Sucker's Rally

The markets have been rallying. One huge reason for this is that under government pressure, the Financial Accounting Services Board just suspended "mark-to-market" accounting rules. Imagine you are running a bank. In a mark-to-market regime, say the bank owns an asset (or a liability)--how do you value it on your books? One obvious way is to look for similar assets, and see what they recently sold for. That's what you and I do when we look at "comps" before we buy or sell our houses.

What an asset is worth matters a lot to banks, because if their assets are too small relative to their liabilities, regulations may kick in and force them to raise money so that they are not undercapitalized. (This is, essentially, the issue of how much "leverage" an institution is allowed to have, which we've talked about before in email.) If they can't do it--say, investors no longer think they are worth pouring money into--then the bank could go under. The details don't matter: all you need to know is that if the bank isn't worth enough on their books, they are in big trouble, and might even have to declare bankruptcy if they can't raise enough cash to compensate for the losses.

One way to make it so that the banks don't have to recapitalize is to simply change the rules about how they value their assets. I mentioned the "mark-to-market" rule, but there are others. There's "mark-to-mark" which means, whatever I bought/sold this very asset/liability for is what I can claim it is worth. (That would be like Momcat, for instance, valuing the house we grew up in at its 1972 price.) No one uses mark-to-mark for pretty obvious reasons.

Another rule would be "mark-to-model," which says you figure out what something is worth by cogitating on it, and making a lot of assumptions, and using your "good" judgment (often with a computer model). Enron pioneered this method, and it is one of the things that got them into so much trouble. Nevertheless, many, many other companies followed their lead, because as idiotic as mark-to-model is, it wasn't illegal. This way of valuing assets effectively says to banks, "Your assets/liabilities are worth whatever you think they are worth!"

The use of mark-to-model is why, right now, we are on the brink of financial ruin: banks assumed that the trash on their books was worth far more than it was, because they assumed real estate only goes up, and people don't, en masse, default on their mortgages and credit cards and cars and student loans, etc. Finally, in 2007, mark-to-model was banned; suddenly, banks had to come clean. You have seen the ruin that followed.

And mark-to-model, friends, is what the government has just decided it should reintroduce. The market has gained massively on the news, because it has just been told that the doors to Fantasyland have been reopened. And when you stick your head in the sand, every day looks like a day at the beach!

Many people have ridiculed "mark-to-model" as "mark-to-myth" or "mark-to-make-believe." And mark-to-my-words: this is a sucker's rally. It cannot sustain. Maybe we squeeze a few more months of life out of the market. Maybe even a couple of years. But all we are doing is delaying the inevitable, and when the crash comes, it will be even worse than if we just admitted how many banks were insolvent, and nationalized those that are NOW.