse to mark to market so they can keep adding to their risk are a menace. The S&L crisis is the notorious example.

When market prices are obviously wrong, then mark-to-market is a bad thing. Karabell makes that point eloquently.

I think that market prices are more likely to be right than wrong, and it is particularly difficult to identify when they are obviously wrong. Even now, when I think the odds favor the Bernanke hedge fund making a profit, that's just my opinion. Others think that he is going to take a bath, perhaps an awful one. Ken Rogoff, in the piece I linked to yesterday, seems to be in that camp. So, I still think that, in an imperfect world, mark-to-market is the best choice.

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COMMENTS (5 to date)
shayne writes:

Karabell makes an interesting point - and offers a fairly good explanation - on the "mark-to-market" accounting regulation. But he seems to believe it is an inherently bad regulation. I'm with Dr. Kling on this one - I think it is "the way to go." It offers the market a far more realistic mechanism for valuing a potential investment.

The only thing "bad" about a regulation is if it is ignored or unenforced. In the current cases (Bear-Stearns, Lehman, AIG,, the major players either didn't realize, or blissfully ignored the costs-of-compliance. And I suspect the later is most often the case. Had these firms considered the ultimate cost-of-compliance, the letter and intent of the mark-to-market rule would have exerted a substantial incentive for these firms to avoid the risk and leverage positions they so blissfully assumed.

The Fed and the Treasury actions have every appearance of turning a very sound regulation into a "bad" regulation. In the first degree, anything vaguely resembling a bail out promotes the notion that there are no costs-of-compliance for this regulation. In the second degree, this no costs-of-compliance relief is granted exclusively to that group of perpetrators which can manage to qualify themselves as "too big to fail" - precisely that group whose members are at once the ones most able to understand the cost-of-compliance AND are depended on to do so, because of their size and reach.

In a nation of laws, any law or regulation that goes ignored or unenforced becomes a "bad" law. It becomes worse than "bad" when it is selectively enforced only in the cases of the underprivileged (NOT too-big-to-fail).

KipEsquire writes:

We're already seeing calls for the federal government to "play" the Strategic Petroleum Reserve, selling when oil is high and replenishing when prices are low (i.e., profiting). They might couch it in terms of "easing high prices for the benefit of struggling Americans," but it's really pure profiteering.

So why not do it with the Federal Reserve too, right?

Maniakes writes:

The Federal Reserve, as the institution which issues the currency, is the exception to the maxim that the market can remain irrational longer than you can remain solvent.

Less flippantly, caution is rational for everyone else because they're at risk of becoming insolvent if they bet too heavily on risky assets. But the Federal Reserve has infinitely deep pockets which they can use to ride out any fluctuations and reap the big long-term profits.

Gary Rogers writes:

My understanding of the mark-to-market rules is that it requires financial institutions to mark down securitized debt that is not really traded on the open market so there is no real market value and nobody can really evaluate it for its real content. In so doing, as soon as it is labeled "may contain sub-prime debt" it becomes toxic and needs to be marked down immediately, no matter whether the mortgages are in foreclosure or not. Add this to the reserve requirements that require the mark down to be replaced immediately with new capital and there is a feedback loop that can cause serious problems for the institution. If this is true, it is not good practice.

I would like to know more about the details of how this rule works and hope to see it discussed more in the next few weeks.

I also think the current buyers may end up looking great. If I could, I'd buy Fed stock right now. I did buy BofA yesterday (and caught a 12% run up today!) on the expectation that it'll discover some choice assets in Merrill and even Country Wide. I've also seen hedge funds ramping up in amazing speed recently to start buying up "toxic" assets.

With adversity, comes opportunity.

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