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Providing Relief from the Crisis

How to spare the economy further crippling government intervention by suspending mark-to-market accounting

From the February 2009 issue

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Our economics editor, Brian Wesbury, has put together this symposium in the hope that the present financial crisis can be relieved without much more pain for the taxpayer. We believe that a major cause of the ongoing credit freeze is mark-to-market accounting rules that the Securities and Exchange Commission could simply suspend. In the following contributions, some of the country’s top economic thinkers argue that the government, especially through its enforcement of mark-to-market accounting rules, has deepened and broadened the crisis. In fact, we believe that the current crisis has burned out of control because of the government’s obduracy in refusing to admit that its polices have made things worse.

In their seminal work, A Monetary History of the United States, Milton Friedman and Anna Schwartz reported that mark-to-market accounting rules caused banks to fail in the Great Depression, not from bad loans, but from writing down bond values at the behest of regulators. And as William Isaac, former head of the FDIC, tells us in his submission, FDR eventually called together a panel in 1938 that suspended those rules. By then the Depression had lasted eight years. We hope our current government leadership understands this history.
-- R. Emmett Tyrrell, Jr.

William M. Isaac

The President-elect should immediately call upon the Securities and Exchange Commission to suspend mark-to-market accounting (specifically SFAS 157, adopted in 2006). It’s indisputable that this accounting rule has senselessly destroyed hundreds of billions of dollars of bank capital, is a major cause of the world wide financial crisis, and is crippling the economy.

The SEC began pushing for market value accounting in the early 1990s. The move was opposed strongly by Treasury Secretary Nicholas Brady, Federal Reserve chairman Alan Greenspan, and Federal Deposit Insurance Corporation chairman William Taylor.

Greenspan and Taylor pointed out that market value accounting on bank investment portfolios had been required by regulators until 1938. That year President Roosevelt asked the secretary of the treasury to convene the bank regulators to discuss how to get banks lending again to help the nation recover from the Great Depression. They concluded that market value accounting was impeding bank lending and abolished it in favor of historical-cost accounting.

Brady was prescient in his 1992 letter opposing market value accounting. He noted that market value accounting would introduce a great deal of volatility in bank earnings and make their financial statements more difficult to understand. Most importantly, he cautioned that temporary changes in market pricing could cause large hits to bank earnings and capital, which would diminish bank lending capacity and create severe credit crunches.

I considered market value accounting when I was chairman of the Federal Deposit Insurance Corporation during the banking crisis of the 1980s. I thought it might force banks to keep the maturities of their assets and liabilities in better balance. The FDIC ultimately rejected the notion for three principal reasons.

First, market value accounting could be implemented on only a portion of the asset side of bank balance sheets (i.e., marketable securities)--it was daunting to even contemplate the liability side. A system that captures one change in value without picking up other changes can be very misleading. For example, an increase in interest rates would drive down the value of fixed-rate mortgages and bonds held by banks but might well increase the value of their floating rate loans. That same increase in rates would make most deposit accounts more profitable. The net effect on a bank’s business could be positive; yet, marking the government mortgages and bonds to market would destroy earnings and capital.

Second, we believed that market value accounting would impede banks in performing their fundamental function--taking short-term money from depositors and converting it into longer-term loans for businesses and consumers.

Third, we felt that market value accounting would be pro-cyclical and would make it very difficult for regulators to manage future banking crises. If we had followed market value accounting during the 1980s, we would have forced the nationalization of our largest banks, which were loaded up with Third World debt for which the markets were not functioning. I believe the country would have gone from a serious recession into a depression.

Devotees of market value accounting cringe at the thought of suspending the rules. They argue it would result in a loss of transparency and an overstatement of values. To the contrary, market value accounting has produced terribly misleading disclosures by valuing specific assets well below their true economic value without considering offsetting changes in value of other assets and liabilities. It is transparently bad accounting.

Historical-cost accounting--the cornerstone of Generally Accepted Accounting Principles--is vastly superior. Under historical-cost accounting, marketable assets are carried on the books at their amortized cost, and the balance sheet contains footnoted tables showing the current market value of those portfolios. This gives investors all the information they need to evaluate the adequacy of a bank’s capital and its earnings power.

Historical-cost accounting does not run market depreciation through the income statement and does not deplete bank capital (unless the decline in value is considered permanent). This system provides a more accurate financial picture of a bank and does not destroy bank lending capacity.

The crisis in the financial system demonstrates that major principles of accounting are much too important to be left solely to accountants--or, worse yet, to an international board of accountants, as the SEC is currently considering. We urgently need to change our system of setting accounting standards to make it more accountable. Accounting principles affecting our financial system should require approval from both the Federal Reserve and the FDIC--the two agencies charged with maintaining stability and picking up the pieces when a crisis hits.

It makes no sense to allow the SEC and the Financial Accounting Standards Board to continue destroying capital in our banks while the Treasury is using taxpayer money to recapitalize the banks. Our new president should call upon the SEC to get on the same page as the rest of the government and end the destruction of bank capital under SFAS 157. 

William M. Isaac is chairman of the Secura Group of LECG and former chairman of the FDIC.

Edward L. Yingling

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 sub-prime 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 and Financial Accounting Standards Board 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. 

Edward L. Yingling is president and CEO of the American Bankers Association.

Brian Wesbury

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 their portfolios. 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.

Brian Wesbury is chief economist for First Trust Portfolios, L.P. and The American Spectator’s economics editor.

 

Newt Gingrich

Several months have passed since Treasury Secretary Henry Paulson created the Capital Purchase Program. Under CPP, Paulson allocated $200 billion of taxpayer money to shore up banks’ balance sheets.

Instead of stabilizing the capital markets, many of these banks have used this government hand out to buy up their competitors. The Washington Post reported that JPMorgan Chase, BB&T, and Zions Bancorporation all said that they were considering using “some of their federal money to buy other banks.”

The New York Times quoted an executive of J.P. Morgan bank as stating that the federal money would allow the bank to be “more active on the acquisition side or opportunistic side.” In his own words, “I would not assume that we are done on the acquisition side just because of the Washington Mutual and Bear Sterns mergers.”

Meanwhile, many regional and smaller banks are still not lending. As Treasury funds are slowly becoming accessible to smaller, regional banks, many of these banks have been forced to record major losses in the valuation of their assets, some of which have experienced no credit losses.

Instead of giving these uber-banks a blank check to conquer their smaller competitors, Congress should push the Securities and Exchange Commission to move toward replacing mark-to-market accounting with an accounting system that reflects a truer picture of economic value than does mark-to-market. William Isaac, former FDIC chairman, has been an early advocate of moving toward historical-cost accounting to better improve the “real economic value” of assets. Washington’s policymakers should follow his lead.

Under the Financial Accounting Standards Board rules, namely SFAS 157, mark-to-market accounting was implemented to provide investors with a more accurate, up-to-date asset price. Yet, its application led to a rapid decline of asset values. Banks and corporations alike have been forced to write down assets and have been left with contracted balance sheets.

Banks will not begin to start lending to their communities until they can reappraise the value of the assets they already have on their books. To get the American economy running, Americans need access to credit so that they buy cars, take on mortgages, and pay for their children to go to college. We cannot wait for Treasury’s funds to slowly chip away at the credit crunch. With this reform, Washington would do more to stabilize the financial markets without costing the taxpayer a penny. 

Newt Gingrich was Speaker of the House of Representatives from 1995 to 1999. 

Gary Wolfram

The current financial crisis has led to unprecedented peacetime government intervention in the national economy. Approximately $8 trillion of government purchases of equity in financial institutions, loan guarantees, and other credit has flowed from various federal agencies in a matter of weeks. Those who agree with Hayek that government agents are unable to collect and process the information that is necessary to direct a modern dynamic economy will wonder at the speed with which we have moved towards what Ludwig von Mises called “planned chaos,” and Hayek called “the road to serfdom.”

Regardless of issues, such as the risk to taxpayers, the real concern should be that we are expanding government in a way that Robert Higgs warned about in his 1987 book, Crisis and Leviathan, while ignoring a simpler noninterventionist approach.

There has been a good deal of literature on the cyclical effects of regulatory capital requirements, and in particular mark-to-market accounting. In a 2004 paper, University of Chicago and Harvard University professors Anil Kashyap and Jeremy Stein concluded that enforcing exactly the same capital requirements during the upside and downside of business cycles has the potential to add significantly to cyclical behavior and results in inefficient credit markets. An implication of their research is that capital requirements should be lower in a downturn when the cost of capital is high.

In the current credit crunch, mark-to-market accounting has exacerbated the already pro-cyclical effects of capital requirements. Wachovia having to sell its mortgage-based securities at fire-sale prices caused other financial institutions to mark the value of similar assets down, requiring them to raise capital, reduce their loans, or both.

As mortgage-based securities decline in value no financial institution wants to hold them, the market becomes illiquid, and the sales that do occur are under distress, further reducing bank capital. Rather than reducing capital requirements in a downturn, as suggested by Kashyap and Stein, mark-to-market accounting has the effect of increasing capital requirements, leading to further contraction of credit, a scramble for capital, and declining economic activity.

Rather than the government buying banks and other financial institutions, and lending trillions of dollars to whichever firm shows up with the best lobbyist, a simple solution is to allow financial institutions to account for their assets in a fashion that allows for a value closer to the true value of the underlying asset and yet is transparent, so investors and depositors may make a rational choice as to whether to invest in or make a deposit in the institution. Individuals acting according to their own plans and taking responsibility for their actions will outperform regulation. While there may be costs to eliminating mark-to-market capital requirements, the alternative of massive government intervention will be much greater in the long term. 

Gary Wolfram is William Simon Professor of Economics and Public Policy at Hillsdale College and former chief of staff to Congressman Nick Smith.

Bob McTeer

The last time I looked I couldn’t find mark-to-market accounting in the Constitution of the United States. It must be the 11th commandment because it’s obviously sacred. I understand the president has the authority under the Emergency Powers Act, or some such legislation, to suspend the Bill of Rights in case of a national emergency. Well, we have a national emergency, so mark-to-market must be more important than the Bill of Rights.

If a foreign power destroyed a fraction of the wealth that mark-to-market accounting has in the past year, we’d go to war. I’m no accountant, but, as I understand it, mark to market is part of what they call “fair value” accounting, so it must be fair.

If so, I have a couple of questions. What’s fair about a financial institution being put out of business because a small portion of its bundled assets become impaired and the whole bundle must be treated as a loss? How is it fair that an expected loss of a few thousand dollars a few years from now, in some cases, must be treated as a loss of millions in the here and now? If a small number of mortgages behind a mortgage-backed security become impaired, or potentially impaired, why must the whole bundle be written off? If I have a sack of apples with a couple of bad ones, I throw the bad ones away--not the whole sack.

More questions: If the “impairment” results from lack of liquidity because markets aren’t working, why can’t banks simply hold on to their securities--until maturity if necessary? Why must they assume a fire sale at fire-sale prices for something they don’t have to sell? If some of the impairment results from actual losses on the underlying mortgages, why can’t they write off only that portion of the impairment? Does it really make sense to force write-offs of the whole bundle of mortgages when only a few would have to be written off if the mortgages were held individually?

What makes the answers so crucial is that these write-offs we’re talking about reduce the banks’ regulatory capital dollar for dollar. That used to mean failure or a forced marriage when capital reaches zero. These days it only has to approach zero to preserve insurance funds and stretch bailout money.

The answers to my questions apparently have to do with transparency--investors and creditors need to see exactly what you’ve got in your portfolio. Well, show them. Surely you can show them what’s in the sack without having to throw the sack away. Surely transparency can be achieved without throwing common sense out the door.

In a recent blog posting, I described a variant, the PWC proposal, which would count only the markdowns attributable to credit impairment against regulatory capital and would treat those attributable to illiquidity in another manner. Show it all; let it all hang out; just don’t crucify our financial system and economy on the cross of mark-to-market accounting.

Now is the time for all good accountants to come to the aid of their country, and put some fairness in fair value. 

Bob McTeer is the former president of the Dallas Federal Reserve Bank.

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