Mark-to-market accounting existed in the Great Depression and according to Milton Friedman, it was responsible for the failure of many banks. Franklin Roosevelt suspended it in 1938, and between then and 2007 there were no panics or depressions. But when FASB 157 went into effect in 2007, reintroducing mark-to-market accounting, look what happened.
According to my favorite economist, Brian Wesbury, two things are absolutely essential when fixing financial market problems – Time and Growth. Time to work things out and growth to make working those things out easier. Mark-to-market accounting takes both of these away.
Because these accounting rules force banks to write-off losses before they even happen, we lose time. This happens because markets are forward looking. The accounting rules force banks to take artificial hits to capital without reference to the actual performance of loans.
This affects growth. By wiping out capital, fair value accounting rules undermine the banking system, increase the odds of asset fire sales and make markets even less liquid. As this happened in 2008, investment banks failed and the government proposed bailouts. This drove prices down even further, which hurt the economy. It’s a vicious cycle.
Former FDIC Chair William Isaac places much of the blame for the sub-prime mortgage crisis on the Securities and Exchange Commission and its fair-value accounting rules, especially the requirement for banks to "mark-to-market" their assets, particularly the mortgage backed securities.
You may recall John McCain's criticism of the SEC during the Presidential race last fall. He even called for the resignation of the SEC chairman Christopher Cox.
Under the mark-to-market rule, declining housing prices don't just reduce the value of defaulting mortgages. They reduce the value of all mortgages and all mortgage-related securities.
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.
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.
In theory, if banks no longer had to account for these valueless assets on their books, their balance sheets would suddenly improve and -- this is the important part -- private capital would start to flow back into the banks. Right now, an estimated $9 trillion to $10 trillion of private capital is sitting on the sidelines because it doesn't want to invest in sick companies.
Again, in theory, if mark-to-market were temporarily lifted, the big banks could get well almost overnight.
Tomorrow Rep. Paul Kanjorski (D-Penn.), will convene a hearing of the House Financial Services Subcommittee on Capital Markets, Insurance, and Government Sponsored Enterprises to talk about mark-to-market.
The downside? If mark-to-market is lifted for good, or is made too lax, companies could create balance sheets that are pure fiction, giving potential investors zero insight into the health of companies.
FASB 157 may ultimately be the right standard, but it was reimposed at exactly the wrong time. This isn't an ordinary period and FASB 157 is creating more stress than it needs to for the financial sector and the broader economy.
Short-term assets should not be given arbitrary values unless there are actual losses. The mark-to-market mania of regulators and accountants is utterly destructive. It is like fighting a fire with gasoline, says Steve Forbes.
He goes on to say, If this rigid mark-to-market accounting had been in effect during the banking trouble in the early 1990s, almost every major commercial bank in the U.S. would have collapsed because of shaky Latin American and commercial real estate loans.
Mark-to-market accounting is the principal reason why our financial system is in a meltdown. The destructiveness of mark-to-market -- which was in force before the Great Depression -- is why FDR suspended it in 1938. It was unnecessarily destroying banks.
Finally, it would be worth your while to listen to Brian Wesbury discuss the issues pertaining to this vital topic. Notice in his comments how the stock market reacted to rumor of a suspension--in early February. Investors are telling us how pervasive this rule is in hindering constructive recovery of banks.
Unfortunately, Treasury Secretary Tim Geithner provided no details in his news conference--and our stock market took yet another hit, affecting millions of Americans' retirement savings.
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