I’ve been working on a piece for Sunday, and the more I look into the financial crisis the more I’m convinced that one of the chief factors behind the crisis is something nobody is talking about, at least in public, though the WSJ has run a couple of articles. It’s called mark-to-market accounting, embodied in Financial Accounting Standard 157, imposed by the government last November, John Berlau of the Competitive Enterprise Institute has been raising the hue and cry, as has former FDIC chairman William Isaac, along with academics from Wharton and Yale. Here’s the gist:
As explained by John Berlau, director of the Center for Entrepreneurship at the free-market-oriented Competitive Enterprise Institute: “[I]f a troubled bank sells a mortgage-backed security at a fire sale, many solvent banks have to take a paper loss on similar assets. This is the case even if the loans are still performing and even if the banks are holding the loans to maturity and simply collecting the payments instead of selling. In a small market such as those for unique securities, one fire sale can set the ‘market price.’
“If all this required was showing a loss to shareholders in annual reports, this would still be bad accounting, but not that much of a contagion problem. But because mark-to-market has been adopted as part of solvency rules, these ‘losses’ contract banks’ ‘regulatory capital’ on paper and mean they can’t make as many loans without being declared technically ‘insolvent.’ So these financial assets become ‘hot potatoes,’ as banks scramble to get them off their books, driving the asset prices down even further. This explains much of the ‘cascading effect’ that has caused the credit crunch.”
Nobody in Washington has been talking about this. I’m convinced that if this rule isn’t repealed we’ll have continuing credit crunches, no matter how much taxpayer money they pour into the system. John Berlau thinks simply repealing the rule would make a taxpayer bailout unnecessary, though there would be some ongoing problems and some bankruptcies arising from people with too much invested in Fannie and Freddie. Here is CEI’s ongoing Bailout Watch blog.