Shaken insurance giant AIG has argued that fair value accounting is what got the world into this financial crisis. This debate is flaring up once again as it becomes ever more apparent that many of the world's largest banks would be insolvent if they priced their securities at "fair" market prices.

Recently, Goldman Sachs CEO Lloyd Blankfein, wrote in an editorial to the Financial Times: "For Goldman Sachs, the daily marking of positions to current market prices was a key contributor to our decision to reduce risk relatively early in markets and in instruments that were deteriorating. This process can be difficult, and sometimes painful, but I believe it is a discipline that should define financial institutions."

To be fair, Goldman Sachs has managed this crisis better than most. However, the day after his editorial was published, Blankfein testified in Congress that Goldman uses models to value its assets based on future expected cash flows. Said differently, even one of the more prudent financial firms continues to use models based on subjective inputs to value their securities. Granted, some assets may be difficult to value, but for many of the securities it has come to the point where no one even wants to trade them for fear that they and others would need to price them down significantly, to match the price any rational buyer would be willing to pay.

AIG (which has long advocated abolishing fair value accounting) comes from an insurance culture. Insurance companies are used to model based valuations, such as calculating the life expectancy for life insurances; or the probability of natural disasters striking an area where policies were written that need to pay when disaster strikes. In the insurance world, insurance companies don't pay into an escrow account if the beneficiary of a life insurance and the policyholder fall gravely ill. But that's mostly because the risks are well quantified and insurance firms are typically sufficiently capitalized. When it comes to derivatives, however, a new world of opportunity and risk opens up. "Insurance" can be written on third parties. Joe can agree to pay Mary if General Electric (GE) fails. GE doesn't know about the contract; indeed, a corporate event, such as a re-organization or a takeover, may trigger payment, depending on how the agreement is structured. For years, writing "policies" on credit defaults (commonly known as credit default swaps) was an immensely profitable business, as firms would collect premiums on, say, the likelihood that GE is going to default on its obligations. Impossible, right? Well, not anymore according to the present default swap spread on GE.

It is now clear that the market had it wrong. Whilst the likelihood of GE defaulting was low two or three years ago, firms such as AIG should nevertheless have allocated adequate reserves to cover such a situation transpiring. Incidentally, White House Press Secretary Robert Gibbs ridiculed CNBC's Rick Santelli as he called for a "Chicago Tea Party" protesting government policies. In the process the Press Secretary tried to discredit the traders at the Chicago Board of Trade (CBOT), grouping them with those bankers that are to blame for the mess we are in. To be sure, there is a lot of blame to go around - from bankers to policy makers to consumers, to name a few. However, Mr Press Secretary: if all derivatives were traded on a regulated exchange such as the CBOT, we wouldn't be in this mess.

Here's why: derivatives at the CBOT are marked to market every single day. For any position taken, a deposit (margin requirement) is made. If the position shows a loss for the day, a margin call is issued and the trader has to supply additional funds. Conversely, he or she receives funds if there is a gain for the day. When volatility rises, the margin requirements tend to be increased. There is a good reason why margin requirements are low. Traditionally, derivatives were set up to hedge against risks, say hedge your corn production against a decline in corn prices between planting the seeds and the crop. If hedging becomes too expensive as margin requirements are raised, farmers don't hedge their production anymore, leading to overall lower output and potential supply disruptions. But the producers require that speculators be on the other side of the trade. Without speculators, the producers don't have anyone to hedge their production with. Please note: this is not supposed to be an encouragement to start trading derivatives, but to highlight some of their attributes and mechanisms.

If a trader cannot meet a margin call, the broker will close the position - the "grace period" may be a few days at most; in a volatile market, the grace period may be as little as a few hours. The counterparty risk is virtually eliminated as the exchange guarantees the functioning of the markets. Let's take a situation where, say, the price of oil rises to over $140 a barrel before plunging to less than $40. On a regulated exchange, the speculator who shorted oil when it soared above $100 would have ultimately been proven right, but likely was out of money and had the position closed. In comparison, firms such as AIG had never factored in such volatile price movements into their off-exchange derivative exposures. They had, in essence, become the speculator of perpetually favorable economic conditions.

Should we now bail out the speculator because he or she may ultimately be right? No. What is required are fair rules that minimize systemic risks. If derivatives were all traded on an exchange, the systemic risk would virtually be eliminated. We don't need to restrict speculators from engaging in risky bets, but we need to make sure that if the speculators fail, the rest of the system does not fall apart. Currently, everyone cries for more government intervention, more help. But there is the real risk that the baby is thrown out with the bathwater. Mr. Press Secretary, if you want to destroy the CBOT, Singapore will be waiting to welcome those traders.

Let us consider if these off-exchange derivative products had been regulated and market to market. Take as an example a derivative that insures against the risk of Iceland defaulting on its debt. A few years ago, this may have seemed like easy money (collecting the premiums) for those writing the policies. However the writers of these policies would have likely been forced to close their positions well before disaster struck. And that's precisely the point - the risk to the system must be contained.

The regulators can influence how much collateral is required - mindful that speculation itself is not the root cause of all evil; instead, given our present situation, we urgently need more risk takers! Odds are that many of the positions in the derivatives market in the hundreds of trillions would have never been taken because more transparency would have made the speculators realize just how risky their bets were.

We need a banking system that encourages sustainable risk taking. All of us have a stake in this; risk is the life and blood of capitalism, but it needs to be applied prudently. The right incentive is not that Uncle Sam takes your jet away, but that there are market incentives to control risk. Creating clearing places for financial instruments should be one of the top priorities of both industry and government. By the way, exchanges are profitable enterprises and profits generate tax revenue; restricting bonuses also restricts tax revenue.

That's the type of public-private partnership required - not government run banks. Those financial institutions that are insolvent must be dismembered. We need good banks, not bad banks. It's not just our wish, it's the law. The FDIC improvement act of '91 (FDICIA) requires that prompt and decisive actions be taken when financial institutions run into trouble. The act further requires that the action taken minimizes losses to taxpayers. Buying bad assets from banks doesn't live up to that test. Let's bite the bullet, do what's necessary and not drag the economy down further by losing trillions of dollars in taxpayer money through propping up a broken system.

Insolvent banks may need to be dismembered anyway, but the longer it is dragged out, and the more money that is thrown at the problem, the more the purchasing power of the dollar gets eroded. And that closes the loop of why we take an interest in this. We manage the Merk Hard and Asian Currency Funds, no-load mutual funds seeking to protect against a decline in the dollar by investing in baskets of hard and Asian currencies, respectively. For those interested in an in-depth analysis on the dollar and the euro, please see our recent analysis on whether there are any hard currencies left at merkfund.com. To be informed as we discuss other currencies, from the Swiss franc to the yen to the Australian dollar, subscribe to our newsletter at www.merkfund.com/newsletter.

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