Mark to Market Watch

Market Value Accounting Crippling Economy

The case for suspending mark-to-market accounting. Part one in "Providing Relief from the Crisis," a seven-part series on our economic emergency.

By 12.11.08

Send to Kindle

Herewith the first installment of an economic symposium that Brian S. Wesbury, our economics editor, has put together 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. Over the next three days we shall publish seven pieces -- two a day -- in this symposium titled "Providing Relief from the Crisis" wherein 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.

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 affect 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 terms 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 of 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 at the same time 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.

Like this Article

Print this Article

Print Article
About the Author

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