Friday, September 26, 2008

Repeal mark-to-market accounting rules

Here's one way government contributed to the financial crisis that has only been acknowledged briefly.

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 I’m convinced that if this rule isn’t repealed we’ll have continuing credit crunches, no matter how much taxpayer money they pour into the system.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.


chofland said...

I've heard this raised other places in FreedomSpace, and I'm as sympathetic as any other free marketeer in adding this to the pantheon of Economic Stupidies Propagated By The Government, but...

I have some trouble believing that this has a lot to do with getting "Wall Street" to this point, or to it being the fuse to the alleged Doomsday bomb that only the Billion Buck Bailout (x 700) can fix.

My point being, think of this in terms of game theory and Coase's work on markets, rights, and rules. If you are the only competitor that has to follow a stupid accounting rule, then you are at a disadvantage. If everyone has to follow that rule, then it moves the goalposts one time, and everyone adjusts accordingly.

If everyone is being driven into "paper insolvency" at once, then they can go file their Chapter 11s together, with big press / Internet announcements that this is only to follow the new rules, but payments will continue as before, etc. etc.

Caveats to that would include 1) the rule so obscures real information (in the short term) that companies have been unable to see where they are heading and markets are unable to price what they're worth; 2) the market is so spooked that it can't act rationally, so just the word "insolvent" will send everyone to the doors (crushing each other on the way).

My faith in market economics is such that I find these unlikely.

MIchael Mack said...

In and of itself the mark to market rules were not a problem until... other banks began purchasing them, and they were sold 2,3,4,5 times creating a ponnsi scheme and when the value of the assets began dropping that is when things fell apart, and thats the reason we are having multiple bank failures...
we do need to repeal or rework the rules so they will work properly.

Michael Mack
Redneck Problem Solver

Anonymous said...

Mark to Mark accounting is the only accounting method that allows businesses and "INVESTORS" to ascertain the Fair Market Value of an Asset.

If you do away with the rule...assets will be written up in value beyond "Fair Market Value."

The write ups will be whatever is necessary for businesses to look solvent on paper in order to secure loans.

The net effect of this is to prolong the bubble years...but it will just result in a much bigger pop.

The reason why we are in this mess if because asset value did not reflect fair market value for years because the market over-valued collateralized debt instruments.

Cliff Notes:
If you suspend mark to market accounting, then businesses can overvalue assets, which will cause a lack of investor confidence...if will just stall the bubble and make way for a much bigger pop.

Anonymous said...

The worse thing to happen would be to bot Waive Mark to Market Accounting...and Pass the 700 billion bailout package.

If you do BOTH the Federal Government will buy back the assets from insolvent companies based on THEIR VALUE OF THE ASSETS.

If you preserve mark to market accounting, then the federal government will buy the collateralized debt at Fair Market Value and inevitably turn a profit.

If Mark-to-Market is suspended...and the bailout goes through, then Wall-Street gets a double benefit.

Make no mistake though...repealing mark-to-market is as much...if not more of a bailout than buying the assets.

If the federal government buys the assets from wall-street then wall-street will have a much better looking balance sheet.

If wall-street does not have to account for their assets at Fair Marktet Value, then the balance sheet will also go up.

However, the bailout package preserves "Fair-Market-Value" whereas repeal would not.

Again, as you all know, when the market operates on speculation and prices are not fixed...then you have a market crash.

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