******************
Posted by John Berlau
Bailouts.
Global interest rate cuts. More bailouts. Global government liquidity
injections into banks. Direct government buying of commercial paper. And even
more types of bailouts.
But nothing
seems to stop the downward spiral of equity and credit markets throughout the
world that have been accelerating this week. But there is one intervention the
governments of the world haven’t tried yet: Standing up to the high priests of
the accounting profession and suspending requirements of mark-to-market
accounting for illiquid assets.
Markets are
more connected across the world than ever before, but, more importantly, so are
accounting rules. Over the past decade or so the U.S. Financial Accounting
Standards Board (FASB) and the European International Accounting Standards
Board (IASB) — private professional organizations that basically have a
monopoly on setting the accounting rules that government agencies adopt for
regulations on the private sector — have worked on a project of “convergence”
of accounting standards. This wouldn’t be so bad if it just amounted to mutual
recognition of each others’ rules. But it often has meant mandating a
one-size-fits-all-rule throughout the world.
And this has meant a disaster with the
flawed mark-to-market rule.
Despite the
credit crunch being described as the spread of the “American flu,” the
mark-to-market rules that are spreading it were hatched part of the Basel II
international rules for financial institutions. It’s just that the U.S. jumped
into the really icy water last November when our Securities and Exchange
Commission and bank regulators implemented FASB’s Financial Accounting Standard
157, which makes healthy banks and financial firms take a “loss” in the capital
they can lend even if a loan on their books is
still performing, even when the “market price” an illiquid asset
is that of the last fire sale by a highly leveraged bank. Late last month,
similar rules went into effect in the Eurpoean Union, playing a similar role in
accelerating financial failures.
And now the
rules are a significant factor in the ongoing paralysis of global credit
markets. Yesterday, a Bloomberg article
quoted an attorney specializing in commercial financing as saying that “it
dramatically affects the price at which companies can raise money” because “no
bank wants to take the risk they’ve priced a loan incorrectly.” And the head of
leveraged syndication at BNP Paribas SA in London told Bloomberg that the
sell-offs“will inevitably have a knock- on effect on the mark-to-market for the
rest of the loan investor community.” The panic is in a sense rational because
since mark-to-market is used by regulators to measure solvency, financial firms
know that even if they hold on to a performing
loan they may still have to take a bigger paper loss in the future that would
reduce their “regulatory capital,” thus further constraining credit.
As I’ve noted
previously in Open Market, government purchases of loans through the
recently passed TARP (I’m not even going to bother spelling out the acronym; in
this case, it fits because it sounds like another word ending with “p” that is
perfect to describe the bailout) will not solve this problem, and could
possibly even worsen the mark-to-market contagion. Massive state purchases could trigger massive writedowns and
cause credit to “crunch” even more.
And
apparently, it turned out to be false hope that the accounting boards and
regulatory agencies would suspend mark-to-market. As U.S. politicians from
former GOP House Speaker Newt Gingrich to liberal Rep. Peter DeFazio, D-Ore.,
called for a suspension of mark-to-market rules instead of a bailout, regulators
promised, promised, promised that they would act
quickly on mark-to-market. But as economists Brian Wesbury and
Robert Stein noted
yesterday in National Reveiw, “news on September 30 of a potential change by
the SEC to fair-value accounting rules fueled a 400-point rally in the Dow. This rally faded rapidly when the rumors proved false.”
It turned out
the guidance the SEC issued
was not a suspension but a mere “clarification” of mark-to-market rules, but
one that didn’t clarify much. It restated that mark-to-market is the preferred
method even for most illiquid assets, acknowledged that there were some
“distressed” sales where this valuation was inappropriate, but then stressed
that the agency was in no way laying out a “safe harbor.” Basically it said to
firms and their accountants, disregard mark-to-market at your own risk. Same as
when FAS 157 was implemented.
And even if
SEC did clarify something, we still haven’t heard from bank regulatory agencies
such as the Federal Deposit Insurance Corporation, which have been argubably
more consequential in this crisis in their implementaions
of FAS 157 in the rules measuring bank solvency.
The crisis is
often called a “market failure,” and the term “mark-to-market” seems to reinforce
that. But the mark-to-market rules are profoundly
anti-market and hinder the free-market function of price discovery.
They are a form of what Competitive Enterprise Institute President Fred Smith
calls “market socialism,” and like other regulatory scheme such as
cap-and-trade that claim to utilize the market, they actually limit true market
inputs. In this case, the accounting rules fail
to allow the market players to hold on to an asset if they don’t like what the
market is currently fetching, an important market action that affects price
discovery in areas from agriculture to antiques.
And
mark-to-market valuation for loans, credit default swaps, and other
individualized contracts between a small number of parties — as opposed to
stocks and bonds traded on an exchange where millions of parties have the exact
same security — is inherently misleading. By definition, an indivualized
contract has specific characteristics. By forcing banks to treat their
individual loans like other banks loans, they are requiring banks to literally
compare apples and oranges, and in many cases compare rotten apples with
perfectly ripe oranges.
When the
global financial regulators meet this week, someone should lock them in the
room until they get the gumption to stand up to the accounting bodies and throw mark-to-market rules like FAS 157 in the dumpster
where they belong.
For further reading, please look at this 2006 paper
by Wharton School Finance Professor Franklin Allen and University of Frankfurt
economist Elena Carletti that predicted that mark-to-market rules could cause a
liquidity crisis. It didn’t forsee that subprime mortgages would be the
catalyst, but was prescient in the many other ways it outlines how the
contagion would occur. Godspeed.
Another
analysis:
Mark-to-market accounting
(also known as "fair value" accounting) means that companies must
value the assets on their balance sheets based on the latest market indicators
of the price that those assets could be sold for immediately. Under such a
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 because the housing collateral
protecting them is worth less.
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.
Contact
your Senators and Representative www.aopa.org/whatsnew/citguide.html
Contact the President
and Vice President http://www.whitehouse.gov/contact/
Simple
example:
If you bought a
building for $500,000 and kept it on your books as an asset worth $500,000 and
the current market was $400,000, under MtoM you would be forced to write off
$100,000 and in some cases raise the money to increase your net
worth. (so called minimum NW requirements).
If you had a 30 year loan on your books for $500,000 @ 5.0 % and you could make the same loan today at 7.5% you would need to write the loan on your books down to $333,333 because such a loan at 7.5% would give basically the same yield as a $500,000 loan @ 5.0%. Even if the loan was paying regularly and was not delinquent. Crazy?