One of the crazier regulations that must be changed before the economy will come out of recession is mark-to-market (m2m). What is it?  In its simplest form, it means that financial institutions (and others) must evaluate and reprice assets daily or monthly, based on what those assets are worth right now.  It’s like saying, hey, what can I get for this gold coin today?

Let’s talk about how mark-to-market works for a bank.  Banks loan money (well, they used to).  When they make a loan, the value of that loan becomes an asset on the bank’s books.  Say Big Bank loans you $100,000 to buy a new truck for your business.  Big Bank then has an asset that is worth a hundred grand on its books.  If you are credit worthy (meaning the bank thinks you’ll pay the loan back), Big Bank can sell your loan to Bigger Bank for what it’s worth today, less the time value of money (look it up — I’ll post on it later).  Assume that your loan is at 10% for 5 years.  At simple interest, you’ll pay $150,000 back.  So the bank might sell your loan for $130,000, figuring the $30,000 profit now is better than $50,000 profit in 5 years.

Well, the fly in the ointment is the economy.  If things go bad in the economy, you might get behind in your payments.  Does that mean you won’t pay off the loan?  Not necessarily.  How does a bank calculate how much of a risk you really are?  They can’t, really, predict any one firm’s failure.  But by having a large pool of loans, they can calculate the statistics of how much of their loan portfolio will go bad over the years.

Let’s get back to you and your $100,000 loan.  Let’s say there is a general downturn in the economy, and truck drivers are defaulting on their loans.  Let’s say that 20% of truck loans go bad.  Now, the bank and the accountants will try to guess how much your loan is worth today, based on statistics and SWAGs.  The key is, the bank and the accountants are supposed to reprice their assets regularly.  So let’s say next month they write down the value of your loan by 20%, or $20,000.  Remember in the earlier post when I talked about bad loans being subtracted from a bank’s capital?  Well, this “markdown” gets subtracted from capital, too.

The economy might be going through a rough patch, but let’s say you’re a conservative bidnez-man, and you have a couple of hundred grand in the bank, in cash, just in case you need it to pay off your loan.  Well, the bank is still going to mark the value of your loan down to what the market price is that day — regardless of your cash position or other factors.  Silly, right?  Well there are times when mark-to-market is a good thing (think crude oil, or gold, or corn).  But when you’re talking about a 5-year loan, especially on hard goods (those that last a long time), a lot of things can happen over that 5-year period that are bad for the economy in general, but that don’t necessarily affect your ability to pay back your note.

Think of your house and your 30-year mortgage.  The fact that your house loses $20,000 in value this year doesn’t really mean much to you if you plan on staying in it for 25 more years.  The ups and downs will average out.

But banks can’t take into consideration the fact that your loan is a long-term one, and that you have money in the back to cover it in case you get hit by your own truck.  They are required to mark that loan to market price.  So you see how this mark-to-market can wipe out a bank’s capital, even when all borrowers are paying their loans?  It’s madness to follow m-2-m in this type of situation.

Mark-to-market is causing banks to lose capital.  That’s one of the reasons banks aren’t loaning money.  If we let banks carry loans for full price, less the interest, why, we’d shore the banks up overnight and new loans would start flowing.  But as long as we have m2m around, banks won’t loan us any money.  They will be too busy writing down loans with one hand, and asking for more bailout money with the other.

There are a lot of times when m2m is sound policy.  Now is not one of them in the banking business.