You are an advocate of mark-to-market accounting. Opponents argue mark-to-market forces institutions to use artificial and false values for their assets, and it has abetted the practices of short sellers who forced institutions to mark down asset values. What is your defense of mark-to-market?
In a normal market environments, observed market prices can be assumed to be the same as the intrinsic values of financial instruments, so marking-to-market is appropriate in this regard. In stressed environments, however, fire sale market prices may not reflect intrinsic values, which should be addressed via regulation that accounts for such systemic effects. In times of crisis, financial institutions should be required to mark their holdings to “fair” prices determined in some objectively defined ways. Such a solution is dramatically better than abandoning mark-to-market altogether and going back to accounting standards that tends to obscure the risks taken by financial institutions. Financial Darwinism argues that accounting earnings, standard financial disclosures and credit ratings – all of which are not grounded in modern risk management – have exacerbated the leverage and risk taking in the years preceding this crisis.
What is your forecast for how long the de-leveraging process described in your book will last, and what impact this will have on future market performance?
This remains highly uncertain. The path of the financial crisis from here depends on the macroeconomic environment first and foremost, on how long and deep the worldwide slowdown or recession will be. Secondly, it depends on how successful government intervention will be in breaking the vicious circle of deleveraging described in Financial Darwinism.
In that vein, I believe the abandonment of the original purpose of the TARP (buying “toxic” assets from institutions) will be very detrimental. This was the only direct measure that could have brought fire sale prices closer to intrinsic values, and stemmed the de-leveraging process and further write downs. Abandoning this is likely to make the crisis longer and deeper.
In normal times, injecting the capital from the TARP program directly into banks would certainly help the lending environment. But when banks are uncertain how deep the crisis there will be, they won’t lend, exacerbating the impact on the real economy. Some may use the TARP funds for mergers and acquisitions, while others may sit on it as an insurance policy against future losses – with both outcomes defeating the purpose of the bailout.
The nature and extent of government actions during financial crises, the role of systemic regulation, and the future of capitalism, free markets, and globalization – are the topics that are bound to dominate the public debate for years to come. By providing a new evolutionary explanation and a new decision-making paradigm, Financial Darwinism hopes to help shape this debate.
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