In late 2007, the Financial Accounting Standards Board (FASB) changed the definition of mark-to-market accounting rules as they applied to the U.S. financial industry. The board forced financial firms and auditors to use “observable,” market prices to value securities rather than models or cash flow. Within a year, the U.S. was in the middle of the worst pure financial panic in a hundred years. Coincidence? We think not.
On its surface, market-to-market or “fair value” accounting makes some superficial sense. Markets usually provide transparent and verifiable prices, so companies can’t just contrive numbers to make their earnings look good.
The problem with mark-to-market is its failure to recognize that market prices for securities often deviate–sometimes substantially, but always ultimately temporarily–from the underlying fundamental value of the assets. Since markets are forward looking, mark-to-market forces financial firms to take hits to capital over something that “might” happen in the future, but has not happened yet. It’s like forcing homeowners to come up with more capital when the weather man forecasts a hurricane because their homes might be destroyed.
This, in turn, can create a vicious downward cycle as capital constraints hurt banks, undermine the economy and drive prices lower, and then destroy more capital. In 2008, when markets for mortgage-backed securities became extremely illiquid, the financial crisis intensified. This drove away private capital and enticed government to flood the system with liquidity. This government activity helped cause panic and a recession. But all of these government programs were just a way to work around the accounting rules.
As former FDIC chairman William Isaac has repeatedly said, if mark-to-market rules had been in place in the early 1980s, the Latin America debt crisis would have destroyed every money center bank–large banks that borrow and lend to governments and large companies–in the U.S. Thank goodness that did not happen. Instead, the system was given time to heal. That’s what should have happened in 2008. Instead, FASB stubbornly stuck to its guns over MTM accounting.
Finally, in mid-March 2009, with stocks at new lows, Congress started to twist arms on the issue, a rare and unheralded moment of bipartisan action. FASB was forced to loosen up its rules and allow cash flow to be used when markets were illiquid. Just this small change did the trick. Banks were finally able to raise new capital, $100 billion or so, and the stock market surged. In fact, things have improved so much that the Federal Reserve and Treasury are finding less and less interest in the programs they designed to “save” the financial system.
Suspend Mark-to-Market–Now – Brian Wesbury & Robert Stein, Forbes
