This is the third installment of “Providing Relief
from the Crisis.” Read editor-in-chief R. Emmett Tyrrell, Jr.’s
introduction here.
The government has pulled out all the stops, and is injecting
trillions of dollars into the economy through just about every
avenue that anyone can dream up. What’s so frustrating is that no
one in control will seriously consider a change to the inflexible
rules of mark-to-market accounting.
Mark-to-market (or fair value) accounting forces financial
institutions to use market prices (gathered by soliciting bids
from buyers) to value assets in its portfolio. Then, those values
are used to mark an institution to market.
Any loss gets pushed though the income statement, which in turn
subtracts from capital. If capital-asset ratio falls below legal
levels imposed by regulators, the institution can fall into
insolvency. While this is typically an end-of-quarter
calculation, the government can step into an institution at any
time and apply mark-to-market accounting.
As a real life example, imagine that a forest fire is one mile
from your $1 million home, the winds are blowing it your way and
you have a $600,000 mortgage. Then, imagine that your banker
knocks on your door, and demands that you mark the value of your
home to the price that you could sell it for, right now. Then,
the bank forces you to come up with more money or be foreclosed
on. If the wind shifts and your home is saved, it’s too late.
You’ve already been “marked-to-market.”
Forcing firms to mark assets in the midst of a fire storm
needlessly destroys capital. Everyone knows it. So the question
is why won’t the powers that be change it? There are a number of
reasons used to defend inaction.
First, they say that suspending fair value accounting would
create less transparency and allow companies to make up whatever
values they want. This is a curious argument because activity in
this past year has been anything but transparent. In addition,
there are many ways to value assets and footnoting with detail
about how values were calculated in a financial report would be
very transparent.
Second, some say that it is too late — suspending accounting
rules at this point would not help. This is almost ridiculous.
Because the financial system has priced in a very deep and
damaging recession, and many markets have become illiquid, assets
values have been pushed well below their fundamental value. This
creates a vicious cycle of asset write-downs, capital impairment,
a tightening of credit, which then hurts the economy. In turn,
this causes credit agencies to lower ratings on more bonds, which
in turn causes more asset write-downs. Stopping this is important
and suspending mark-to-market accounting is still very important.
Third, those against suspending mark-to-market ask: what will
replace it? There are many answers to this question, but as long
as liquidation-type, fire sale prices are not used, and
reasonable cash flow values are allowed, it will be better for
the economy.
In the end, the real reason accountants, auditors, and regulators
won’t push for a change in the law is that they are the ones who
put it in place, saying that it would keep things like this from
happening. Changing it would be an admission that they were
wrong.
Also, the rule exists to protect auditors and regulators. It
keeps them from making any judgment calls. As long as they have
rules, and they follow them, they can’t get in trouble. The
problem is that managing a business takes judgment. Judgment is
stifled when fire sale prices are applied to the management of
financial risk.
Finally, there are many who think that enforcing the right rules
will take the risk out of economic and financial market activity.
This is impossible. An economy without risk is an economy that
does not grow. Rules have consequences and one of the most
consequential rules of our lifetime is mark-to-market accounting.
Unfortunately, its consequences have created a real crisis for
the economy.
