Want to see a 25% jump in the stock markets?

Who doesn’t, right?

As you can imagine, we are often asked these days what is going on and why:

Why are the markets going down?

Why aren’t the banks lending?

When will the markets start going back up again?

We believe there is one issue that has had a major impact on the drop in the market, but it could also have a significant, and immediate, impact on the recovery as well.

Mark to Market Accounting.

It can be argued that Mark to Market has had a tremendously negative impact on the problems banks are having, the clogging of credit markets, and the precipitous drop of the stock markets over the past 12 months, but most notably the past 5 months.

A little more than two years ago, lawmakers in Washington passed into law Mark to Market accounting in response to the Enron debacle.  Enron had inflated its asset prices, essentially making up and assigning values to assets that were nowhere near what some one, or some other entity, would pay for them.  This was one of the many reasons that led to the decline (and eventual failure) of Enron.  In a desire to provide transparency, the law mandated that companies and banks list their assets according to its “fair market value,” or what someone else would actually pay for the asset.

Mark to Market accounting did not cause the financial mess that the banking system is dealing with.  And in the grand scheme, the idea of marking assets to where a willing seller will sell the asset and where a willing buyer will buy the asset intersect, is a good strategy.  The hope is to limit companies from inflating balance sheets and cheating investors and the public.  However, mark to market accounting has inadvertently caused the credit markets to freeze and lead to an expeditious decline in the stock market.

Consider this:  Asset A was originally purchased for $1.00.  We therefore know that this is the value of Asset A.  But now, because of a variety of factors, Asset A is now considered a “toxic asset.”  (What makes it toxic is irrelevant for this discussion.)  We know that it is listed as a bank’s asset, but it is now effectively worth $0 because no one will purchase it from the bank, no matter how nice the brochure is.  Many large banks in the United States and around the world have large quantities of these toxic assets, so with no one willing to buy them, these banks have had to undergo “massive writedowns.”  In essence, they have had to report a large decline in asset value solely based upon the fact that no one wants to buy it.

OK.  But why are banks not lending?  Don’t they have all kinds of cash and “bailout” money?

Banks are required by regulation (law) that they need to have a specific amount of reserves to cover their obligations.  The amount of reserves that are required are based upon the assets and liabilities of the institution.  As asset values fall, more capital is required.  Because the “toxic” assets continue to lose value, banks that have these assets on their books continue to need more capital, so many continue to go back to the government asking for the cash needed to meet these reserve requirements. (I have contemplated commenting about how if there were requirements like this for individuals, we would likely not be in this mess, but I’ll refrain.)

Banks do have quite a bit of cash, and yes, they are hoarding it.  Why?  Because their assets are artificially dropping in value due to the fact that their actual prices are not being allowed to be determined by buyers and sellers.  (If you put your house on the market, do you want to list it for what you believe it is worth or what the government tells you it is worth?)

Are banks not lending because they want hoards of cash?  No, banks are not lending because of the law.  The more a bank lends, the more assets and/or cash is required by law to support the liabilities associated with the loans.

Consider Asset A from our earlier example.  It is likely that it is no longer “worth” $1.oo.  However, it is more likely that it is not worth $0.00.  We believe that if banks were given the option to set their own prices, say at $0.50, the market would be allowed to work again with buyers and sellers agreeing to values and accurately setting prices.  This would provide a much needed boost of cash flow into banks.  It would stop asset prices from dropping, which in turn would halt the need for banks to continue asking the federal government for more cash.  And finally, it would open the “frozen” credit markets and allow banks to start lending again.

Contrary to what the media and many politicians would lead you to believe, banks want to lend money.  This is how they make money.  But because of the current circumstances, they can not.

We don’t know if it would be best to eliminate Mark to Market accounting for good, but it makes a lot of sense to at least suspend it for the remainder of 2009 to get the markets (stocks, bonds, business, and credit) moving again.  We don’t know if the stock market would immediately jump 25%, but the suspension of Mark to Market would have an immediate, dramatic and, ultimately, positive effect on the financial system.

Admittedly, this is a fairly basic explanation of a very complex subject.  However, if our politicians want to “grab a saw and just start cuttin’” (see: Everybody Grab a Saw! ), this would be one option to try - and it doesn’t cost the taxpayer very much, if anything at all.

To your success!

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