Mark to Market Watch

Rules Have Consequences

And those consequences can be very dire for our economy. The third part of "Providing Relief from the Crisis."

By 12.12.08

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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.

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About the Author

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