2008 October 02 Thursday
Mark To Market Accounting Rule Caused Financial Crisis?
Did a change in bank regulations by the SEC and FASB cause the financial crisis? The requirement to use mark-to-market valuations on all mortgage-backed securities (MBS) might have caused the bank solvency crisis.
In recent years, firms were required by the Securities and Exchange Commission and the Federal Accounting Standards Board to use for all the MBS on their books.
As more subprime borrowers started to default on their loans, that quickly eroded the value of many MBS pools. Major banks and financial firms around the globe have taken writedowns topping $500 billion in the last year, as a result.
For this reason, some have argued that fixing the rule would solve the credit crisis.
"The SEC has destroyed about $500 billion of capital by their continued insistence that mortgage-backed securities be valued at market value when there is no market," said William Isaac, a former chairman of the FDIC.
"And because banks essentially lend $10 for every dollar of capital they have, they've essentially destroyed $5 trillion in lending capacity," he added.
The argument here is that declining market values on MBS caused banks to sell them causing further price drops and basically a vicious cycle where the MBS became grossly undervalued and the banks insolvent. Could this really be the cause?
I suspect this crisis was caused by a Perfect Storm. Government pressures to lower lending standards certainly helped. So did innovations in new kinds of financial instruments which in 2003 Warren Buffett labeled "financial instruments of mass destruction" which were creating "mega-catastrophic risk" for the economy (if only US Presidents, US Congressmen, and federal regulators were as wise as Warren). But an assortment of regulatory changes set up dominoes for a fall. The account rule described above was just another domino in a row.
Mark-to-market was no doubt being pushed by the hustlers now looking for a bailout. The idea was they could get bonuses for their adventurous trades by pointing to immediate gains. Of course now it's all imploding, and the effect is quite the opposite of what they were hoping for. Poetic justice, certainly, but I'm not a fan of mark-to-market. For publicly traded securities, sure. But otherwise I think a "good-faith" valuation based on the actual returns of the asset or depreciated purchase price (for real assets) is appropriate.
It's not the entire cause even of the current blockage of credit flows between financial institutions, but an official switch to cash-flow valuation would probably largely solve the immediate problem. The long-term one needs years to work itself through the system. In any case the perhaps stage-managed media-induced panic seems to be over. Back to politics as usual.
Don't forget the rating agencies. They were paid by the Bond issuers, not the bond buyers which caused a predictable conflict of interest. How else could they rate garbage CDO's as AAA? This more than any other single act caused the credit crisis. Once they rated toxic mortgages and other sludge cooked up by the investment banks as AAA, demand rocketed for more sub prime, ALT-A crap which mortgage brokers were more than happy to deliver to a deluded financial system. The spiral continued for a few years until July 2007 when the first of these financial alchemy CDO's blew up.
I have no idea what's going to restore confidence.
There are two similar-sounding but very different arguments about mark-to-market:
"Mark-to-market polices force us to place a very low value on assets when they become temporarily illiquid due to unusual market conditions."
"Mark-to-market polices force us to place a very low value on assets that have a low but indeterminate value. In addition, it aggravates the situation when additional liquidity problems arise due to unusual market conditions."
Clearly, the second is closer to the reality of most troubled mortgage-backed securities.
The problems are
(1) the underlying real-estate assets are now much less valuable than the mortgage issuers claimed,
(2) as more properties foreclose and re-enter the market, asset values will decline further due to supply and demand,
(3) future cash flow is hard to predict, and
(4) the financial instruments themselves are so complex that it is difficult to value them with any confidence.
The institutions holding MBS's don't like mark-to-market, but the rest of us should be skeptical about replacing it with another subjective standard vulnerable to "trust us" manipulation.
The basic problem wasn't asset valuation. It was that--with Washington's enthusiastic support--Wall Street adopted the Ponzi scheme to the mortgage market.
Mark-to-market might have been the straw that broke the camel's back. In my opinion, ditching it would do little to address the real problems, or to ease the reckoning.
I've read claims of mortgage backed securities (MBS) that will sell for 25% of face value even though their projected losses should cause them to be valued at 75% of face value. I do not know how to evaluate these claims. So I'm not clear which is the more accurate argument.
I ought to have done blog posts when I read those claims. Gotta remember to record this sort of thing in my extended memory banks.
For what it is worth, there is a provision in this bill allow the SEC to suspend the Mark to Market rule.
"Gives the chairman of the Securities and Exchange Commission the authority to suspend mark-to-market accounting and requires the agency to complete a study on the effectiveness of this accounting method" http://www.forbes.com/home_europe/2008/10/03/bailout-congress-credit-biz-beltway-cx_bw_1003bailout_passes.html
Martin Hutchinson offers a compelling reason to disdain mark-to-market:
"'Investments should be recorded in the books at the lower of cost or market value until they are sold.' This time around the accounting profession adopted 'mark to market' accounting which allowed investments to be 'marked up' on rises in value, with mark-up earnings reported and bonuses paid even when the investments had not been sold. Wall Street is now bleating about 'mark-to-market' because it requires mark-downs of investments that have fallen in value; the real reason why it should be dropped is its enabling of spurious mark-ups, of which the Street took full advantage. Mark-to-market is highly pro-cyclical and provides counterproductive incentives to fallible and greedy bankers."
This is a better view than the one I offered on 10/4/08, above, that only considered valuation issues in the current declining market.