Is cash flow bank analysis better than mark-to-market accounting?
Taxpayers and banks being bailed out would both be better off if the government were to buy bank assets at "net realizable value." This would be based on an evaluation of an asset’s current cash flow, discounted by expected credit losses over time.
Accounting rules relating to assets, including mortgage-backed securities, require that they be marked-to-market if held for trading, or held "available for sale." Most banks hold such assets in one of these two accounts, Thus mark-to-market rules apply.
But what happens when there is no real genuine market for these assets? The banks first find the net realizable value for the portfolio. That is, what the value of the cash flow would bring in a fully functioning market. That would include discounts for factors such as anticipated future losses. Many of the banks' most troubled assets are flowing cash near expected rates, and therefore their net realizable values are higher than the values which have been written down.
After establishing a net realizable value, the banks mark the assets to market. Thus write-downs happen.
Because there are few buyers, market value are heavily reduced. Potential buyers have no assurance they will be able to resell the assets. Therefore, mark-to-market rules make banks discount their assets' values. and produce write-downs that impair capital.
If the government bought assets at their net realizable values, and not marked-down values, the capital positions of the major banks would improve.
The taxpayer could not be hurt. Because cash flows will determine value, the government should be able to sell such assets in the future at about what it paid.
In short: Much of the banking problems we have had, could have been avoided with clearer thinking by the regulatory experts we have been depending upon. A lesson to remember when we allow Washington to fix all our financial ills. They could have been self-corrected by marketplace principles.
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