Monday, March 9, 2009

To Mark To Market?

Imagine that I'm in the business of selling a peanuts. The highest price the market (you, and any other peanut shopper) that is bidding is $500 per ton. Now, personally, I think a ton of peanuts is worth at least $3,000. If I apply for a loan, and the bank asks for collateral, if I use the mark to market rule, it'd mean that I'd have equivelent of $500 (which is the case if I was to liquidate/sell my peanuts). However, if I don't use Market To Market, I can claim the peanuts are really worth $3,000, and thus be able and borrow $3,000 instead of $500... or can I?

The question becomes, which story does the bank believe? If I was to default on the loan, the bank would have to liquidate/sell the collateral I gave them... and the most they'd get is $500.

Thus, at best, removing mark to market will not change the market's perception about the value of your assets. At worst, removing mark to market will remove transparency, which would only add to more uncertainty, and subsequent risk in the market place. It will be much harder to judge which banks have toxic assets and which don't. In the end, removal of mark to market doesn't change the underlying reality. What removal of mark to market does is far worse -- it gives banks permission to make up the value of their assets as they see fit.

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