Even the easy answers aren't easy

I am in favor of some form of government bailout, and I am also in favor of some major changes in the way that we regulate the banks.  But even simple, seemingly obvious changes are trickier than they look. 

Mark-to-market accounting, for example, was mandated by Sarbanes-Oxley.  The idea was that we wanted to keep companies from playing games with the securities they owned by forcing them to update the balance sheet at the end of the day with the new values. 

Seems obvious and good.  But mark-to-market was a major factor in the bank collapses.  When markets for various securities froze up, the book value of those securities was basically zero, even though many of those securities would eventually pay off.  That collapsed the value of balance sheets.  This not only panicked investors, but also threatened their credit rating.  For a bank, a credit downgrade is death.  They borrow a lot of money short term to smooth their cash flows.  Also, a lot of regulated entities have strict rules about the credit rating of the institutions they're allowed to lend to.  The result is a drying up of capital all out of proportion to the underlying financial condition of the institution.

Or take capital requirements.  I'm in favor of higher ones.  But a high capital requirement, perversely, hurts companies in a downturn.  This sounds bizarre.  But say you have a broker-dealer that is only allowed to leverage itself 5 to 1--a very, very safe capital ratio.  (12-to-1 is, IIRC, about standard). 

Now say that the bank suffers a major setback, like a bunch of totally illiquid mortgage backed security whose nominal value has dropped to near zero.  Having a lot of capital protects the creditors in bankruptcy, who now get 20 cents on the dollar instead of six.  But the firm still goes into bankruptcy, because they can't dip into their other capital to make good the debts.  Indeed, the higher their capital requirements, the more they have to deleverage in a crisis, because they need to unwind more positions to shore up the bad ones they can't sell.  That deleveraging dries up capital in other markets, decreases the value of whatever securities they're dumping, and thus threatens other institutions.

This is not a brief for doing nothing.  Only a caution that even things that sound simple and obvious are neither.

Presented by

Megan McArdle is a columnist at Bloomberg View and a former senior editor at The Atlantic. Her new book is The Up Side of Down.

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