Saturday, September 20, 2008

The Danger of Mark-to-Market

SEPTEMBER 20, 2008

Maybe the Banks Are Just Counting Wrong

By JOHN BERLAU


In the year since the credit crunch began, reading the financial pages has become a bit like perusing a medical journal. Market epidemiologists speculate where the financial "contagion" will strike next.

First it hit subprime mortgages and mortgage-backed securities. Then asset-backed commercial paper and auction-rate securities. Then the epidemic spread to whole financial firms like Bear Stearns, Fannie and Freddie and Lehman Brothers. This week the insurance giant American International Group got the inoculation of a $85 billion federal loan, and now there is talk of creating a giant government agency to buy billions of dollars of illiquid debt from various financial firms.

The method of disease transmission is still somewhat of a mystery. The latest mortgage delinquency rate is just 6.4% -- historically high, but not anywhere close to the mortgage default rate of over 40% in the depths of the Great Depression.

Helping to spread the contagion is a relatively new accounting method called "mark to market." For decades, lenders used historical cost accounting, meaning that a loan would be booked at its cost at the time it was made. Payments would be recorded as they came in, and the book value of the loan would only change if it was sold or became impaired, perhaps because of default.

The pressure to change this method came after the collapse of U.S. savings and loans in the 1980s, and the Japanese banking crisis of the '90s. Regulators and accounting bodies argued that traditional accounting allowed banks to "hide" bad assets on their books, and that financial instruments needed to be valued based on what they would trade for in a market today.

So over the past decade, various mark-to-market accounting rules became part of the official U.S. Generally Accepted Accounting Principles (GAAP), and began to be required by the Securities and Exchange Commission, bank regulatory agencies, credit rating agencies and in the Basel II international framework for measuring bank solvency.

This supposed "reform" is exacerbating the current crisis. Markets for individual loans are still much thinner than for stocks and bonds. The market for securitized loans with unique features is even thinner, and a disruptive event can cause these markets to virtually disappear. As a result, if a highly leveraged bank sells a mortgage-backed security at a steep discount, this becomes the "market price."

Financial Accounting Standard 157, which U.S. regulatory agencies put into effect last November, requires accountants to look at market "inputs" from sales of similar financial assets even if there isn't an active trading market. That means that less-leveraged banks holding mortgages that haven't been impaired often have to adjust their books based on another bank's sale -- even if they plan to hold their loans to maturity. Yale finance Prof. Gary Gorton wrote in a paper presented last month at the Federal Reserve's summer symposium: "With no liquidity and no market prices, the accounting practice of 'marking-to-market' became highly problematic and resulted in massive write-downs based on fire-sale prices and estimates."

These write-downs, based on accounting standards, can jeopardize balance sheets and solvency -- much like a spreading contagion. In effect, a single bank's fire sale can decrease the "regulatory capital" (or the total dollar value of assets that government regulations require banks and other financial institutions to keep as a reserve to immediately make good on their obligations to depositors and other creditors) of others. So "partly as a result of GAAP capital declines, banks are selling . . . billions of dollars of assets -- to 'clean up their balance sheets,'" notes Mr. Gorton, creating a "downward spiral of prices, marking down -- selling -- marking down again."

These rules also affect credit insurance of the type that AIG was providing. As Barron's reported earlier this year, because of the ongoing fire sales of mortgage instruments, "accountants were forcing AIG to boost its fourth-quarter write-down of the value of its credit insurance on a large mortgage security portfolio from $1.6 billion to $5.2 billion." Barron's also noted that AIG was "likely looking at even bigger mark-to-market hits" later on.

Treasury Secretary Henry Paulson has pushed through many creative measures attempting to shore up the financial system. But he won't budge on mark-to-market accounting. "I think it's hard to run a financial institution if you don't have the discipline which requires you to mark securities to market," he declared in a speech at the New York Public Library in July. Financial firms, he said, shouldn't expect much relief.

But relatively simple changes to mark-to-market rules, like suspending the rules for illiquid but performing loans if a firm meets other solvency requirements, would lead to more accurate information and could quell demands for more "emergency" bailouts such as that of AIG. This kind of reform should be a top priority of any new administration promising "change."

Mr. Berlau is director of the Center for Entrepreneurship at the Competitive Enterprise Institute. CEI associate Al Canata contributed to this article.

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