Defending Market-Value Accounting
By Arnold Kling
Felix Salmon writes,
Krugman’s saying they’re all wrong, and that Bear Stearns, along with other financial institutions, actually has a negative book value. He’s not giving any reasons why he’s right and they’re wrong, he’s just asserting it. And so I’d ask him: what makes you so sure that these institutions are insolvent? Because if you’re not sure, it’s irresponsible, in the present environment, to start shouting such things from the virtual rooftop of nytimes.com.
I don’t like to talk about Krugman unless he is saying something halfway reasonable. And although I was put off by the snide tone of Krugman’s post that Salmon is talking about, I think that what Krugman was saying was more than half-way reasonable.
The Fed is treating the problems in financial markets as a liquidity crisis. What that means is that the assets that the institutions are holding, such as mortgage-backed securities, are really worth $X, but their current market value is, say, $X times 0.95, and no one will lend the institutions the money to enable them to carry those assets to maturity. If the Fed acts as lender of last resort, then eventually the Fed will get paid back out of the cash flows from those securities–more likely sooner, as investors regain their confidence.
That’s if the mortgage-backed securities are really worth $X. But if those securities are actually worth $X times 0.95, then the Fed will take a huge loss on behalf of its owners, the taxpayers.
[UPDATE: Felix Salmon, in his original post and in comments here, says that even on a mark-to-market basis the Fed should have good collateral. In effect, Salmon thinks that securities have to be marked-to-Krugman (their value under Krugman’s scenario of a housing market meltdown) for the Fed to lose money.]
Krugman thinks that housing market defaults are going to spread from the subprime segment of the mortgage market to the prime segment in a big way, so that mortgage-backed securities really are worth less than $X. I am less pessimistic than Paul in my outlook for home prices and mortgage defaults, but the probability that his forecast turns out to be approximately true is certainly greater than zero. So I don’t see how you can say he is irresponsible for speaking out, even if it turns out that his forecast is wrong.
But the title of this post isn’t “defending Paul Krugman.” I am seeing a lot of people argue that the investment banks should not have to mark down the value of their mortgage-backed securities to the market value of less than $X. But the alternative of historical-value accounting (what the assets were worth before the market turned sour on them) is worse.
To make a long story short, the reason that the U.S. taxpayers took such a big hit in the S&L crisis of the early 1980’s is that S&L’s claimed to be solvent using historical-value accounting, and so they kept borrowing more money even though they were actually insolvent. Market-value accounting provides better protection against insolvency.
I can think of a lot of arguments that mortgage-backed securities are being priced correctly. As I’ve said before, when a security contains embedded short options positions, an increase in volatility lowers value, and we have certainly seen an increase in uncertainty for home prices and interest rates.
The argument that we’re in a liquidity crisis is that there are lots of anomalies. If interest-rate volatility is being priced into MBS, why isn’t it being priced into long-term Treasuries? Why are tax-exempt bonds so cheap?
On balance, I like the case for a liquidity crisis better than I like the case that we’re in a solvency crisis. But raising questions of solvency is entirely fair. And going back to historical-value accounting commits you to the position that this is a liquidity crisis. It will certainly lead to the wrong outcome if it is a solvency crisis.