In time, I would like to see mark-to-market modified to impose a time test on swings in valuation.  This would avoid short-term price fluctuations and get to something that more closely approximates value.  Volatility is too high and imposes unrealistic capital requirements on banks.  Remember, the Chicago School is wrong.  Price does not equal value.  That is the lesson we learned from events like the collapse of AIG.

Sarbanes-Oxley regulation was the beginning of the mark-to-market problem.  Banks started marking down assets long before the bubble burst. 

The problem with mark-to-market accounting is simple – it was conceived by accountants.  If business people had looked at the problem, instead of letting the accountants define the solution, an entirely different regimen would have emerged.

Requiring disclosure of asset valuations is commendable, but this should not affect capital requirements in the way it does now.

No matter what rule is adopted, bankers and traders will game it. 

The market will take events into its own hands.  Citigroup’s situation must be resolved by the end of the first quarter.  If it is not, the market will drive events.  Inaction is not an option.

We must act now - when we are in control - not later, when we would be in reactive mode.

The bond holders of the big banks are highly politically organized, starting with foreign governments, central banks, and managers such as PIMCO.  With backing from foreign, supranational, and domestic stakeholders, the bond holders are very powerful.

On the other hand, the Treasury has a limited ability to provide cash to subsidize operating losses. 

It is what is: Selling assets for pennies on dollar gets rid of the problem.  Selling branches to stronger players makes the industry and the economy healthier.  The driver in terms of timing the resolution must be to manage the cash flow deficit of the troubled entities. 

The government should get good prices for Citigroup’s off-shore assets. Citigroup will come out the other side a lot smaller.  It will have a much smaller capital markets business, with no off-shore operations, and will look a lot like the Bank of America.

The concentration of assets in the industry will be evenly distributed.  Citigroup and Bank of America will be restructured and will emerge a half or a third of their current size. 

Likewise, Wells will sell the Wachovia assets like its branches in the northeast.  Depending on the capital that must be to put in to Wells/Wachovia, it may get broken up.  It is telling that Wells is not consolidating Wachovia with its existing operating units.

The next 10 banks — starting with U.S. Bancorp — will be larger.  That will be the shape of the industry.

Instead of one-third or forty percent of industry assets in the top 10 banks, these assets will be in the top 20 or 30 banks.

Reduced concentration means a healthier system, with less overall risk.  The Congress should take steps to ensure that depositories are not allowed to grow to the size of Citigroup, the Bank of America and J.P. Morgan.  There are no economies of scale in true banking, but, thankfully, even these large derivatives casinos are not really comparable to community banks.  That is the key point to make about Citigroup, UBS, Lehman, and Merrill: all were toxic waste dumps of illiquid securities and derivatives.

I am almost ready to tell people to buy smaller bank stocks, but I am holding my breath to see if the stimulus works and where loss rates peak.  Meanwhile, I am short Treasury bonds.  Pick strong banks and watch them going into Q2.