So I’m loathe to argue with Warren Buffet on financial matters. His wealth being the result of a keen understanding of reality, which is what this blog is about. But if I correctly understand what he is campaigning for concerning the mark-to-market rule, I think he is nearly right.
So the whole issue with the mark-to-market rule and banks begins with how banks are regulated: Banks are required to have a certain amount of assets for each dollar worth of loans they make. So for example if the bank has $1 million in assets (cash, stock, real estate, what have you), they can make only so many dollars in loans. If they want to make more loans, they have to increase their assets. If they reduce the amount of assets they have, they also have to reduce the amount of their loans.
Mark-to-market is a new accounting rule that says this: That $1 million in assets? It is what those assets are worth now, not what you paid for them.
Warren Buffet is arguing that although mark-to-market is a fine rule for the financial statements, it should not be used to kick in regulatory requirements. In other words, if your $1 million in assets drops in value to $750K, by all means report the loss in value on your annual report. But don’t let the bank be required to generate $250K in new assets all on a moment’s notice, because chances are the dip in market value is going to come back up before you know it, and everything will be fine.
I think he’s mostly right here. You can’t run any operation living and dying on the blippiness of changing market values. But, if [if – note the if] Buffet is arguing that the bank can go on as if nothing happened while waiting for a rebound, I think that’s not quite right.
Here’s a similar example that is more concrete, to help you see what I’m saying:
Suppose you bought a house for $200K, and you paid for it cash. [Try not to laugh. We’re pretending.] You own it outright, no mortgage, it’s all yours.
So then you go to the bank, and based on the value of this house, you get a $200K home equity loan. A loan that is secured by your house. If you don’t pay back your loan, the bank gets your house.
Now imagine that the housing market tumbles [I see you aren’t laughing now], and your house is only worth about $100K. We can’t be entirely sure of its market value, since you aren’t trying to sell it, but that’s a reasonable estimate of what you could get if you had to sell the thing right now.
–> Which means you now have a $200K loan, secured by a house worth only $100K.
What should the bank do? Should they require you to quick pony up another $100K in assets or else declare you bankrupt? Or should they continue to act as if your home is still worth $200K, and let you borrow freely based on that value? After all, sooner or later the market will probably turn around and your home’s value will go back up again.
They should do neither. Declaring you bankrupt is nonsense. Chances are you are just going to pay off your home equity loan as previously planned, your house was only really there as insurance in case something happened. –> This is the argument against regulatory mark-to-market. Forcing the banks to behave like they are bankrupt when really they are not is causing all kinds of financial havoc. Not good for the economy, the bank, or anyone, anymore than suddenly calling in that $200k home equity loan would make sense in our example.
BUT, you can’t ignore reality. Your house just dropped in value big time. Who knows why. Maybe it’s a cyclical downturn or the result of some temporary panic, and everything will be back to normal before you know it. Or maybe you paid way way too much for the thing, and if your banker had taken one look at it you’d never have gotten that loan. Or something else — an earthquake just opened a huge sinkhole in your driveway, gangsters are building a compound next door, who knows.
–> All kinds of things can affect the value of a house, or any other asset; some of them are real changes, others are just the vagaries of the market. Some will be easily rectified, others will cause a permanent loss in value.
What should the bank do? Let you pay down your line of credit. At a normal manageable rate. And once your outstanding debt matches the current value of your house, all is good again. Doesn’t really matter, from a regulatory perspective, whether it is because your home’s value rebounds or because you reduce your overall loan. The important thing is that your financial situation reflects reality.
This is where our banks need to be with mark-to-market. Use mark-to-market as a tool to guide what the bank ought to do next. When assets drop too low, no need to declare bankruptcy, but it is time to put the brakes on future lending until the situation balances out again.
Warren Buffet is absolutely right, it is unreasonable and imprudent to ask banks to magically conjure up new assets out of thin air whenever the market takes one of its habitual dives. He knows very well that usually things turn around, usually it will work out in the end if you just sit tight.
But at the same a time, you can’t use ‘it’s just a little downturn’ as an excuse to allow a bank to be in way over its head, continuing to make loans based on what used to be true, but is no longer.
–> If you put together a reasonable mechanism for adjusting to changes in asset values, if the situation really is a temporary market downturn, quickly enough it’ll sort itself out, and you can go back to lending-as-usual. But if it turns out that your assets really do have permanent loss in value, you have begun to make the necessary changes to get your financial situation back in balance.
This, by the way, is a gratuitous econ post. A little lenten penance for you. We’re still on schedule for my hopeless review of Church and State in the Middle Ages come Friday. Or the day that will be called Friday for blogging purposes, regardless of what the so-called ‘calendar-value’ of that day appears to be.