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If you haven’t been able to make heads or tails of the credit crisis, read this.

Thursday, March 12, 2009 is the day the House Securities Subcommittee will hold a hearing on mark-to-market.  The chairman of the committee, Paul Kanjorski (from Pennsylvania) seems to agree with usmark to market standards have proven “problematic” for banks.

Mark to market (also known as fair value rules) has been only one of the contributing factors in the recent credit crunch.

Many mortgage and bond-related assets, many of which had been AAA rated previously, have been experiencing a mandatory write down in value, because of these accounting rules.  Many of these assets needed to be “re-priced” nearly every day.  This is how Citibank could lose $28 billion in the last quarter.  Think about that number.  A quarter is only 90 days long — and not all of them are business days.  And yet, for a bank (or any business) to lose $28 billion is hard to conceive.  That’s over $300 million lost on a daily basis during the quarter.

How can that be?

Mark to market accounting rules required that banks write down the value of assets on their books — nearly every day.  Even though these assets were not bought and sold (they couldn’t be sold — the trading market for asset backed securities has been frozen for nearly a year), they still needed to be marked down.

What I expect we will hear from these hearings on Thursday is something along the lines of “there should be an exemption from a need to repriced these assets on a daily basis since there is no liquid market for these securities presently.”  I also expect we will hear a proposal to improve the situation these banks are facing.  It would not be a big surprise to hear testimony proposing “mark to the model” instead of “mark to market.”

Mark To A Model

Mark-to-a-model” is a proposal that has been gaining speed.  Many have argued it is not realistic to carry these securities at the full face value of the underlying security, nor is it realistic to carry these securities at zero value either (like now).  What might be a better — temporary — solution is a financial “model” that can gauge the average holding period of the securities, the average duration of the portfolio and a model of the credit composition of the portfolio.  At least with a model, minimal (floor) values can be placed on the securities.

What would be the result of a change in mark-to-market, or instituting mark-to-a-model?

The first benefit would be a drastic increase in the book value in market value of the securities on hand at banks.  No one is trying to game the system.  By re-inflating the value of many securities on hand at banks, this will automatically raise the capital ratios at these banks.

So what?

Raising the capital ratios at these banks removes the need for bailout money.

You may have read recently that banks are “hoarding cash.”

Why would the banks hoard cash — especially when lending is needed to restart the economy?

Well, the banks have been required to maintain certain capital ratios, or be declared insolvent and run the risk of being taken over by the government, or closed.  So, although the banks have received capital injections, with the purpose of lending, the same banks have been “hamstrung” because they need to maintain a certain amount of cash on their books to meet capital ratios.

These capital ratios will be met if they suspend mark to market accounting, at least on a temporary basis.

It may also help to re-ignite trading in these asset backed securities.  This helps improve liquidity and lending capabilities.  Put another way, you cannot borrow against securities that don’t have a liquid market and do not trade.  While the “marginability” of these securities is severely hampered, just re-establishing a market for these securities is a step in the right direction.

Let’s hope they don’t screw it up.

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