Moreover, when a company in financial distress begins fire sales of its assets to raise capital to meet regulatory requirements, the market-bottom prices it sells out for become the new standard for the valuation of all similar securities held by other companies under mark-to-market. This has begun a downward death spiral for financial companies large and small.
More foreclosures and home auctions continue to depress housing prices, further reducing the value of all mortgage-related securities. As capital values decline, firms must scramble to maintain the capital required by regulation. When they try to sell assets to raise that capital, the market values of those assets are driven down further. Under mark-to-market, the company must then mark down the value of all of its assets even more.
The credit agencies see declining capital margins, so they downgrade the company's credit ratings. That makes borrowing to meet capital requirements more difficult. Declining capital and credit ratings cause the company's stock prices to decline.
Panic sets in, and no one wants to buy mortgage-related securities, which drives their value under mark-to-market regulations down toward zero. Balance sheets under mark-to-market suddenly start to show insolvency. This downward spiral shuts down lending to these companies, so they lose all liquidity (cash on hand) needed to keep company operations going. Stockholders--realizing that they will be wiped out if the companies go into bankruptcy or get taken over by the government--start panic selling, even when they know the underlying business of the company is fine.
If a deficiency of regulatory capital is the problem, or if forced sales to meet regulatory requirements are driving down asset prices, then suspending mark-to-market rules could be helpful.
However, if the problem is a lack of investor confidence, increasing the opacity of financial reporting will not restore that confidence.
My guess - right now investors look at the assets side of a bank's balance sheet, see a bunch of mystery assets, and feel uncomfortable about lending to or investing in that bank. That won't change simply because the bank gets to report a higher number for the mystery assets.
If the bank could sell the assets at a fair price and remove the mystery and suspense from its financial reporting it could move on to the next step. In some cases, that next step would be to seek new private capital; in other, happier cases that next step would be to resume business as usual with investor confidence restored.
If too many banks are undercapitalized after selling at fair prices, the Paulson plan will not by itself, succeed. However, it will create conditions where risk and return can be sensibly estimated and private capital might choose to re-enter the financial services sector.
Of course, if they load enough conditions onto participants in the Treasury purchases, even that won't happen.