Part two of the “Providing Relief from the Crisis” series: Mark-to-market accounting did not create the financial crisis, but it made it much worse.
This is the second installment of “Providing Relief from the Crisis.” Read the first, with editor-in-chief R. Emmett Tyrrell, Jr.’s introduction, here.
Mark-to-market accounting is contributing to uncertainty in the markets, and it is leading to misdirected public perceptions. Certainly mark-to-market did not cause the financial crisis. Toxic subprime loans and excess leverage in Wall Street firms were the principal causes. But many people, including American Bankers Association members, believe that overly strict application of mark-to-market made the crisis much worse by creating a downward spiral of valuations based on prices in dysfunctional markets. Furthermore, current mark-to-market accounting is very pro-cyclical, exaggerating ups and downs. For years, during the good times, ABA argued against strict mark-to-market. During these bad times, we have pointed out the need to adjust mark-to-market to reflect the dysfunctional markets.
The misapplication of mark-to-market accounting in today’s situation, when there is no functioning market, has unnecessarily destroyed billions of dollars in capital. On a related matter, the recent action by the Securities and Exchange Commission (SEC) and Financial Accounting Standards Board (FASB) to address the concept of “Other Than Temporary Impairment” (OTTI) was very inadequate. The SEC attempted to resolve this issue, but FASB’s interpretation (FASB Staff Position 157-3) muddled it again. As a result, banks may be required to write down securities — even though there may be no threat to principal or to cash flow — because the markets are dysfunctional.
Congress and others have recognized the need to replace mark-to-market accounting. During the development of the Emergency Economic Stabilization Act of 2008, there was unprecedented debate among legislators, investors, regulators, financial institutions and others about the problems with mark-to-market accounting. As a result, the Act required the Securities and Exchange Commission, in consultation with the Federal Reserve and Treasury, to conduct a study on mark-to-market accounting standards applicable to financial institutions.
ABA believes that if an entity’s business model is based on fair value or if an instrument is held for trading purposes, market value (as a proxy for sales price) may represent the most relevant measure of how the instruments will be settled. On the other hand, the lending and investment model of banks is based on cash flows rather than market value, meaning that mark-to-market is not the most relevant measurement. If mark-to-market is overstating gains in good times and overstating losses in bad times, are we providing good information to the public about the performance of financial institutions? We think not.
Mark-to-market accounting needs to be addressed in the short-term by improving both the definition of fair value and OTTI. In the longer term, the efforts to move to fair value for all financial instruments should be abandoned, and existing rules requiring fair value should be examined to determine whether mark-to-market is appropriate. Some tough lessons have been learned in this environment regarding the lack of reliability and relevance of mark-to-market accounting, which should not be ignored.
It is important that any new standards improve financial reporting for users of financial statements. Our recommendations will achieve that and will help reduce some of the unwarranted uncertainty that exists in the markets. Accounting standards have played a significant role in the financial meltdown, and the time to repair them is now.
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