Issue of the day: mark to market accounting

Andrew Leonard cuts loose:

So, mark-to-market accounting contributes both to credit bubbles, which no one on Wall Street ever complains about because they are too busy raking in the cash, and credit busts, at which point, Something Must Be Done.

There's just one big fat honking problem. If mark-to-market rules are suspended, what replaces them? Surely we don't trust the owners of these risky assets to decide for themselves what they're worth?

From the SEC's "Clarifications on Fair Value Accounting," released Sept. 30:

Can management's internal assumptions (e.g., expected cash flows) be used to measure fair value when relevant market evidence does not exist?

Yes. When an active market for a security does not exist, the use of management estimates that incorporate current market participant expectations of future cash flows, and include appropriate risk premiums, is acceptable.

Internal assumptions! Never mind what the market says, we'll just trust you to figure it out for yourselves, boys, because we know you would have no reason to lie about something as immaterial as the state of your own finances!

The attempt by members of both parties to suspend "fair value" accounting is outrageous. Despite Republican claims to the contrary, the United States is not facing a severe financial crisis because of accounting issues. The crisis was created by investors who made huge bets with borrowed money on risky loans and complex derivatives that they did not understand and that blew up in their face when the housing market collapsed. The crisis was created by greedy fools who blithely sold insurance against the possibility of anything bad happening to these securities, without ever dreaming that they might actually have to pay up. The crisis was created by politicians who explicitly made sure that these bond-default insurance policies -- credit default swaps -- were unregulated.

Don't blame the accountants. Listen to them: (Compiled by Calculated Risk.)

"Suspending mark-to-market accounting, in essence, suspends reality." -- Beth Brooke, global vice chair at Ernst & Young LLP, WSJ, Sept 30, 2008

"Blaming fair-value accounting for the credit crisis is a lot like going to a doctor for a diagnosis and then blaming him for telling you that you are sick." -- analyst Dane Mott, JPMorgan Chase & Co., Bloomberg

"Suspending the mark-to-market prices is the most irresponsible thing to do. Accounting does not make corporate earnings or balance sheets more volatile. Accounting just increases the transparency of volatility in earnings." -- Diane Garnick, Invesco Ltd., Bloomberg

The just released draft of the Senate bailout bill, a 451-page monstrosity, includes a provision expressly giving the SEC authority to suspend mark-to-market accounting.

I think that Leonard is right, in that suspending mark-to-market accounting is fairly insane.  But I think he's wrong to short-shrift the very real problems with it.

For those who are perhaps not familiar with mark-to-market accounting, the basic idea is that you have to price the assets on your balance sheet at their market value, not at what you think they're worth.  This rule is a result of the Enron crisis; it was intended to keep companies from misrepresenting the assets on their balance sheet to the point of bankruptcy.

But it does create real problems in an illiquid market.  As Alan Blinder, channeled through Matthew Yglesias, explains:

The idea of mark-to-market accounting is that when you're reporting your balance sheet -- your assets and your liabilities -- you need to report the value of your alleged assets at what you could actually get for them on the market. In a normal highly liquid market, this is easy and non-problematic. But as Blinder says, in an illiquid and non-functioning market, as we currently have for our "troubled" assets, you get into trouble. Specifically, you get these huge spreads between the bid price and the ask price for the assets and no actual sales happening. Blinder's example is that if the highest bid is $20 and the lowest bid is $60, where do you value the asset? Thus, "there are legitimate problems that need some attention in how you apply mark-to-market accounting when markets aren't functioning."

The other problem is that in an illiquid market such as ours, where the risk premium on some assets has gone so irrationally high that they basically have no market value, revaluing those assets is not actually a fair estimate of what they're worth.  Beth Brooke says suspending these rules "suspends reality", but what is reality?  Is it what you could sell the asset for today, or the expected future cash flow?  In a rational market, those things are supposed to track fairly closely.  In the current market, they clearly arent'.  Which "reality" should we choose?

The first principle of accounting is to be "conservative", that is, to give executives as little room to play with the numbers as possible.  For that reason, I agree with Ms. Brooke that it's a bad idea to suspend these rules, much less abolish them.  But Leonard is dead wrong when he says "the United States is not facing a severe financial crisis because of accounting issues" and blames the problem exclusively on greed and deregulation. 

This crisis is so huge and complex that I don't think you can fairly cite anything as the main cause.  But it is certain that the way we account for securities has contributed, by turning illiquidity in various banks into insolvency.  Moreover, while deregulation played a role, so has regulation.  One of the reasons that severe markdowns are such a problem for banks is that the thin balance sheet triggers a ratings downgrade.  At that point, many large institutions are legally prohibited from investing in them; others are forbidden by charter.  The change in the government sanctioned rating kicks in government rules which ensure that bankruptcy rapidly follows a writedown.  Did I mention that financial firms are not allowed to restructure in bankruptcy?  They have to liquidate.

Here's the thing:  to say that government regulations have contributed does not mean that those government regulations are a bad idea.  Mark-to-market accounting is a good idea.  So are stringent limits on what types of securities pension funds and insurers can invest in.  Requiring companies to open their books to ratings agencies is a good idea, though I don't think the SEC-enforced monopoly of the big three was so grand.  There is probably a decent argument for the rules about broker-dealer bankruptcies, though I don't know enough about that particular area of bankruptcy law to say.

Good rules can produce bad results.  They can produce bad results simply because there is no such thing as a perfect rule, and with the abovementioned regulations, I think we're just going to have to live with their imperfections.  We are not going to find a flawless solution that will prevent any further problems in the financial markets without creating any other problems; you cannot make an omelette without breaking eggs.

There is one aspect I think we could and should address, however, and that's our basically piecemeal approach to enacting regulations.  Sarbanes-Oxley solved the last crisis, but didn't look towards any future ones it might be helping to create.  That's how financial regulation always is in this country (and probably most others); whatever problem we just had is the only problem worth solving.  Just as banks were looking only at individual securities, not the systemic risk of the way other market players were investing, regulators looked at each piece of the puzzle, rather than assessing how all the pieces fit together.  Had they done so, we might have had time to come up with some way to alleviate the regulatory issues that have exacerbated this crisis (though we might not have, either--I certainly can't think of any off the top of my head).

Instead, we're flailing.  Mark-to-market is causing problems?  Suspend it!  What about Enron?  WHY ARE YOU TALKING ABOUT ENRON?!  WE'RE HAVING A CRISIS!

Yes, we sure are.  Maybe that's because every time we have a crisis, we have that same damn conversation.