Thursday, April 2, 2009


Suppose I asked you how you think a business should value its inventory, say widgets? Should it accord widgets on hand a fair market value, i.e., a value that the business could realize if it sold the widgets today? Or should it give a value that the business thinks it could realize from selling the widgets, not today, but a year from now?

Is there anyone who would not say, value the widgets at their fair market value today? Who knows if the business would even be able to sell the widgets in another year?

This is called "fair value" accounting, or "mark to the market."

It is just the same with banks that make mortgage loans. Some of these banks having made these loans now find that there is reasonable doubt whether a certain percentage of them will continue to make monthly payments. In other words, there is reason to believe that a percentage of the borrowers will default, walk away, suffer foreclosure.

Banks want to value the mortgages at full stated value, as if every homeowner were going to pay on time, and as if there were not going to be lots of foreclosures, especially in the sub-prime mortgages the bank granted. Take one mortgage loan initially made for $200,000. Suppose this were a "toxic" loan, meaning there is a good statistical chance that the borrower is going to default and go into foreclosure. If the bank tries to sell this mortgage loan to another bank, how much do you think the other bank would pay? $200,000? $100,000? $50,000? $20,000?

Maybe $20,000 is all the other bank would pay. So FASB (accounting standard board) required the bank to value its receivable at only $20,000. But banks hate this. They claim it is unfair to them and causes their required capital to vanish and disappear. They also say that if they are forced to "mark to the market," i.e., value the loans for what they are worth today, they are in danger of going out of business.

So today FASB at the pressure of many in Congress who have no idea of accounting standards retracted the mandatory rule of "mark to the market." Banks now can value these toxic assets at any number they wish.

Who then knows what a bank stock is worth? If banks can get away with hiding the true value of their assets, why should anyone buy a bank stock?

Warning! Be careful in dealing with banks that applaud this obfuscation and lack of transparency. If they want to hide this stuff, what else are they concealing?

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