Unpacking the asset values debate

The central issue over capital adequacy and risk exposure is about the controversy of asset values mark-to-model (the pricing of a specific investment position or portfolio based on internal assumptions or models) against mark-to-market (a measure of the fair value of accounts that can change over time). Mark-to-market is real measure, while mark-to-model has meaning only if the model reflects reality. Basel II was instituted because mark-to-model value was considered inoperative, devoid of reality. Thus mark-to-market value was required at the close of each trading day.

Yet mark-to-market is generally recognized as the detonator of the current credit crisis. Now, the Fed’s stress tests for banks have switched back to mark-to-model to calculate the capital adequacy of banks. But if mark-to-model was considered inadequate for informing investors on the true financial health of a holder of financial instruments and only mark-to-market is truly reliable and meaningful, then the bank stress tests by reverting to mark-to-model do not yield reliable information on the capital adequacy of the tested banks.

The differential between the two values in a market failure can be more than total for an asset to become “toxic” because of the interconnectedness of structured finance instruments. In other words, a bank exposed to counter-party default on one single credit instrument can affect the mark-to-market value of all other credit instruments in its possession and also those held by other institutions, even those that had no direct counter-party exposure.

The seemingly innocuous rise in default rate of the riskier unbundled tranches of an inverted credit pyramid can affect the credit ratings of the upper “safe” tranches and cause the whole credit superstructure to crumble.

The banking system in recent decades has morphed into an inherently risk-infested system, because of its precarious dependence on unimpaired counter-party credibility. The shadow banking system has deviously evaded the reserve requirements of the traditional, regulated banking regime and has promoted a chain-letter-like inverted pyramid scheme of escalating leverage, based in many cases on a non-existent reserve cushion. Example? The AIG collapse in 2008, caused by AIG’s insurance on financial derivatives known as credit default swaps (CDS).  AIG’s collapse illustrates a broader system failure.

Braintruster Henry C.K. Liu is an independent commentator on culture, economics and politics.