The American Spectator : Mark to Market Means Mayhem

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Mark to Market Means Mayhem

By Brian Wesbury & Robert Stein on 12.8.08 @ 6:08AM

One again, a supposed "market failure" is actually the result of bad government policy.

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Subprime loan problems, which started out as a $300 billion problem, have morphed into a $1.5 trillion dollar problem affecting many different markets and types of institutions. Even if the wind shifted, and the fire moved the other way, the damage would have already been done. In other words, it would not matter if the house had actually survived because the bankruptcy would have already occurred.

Suspending mark-to-market accounting will not keep institutions that took excessive risk from failing. Bad loans are still bad loans and there is no way to avoid the pain that they cause. It will, however, end the negative feedback loop, which drags everyone down. It allows time to see if the wind shifts and keeps the flames from spreading.

In the 1980s, loan problems took down thousands of banks, but because we did not force fair value accounting, the economy and stock market actually thrived. Every money center bank would have been insolvent in the early 1980s if they were forced to write down Latin American debt to 10 cents on the dollar. Add in bad oil loans, which took down Penn Square and Continental, and bad S&L loans, and it is easy to see that the bank problems in the early 1980s were much more severe than those of the 2000s. But the rules were not as inflexible then as they are today. Problems did not spread, many banks eventually recovered their principal on Latin American debt and the economy grew.

In contrast, today's problems are expanding, and have now caused the government to put almost $4 trillion of taxpayer funds at risk to support the financial system. This is an amazing sum of money, equaling 28% of GDP, or 42% of total U.S. stock market capitalization, or more than a quarter of all household debt outstanding, or nearly 40% of all private household mortgage debt, or three times the amount of subprime loans outstanding at their peak.

The government has tried multiple strategies. The only thing they all have in common is that they are designed to offset or stop the damage caused by mark-to-market accounting.

For example, banks have increased their excess reserves from virtually zero to over $630 billion because the Fed now pays interest on those reserves. The Fed uses these funds to buy commercial paper and other debt instruments. So banks are pushing off credit risk to the Fed to avoid any chance of further markdowns or losses. As long as there is a threat to the economy, the Fed will not be able to extract itself from this arrangement, and unless the Fed can extract itself there will be a threat to the economy.

In addition, the Fed has decided to buy Fannie Mae and Freddie Mac debt in order to bring mortgage rates down. One of the key reasons that mortgage rates have remained elevated in recent months is that lenders have become more risk averse, not less. And much of that is due to the erosion in asset values and the interplay with fair value accounting rules. Forcing interest rates down may encourage more home buying, but it does not change the underlying threat.

At some point the government will have thrown so much money at this problem that it could overwhelm the negative feedback loop of mark-to-market accounting. But, in the process, the government will grow larger and the free market will suffer. Moreover, every step on this path the government takes makes it harder to reverse course.

After all, when Chairman Volcker finally put the brakes on the money supply, inflation finally came to an end just like Milton Friedman predicted. But by that time, the government had done incredible damage to the economy as a whole and unemployment had climbed to almost 11%.

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topics:
Economics

About the Author

Brian Wesbury is chief economist for First Trust Portfolios, L.P.

About the Author

Robert Stein is senior economist at First Trust Advisors.

Letter to the Editor View all comments (6) | Leave a comment

James Bailey| 12.8.08 @ 7:30AM

You have to have a market, and be in the market, to be able to mark to market. And the market has to be large enough to be able to cope with swings. Markets are designed to adjust prices until every buyer has a seller and every seller has a buyer.
If you had some money, would you want to buy some of these for 50 cents on the dollar? Of course some of us would, the default rate is not that bad.
When there is a market, mark to market works well.
Without a market, what does mark to market mark to? A couple years ago, it was marking to imaginary greed. Now it is marking to imaginary fear.
The government should have guaranteed some low price, enabling the banks to have a floor to mark to. At the same time, we should have created a market, and took the time to make rules that would allow good information about the status of various mortgage packages, cleaning up the confusion.
We should also put a whole bunch of crooked Dem leaders up on trial for their role in creating this, and for their bribery, ala Countrywide, etc. If we clean up the malregulation that got us in this mess, and fix the banking regulations that allowed all sorts of companies to act like banks, but with weakened rules, we will be much better off.
And we should make damn clear that all we have done so far is bail out the rich bankers, keeping them in their mansions, and keeping their money flowing 9 to 1 to Democrats, but not to loans.
As the rest of us begin to lose jobs, and have to work harder to pay off these huge new debts, keep in mind, that we are doing it to put and keep Democrats in office.
Thanks you President Bush and your 'Chicken Little' team of financial advisors.

Jerome Brick| 12.8.08 @ 12:10PM

A basic, generic home mortgage is not a marketable asset. Just because it is bundled up with other home mortgages (securitized) and sold to an investor still does not make it a marketable asset as such. A home mortgage is a contract between a borrower and a lender, which if it performs as agreed, should be classified as an investment and carried at cost. It is only when default occurs and repayment is put in jeopardy that a market adjustment becomes necessary.

To the extent that FASB 157 forces a market revaluation on a mortgage backed security, absent a default, then I would say the accounting rule is inappropriate.

Dai Alanye| 12.8.08 @ 1:01PM

One of the sad aspects of this is that if someone convinces David Axelrod to get rid of mark-to-market--and it works--Obama gets credit for saving the economy. Further, the lesson gained will not be that mark-to-market was a bad idea but that government interference was needed to correct economic dislocation.

Pat Wilkie| 12.8.08 @ 4:06PM

Your statements about mark-to-market are completely wrong. To start, #157 does not require M2M, that began with #115, back in 1994. Further, even before that time, investments were always marked at LCM.

The absence of liquid markets is directly addressed by #157 - it allows Tier 3 assets to be valued used assumptions specified by management - as long as such assumptions are disclosed. Funny, how critics of M2M never mention that...wonder why?

Finally, GAAP/IASB is not intended for regulator capital purposes. The various Capital Ratios via Basel I and II employ various definitions of "Capital" that are not GAAP/IFRS. If one is concerned that the bank will be declared insolvent by regulators, such as the FDIC, then have then develop their own notions of regulatory income, just as tax authorities throughout the world have their own definitions of TI.

If, on the other hand, you simply don't like the "look" of financial statements because of M2M, then there is a simple answer - don't look - ignore the values and insert your own - and invest accordingly.

Robert Arvanitis| 12.10.08 @ 4:35PM

First, Mr. Wilkie is correct on disclosure and "insert your own value." One reason the sovereign lending crisis of the 80s ended so quickly was transparency. The reader could see which countries owed how much to which banks, and set their own prices.

In contrast, the absence of disclosure in the current crisis has fed panic.

Economists cannot claim markets are efficient, and then say MtM matters. That's as foolish as the former debate over pooling accounting for M&A;.

John Sillren| 3.7.09 @ 12:20AM

Never mind MtM, I want to know what happened to all the money. Phd's in Finance, years of experience in dealing with the complex parameters of the world economy and still, not one individual capable of telling the rest of the world what caused all this grief. Strange, as I look at the world it looks the same now as it did 5 years ago but when I look at CNN the whole planet is in a shamble. It's almost possible to imagine that there is a conspiracy afoot to change the way people live by forcing them into bygone days of slavery and dependence on those in power.