Forbes.com - New Life

Thank you, sir, may I have another? As the stock market gets spanked,down 40% in a year and a day, there is a silver lining. We Americans get our lumps out the way, and start a new life. Much has been made of the "mark to market" rule and its role in the credit crisis, but it probably has saved us from 10-plus years of gloom and doom.

Mark to market just accelerated the inevitable, the write-down of bad loans.

Google the number 157 and the first result that comes up is the Financial Accounting Standards Board (FASB) statement on fair value measurements. It's way too boring to read, but what it says is that if a bank or investment bank has a security that trades at 62 cents on the dollar, you have to carry it on your books at 62 cents on the dollar. Pretty simple. You may think it's worth more--well, of course you do, or else you would have sold it, dummy--but the market says it's only worth 62 cents, so quit arguing.

The problem is that many markets, especially those for the now-toxic mortgage-backed securities and collateralized debt obligations (CDO), are thinly traded. This means, the argument goes, that they don't reflect true value. Devious evildoers can set the price wherever they want it. And since these securities are the collateral for short-term loans that the entire financial system is built on, they are subject to manipulation.

Like this: A hedge fund shorts a bank stock, then bids down the thinly traded value of an AAA-rated CDO, a collection of mortgages from, say, the second half of 2006, which is sitting on the books of said bank. Because of FASB 157, the bank has to "mark to market" at the lower price, write down the difference as a loss and raise more capital, and its stock goes down as previous shareholders get diluted. It's one of the reasons the Security and Exchange Commission halted shorting financial stocks, a Band-Aid on a bigger problem.

Well, boohoo! They shouldn't have owned these crappy securities in the first place. Mark to market just accelerated the inevitable, the write-down of bad loans. For the system as a whole, it is always better to take your lumps post-haste. Get it out of the way. Dow down 45%? So what? It was going to drop that much anyway, and one fell swoop beats the Chinese water torture--drip, drip, drip--of a decade of daily declines. And yes, even if it means losing a few companies.

For me, even a flawed market price is better than no market price at all. On paper, Wachovia  has a book value of $75 billion and is being bought by Wells Fargo  for maybe $15 billion. Not sure exactly what they're marking to.

To better understand a world without mark to market, go read Gillian Tett's 2003 book Saving the Sun. A quick summary: Japanese banks made all sorts of horrendous loans in the 1980s. Many, and maybe most, of the loans stopped paying interest after the Japanese bubble burst in 1990. Banks' balance sheets were stuffed with non-performing loans (NPL). Instead of writing them down, marking to market, they just sat there gathering dust on their books. The banks stayed in business, but stopped writing new loans, the result being Japan's Lost Decade. By the late 1990s, the Nikkei 225 index had basically dropped by half.

Anyway, one Japanese bank, Long-Term Credit Bank, finally collapsed in 1998. The Japanese government allowed an American buyout firm, Ripplewood, led by J.C. Flowers & Co., to come in, buy the bank, rename it Shinsei (or New Life) and write down as many NPLs as they could with the government taking the loss. This was around 2000. The bank started lending again and generating profits. So successful was this deal that Shinsei went public in 2004, clearing a $6 billion gain for Ripplewood.

It may have been catastrophic if, like Lehman Brothers  in 2008, Long-Term Credit Bank had failed in 1991, with reverberations throughout the Japanese financial system and probably the world. Their stock market may--would--have crashed, dropping, uh, 50%. But the government could have bought the bad loans, recapitalized the banks themselves and not lost the last 18 years of global growth to China.

So as hard awful as a Dow dropping like a safe onto Wall Street and Main Street is, cheer up. It's almost over. The gunk is getting cleared out. No pain, no gain.

By the way, as a not-quite-amusing epilogue to the Shinsei story: Like many other banks around the globe, it was buying subprime securities over the last few years. Late in 2007, J.C. Flowers had to put more money into the bank to shore up its finances. Maybe this time they will do the write-downs a little quicker. New Life, indeed.

Comments

[Paul Gunn]

So the government got stuck with the bill for the bad loans while Ripplewood made out like bandits? Sounds like pretty sweet deal at the taxpayers' expense. IMO this kind of behavior is part of the problem - not part of the solution. Sounds a little like the Bear Stearns deal actually..

[Matt Busigin]

Paul,

The government had a direct hand in causing it. Two key factors are at play here:

FNM and FRE we're able to raise far more cash and at far cheaper yields than they would have been able to without the implicit backing of the government (you can see this in the nearly 10% spread in yields between raising cash over the two months that failure appeared imminent).

Secondly, the glut of money the Federal Reserve (principally starting with Alan Greenspan in an attempt to inflate the USA to insulate the effects of the Asian financial crisis followed by the consequent dot-com bust) distorted yields so that they did not at all accurately price in risk. Enterprise, including banks, should be allowed to freely succeed and fail without posing system risk. Instead, their risk arbitrage programmes were subsidized this way to the extent that they posed massive risk with gross over-use of leverage. No subsidies would have meant risk arbitrage would have naturally limited itself as the cost to raise cash increased.

Finally, the actions of banks have lead the way to enrich the networth of the average American to a much greater extent than her individual share of the bail-out package in dramatic stock and housing values. The reason there is so much crying is that instead of saving the proceeds, she went out and bought a new Japanese car and Chinese big-screen TV.

[Swain]

Pardon the nitpicking but

"It may have been catastrophic if, like Lehman Brothers in 2008, Long-Term Credit Bank had failed in 1991, with reverberations throughout the Japanese financial system and probably the world. "

should be

"might have been"?

Otherwise, agree, better short and swift than long and protracted.

Swain

[PJens]

Isn't manipulating the market against the law? The practice of shorting a bank stock, then purposely biding down the CDO's to shrink asset value is not an honorable practice. People who do that violate the integrity of the markets.