Thursday, June 17, 2010

The tragedy of mark-to-market

Steve Forbes lays out the case against mark-to-market:

An economic version of the bubonic plague is ready to reemerge: mark-to-market accounting. This rule was the principal reason that the financial disaster of 2007--09 threatened to destroy our financial system. The system could have survived the losses from subprime mortgages and other unsound exotic transactions--though there would have been substantial casualties among players--just as we survived the raft of bad Latin American and commercial real estate loans in the 1980s and early 1990s.

In effect, mark-to-market accounting rules forced financial institutions to value securities for capital purposes as though they were day-trading accounts. Traditionally, an asset was held at book value for regulatory capital purposes unless it was disposed of or became impaired. In 2007 that standard was overturned by the Financial Accounting Standards Board (FASB). When panic set in regulators and auditors forced banks and insurers to write down the values of assets to absurdly low levels that weren't even remotely justified by their cash flows. Forbes columnist and noted economist Brian Wesbury explained in his book It's Not as Bad as You Think: Why Capitalism Trumps Fear and the Economy Will Thrive (John Wiley & Sons) that if mark-to-market had been in effect during our last big banking crisis some two decades ago the largest commercial banks in the country would have been destroyed. Those institutions had Latin American loans equivalent to 260% of their capital. On a mark-to-market basis those loans would have fetched barely ten cents on the dollar.

Mark-to-market is like being told to mark down the value of your house to a price that it will fetch within the next 24 hours. An absurdly destructive concept. But it explains why the massive losses financial institutions took were mostly book losses and not actual cash losses on bad paper.

Mark-to-market accounting was banned in 1938 because it was contributing to financial distress during the Great Depression. In March 2009 Congress forced a change: The FASB would allow cash flow accounting to be used when markets were illiquid. Overnight the terrible bear market ended, and the credit system came back to life. Remember all the angst over what to do about the banks' toxic assets? All those stress tests? When mark-to-market accounting was amended the toxic assets crisis disappeared as banks were able to deal with assets in an orderly fashion.

Yet, incredibly, the FASB--with the passive connivance of the SEC, the FDIC and others--is set to bring back mark-to-market accounting with a vengeance. This time all loans, not just securities, will be subject to these so-called fair-value rules. The immediate impact will be to crush small businesses. As Wesbury and his colleague Robert Stein observed in a June column: "There is no real market for [individual] bank loans. How does a trader in New York know what price to bid for a loan to a dry cleaner in Burlington, Iowa? In fact, the minute a bank makes a loan to a local small business it will be forced to write down the value because no one else will pay 100 cents on the dollar for that loan, especially in times of economic stress. … When markets freeze up financial institutions must use prices that do not reflect actual cash flow."

It's no surprise that the accounting industry is lobbying hard for this catastrophic change. With a pre-Depression-era mentality of businessmen who thought protectionism would make them richer by stifling foreign competition, many auditors today are salivating at the fees they'll collect from the mammoth, laborious procedures necessary to "evaluate" millions of individual loans. But just as protectionism led to the Smoot-Hawley Tariff, which triggered a global depression, which, in turn, devastated "protected" businesses and others here and around the world, this supertoxic mark-to-market concept will severely stifle job creation and economic growth. We will enter into perpetual recession punctuated by brief spurts of growth.

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