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Tuesday, January 20, 2009

A modest proposal or Why still Mark-to-Market????

I know I am not alone here, but since we are still in the grips of a credit crunch and economic downturn, I would like to make a proposal (or at least a post hock observation).

First a recap...

Way back in 2007, we began to have a freeze in the subprime mortgage markets and some writers began to foretell the economic turmoil that could ensue. (See -The Panic of 2007 - No Buyers at any Price) Since then, we have discovered that many Alt-A and subprime loan portfolios have much higher potential default rates on mortgages than at first expected, coupled with a realization that Moody's and S&P did a collective hatchet job in rating many mortgage backed securities, not just Alt-A and subprime. These deficiencies have lead quickly to a wholesale run on the overall mortgage backed securities ("MBS") market. Unfortunately for everyone, due to existing GAAP and mark-to-market requirements, our public institutions have been required to severely devalue balance sheets during the market freeze which has lead to a massive credit crunch, has left our venerable financial institutions either in ruins or gasping for air and threatens to crash the overall bricks and mortar economy.

So......what could or can we do about it?

Well, we could inject billions of dollars directly into financial institutions in order to re inflate balance sheets and make up for the massive write downs in securities portfolios due to the market freeze (See - TARP) and hope that financial institutions will go back to normal policy and not horde the injections in fear of further write downs due to continued market declines. ***this is apparently where we are


We could recognize that real economic fundamentals are better than the markets are crediting, due to the widespread loss of confidence in rating agencies' scores as an effective measure of MBS safety. Meanwhile, mortgage defaults are still only about 3% and even those still have significant asset coverage, thus leading to sometimes staggering disconnects between market values and "intrinsic value" of many MBS. However, this disconnect creates some interesting options.

One, instead of replacing the lost balance sheet value with US government capital (see - TARP), the SEC and FASB could simply require companies to value portfolio at "expected realizable value" thus allowing them to adjust for short term market irregularities, so long as a given asset is not expected to be sold in that time frame. (See - Suspend Mark-to-Market Now, Gingrich 2008)

Second, the US government could create a "FDIC-like" insurance for the underlying obligations (ie - individual mortgages; See - Governmental "PMI") on selected classes of perceived at-risk MBS, whereby bond holders (or trustees) could petition the insurance for uncovered losses on defaulted mortgages. This should cure the default risk problems caused by the ratings agency malfunctions and thus re inflate the overall security values, while minimizing actual governmental capital outlays to situations of actual loss.

Humbly offered....

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