Money
Why Mark-To-Market Accounting Rules Must Die
Brian S. Wesbury and Robert Stein

We have been accused of beating a dead horse when it comes to our support for either suspension of, or targeted relief from, market-to-market accounting.

And we suppose after writing thousands of words, producing videos and giving speeches about the issue, some might be tempted to let it go. But we can't do that, especially when the government continues to spend trillions of dollars and is coming very close to bank nationalization.

This is a real shame. Suspending mark-to-market accounting could fix major problems at no cost. Unfortunately, many people dismiss this issue without really understanding its impact on the economy.

We are economists, not accountants or bank analysts. We really don't think a debate about how big the housing bubble was, or whether a certain bank is viable or not, is worthwhile when it comes to accounting rules. That misses the point. Mark-to-market accounting rules affect the economy and amplify financial market problems.

The history seems clear. Mark-to-market accounting existed in the Great Depression, and according to Milton Friedman, who wrote about it just 30 years after the fact, it was responsible for the failure of many banks.

Franklin Roosevelt suspended it in 1938, and between then and 2007 there were no panics or depressions. But when FASB 157, a statement from the Federal Accounting Standards Board, went into effect in 2007, reintroducing mark-to-market accounting, look what happened.

Two things are absolutely essential when fixing financial market problems: time and growth. Time to work things out and growth to make working those things out easier. Mark-to-market accounting takes both of these away.

Because these accounting rules force banks to write off losses before they even happen, we lose time. This happens because markets are forward looking. For example, the price of many securitized mortgage pools is well below their value, based on cash flows. In other words, the market is pricing in more losses than have actually, or may ever, occur. The accounting rules force banks to take artificial hits to capital without reference to the actual performance of loans.

And this affects growth. By wiping out capital, so-called "fair value" accounting rules undermine the banking system, increase the odds of asset fire sales and make markets even less liquid. As this happened in 2008, investment banks failed, and the government proposed bailouts. This drove prices down even further, which hurt the economy. And now as growth suffers, bad loans multiply. It's a vicious downward spiral.

In the 1980s and 1990s, there were at least as many, and probably more, bad loans in the banking system as a share of the economy. The difference was that there was no mark-to-market accounting. This gave banks time to work through the problems. At the same time, the U.S. cut marginal tax rates and raised interest rates, which helped lift economic growth. Time and growth allowed those major banking problems to be absorbed, even though roughly 3,000 banks failed, without creating an economic catastrophe.

In Japan, during the 1990s, the government allowed banks to operate without ever recognizing bad loans, which certainly bought time. However, Japan increased taxes and ran an excessively tight monetary policy, which undermined growth. This created an economic disaster. The real problem with Japan was not zombie banks; it was that there was no growth. After all, foreign banks were allowed to lend in Japan and were not in bad shape like the Japanese banks. They stayed away from Japan because the economy was not vibrant.

A final example: In the 1930s, because mark-to-market accounting existed, we limited the amount of time available to fix problems. At the same time, the U.S. raised taxes, increased spending and economic interference, and became protectionist. This hurt growth. The reason the Great Depression was so bad is that we took away time and growth.

Anyone worried about repeating the errors of Japan in the 1990s or the U.S. in the 1930s should focus on the policies that impeded recovery. Suspending mark-to-market accounting is a cost-free way to buy time. It does not allow banks to sweep bad loans under the rug. Bad loans are still bad loans, and banks cannot hide from them. Not suspending it, while at the same time interfering in the economy with massive stimulus and bank nationalization, is a recipe to undermine both time and growth and therefore hurt the economy even more.

Brian S. Wesbury is chief economist, and Robert Stein senior economist, at First Trust Advisors in Lisle, Ill. They write a weekly column for Forbes.

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FASB
Mark-to-Messy Accounting Change
Dan Bigman and Maurna Desmond 

Mark-to-market rules on valuing assets have been softened. Expect banks, hard-pressed to right their balance sheets amid imploding markets, and their investors to cheer. Not everyone is so happy.

The Financial Accounting Standards Board voted Thursday to allow firms greater leeway in how they value illiquid assets. Currently, investments like mortgage-backed securities are priced based on their last sale. Since the seller is usually distressed and parts with their goods for a fire-sale price, all similar assets must be marked to a lower price.

Critics of this brand of "fair value" accounting, outlined in FASB rule FAS 157, say it's crippled the banking system, forcing firms to continually write down the value of assets in the worst possible market conditions, regardless of whether or not they're for sale. This, in turn, has put tremendous strain on balance sheets, forcing financial companies to hunt for new capital to make up for paper losses at a time when few investors are willing to put money into banks. The spiral devastated the industry.

As Forbes chairman and editor-in-chief Steve Forbes has noted in repeatedly calling for ending mark-to-market rules, of the more than $700 billion that financial institutions have written off, almost all of it has been book write-downs, not actual cash losses. "Mark-to-market accounting is the principal reason why our financial system is in a meltdown. The destructiveness of mark-to-market--which was in force before the great depression--is why FDR suspended it in 1938. It was unnecessarily destroying banks", he says (see: "End Mark To Market").

With the changes to rule 157, companies can now value the assets on their books as if they were unloaded in an "orderly" sale rather than dumped in a forced or "distressed" sale. The guidelines will apply starting in the second quarter, which began Wednesday.

Good news for these uncommonly bad times, which demand bold remedies. But the point of FAS 157, critics of its repeal remind us, was to avoid the kind of dot-com bubble, Enron-era mark-to-fiction accounting that artificially inflated the value of companies, leaving investors holding the bag when optimistic company guesses met real-world market pricing. "[the changes] would basically give businesses more leeway to decide what they report is on their books. That can't help investor confidence," says Espen Robak, president of Pluris, a valuation advisory firm. "That means higher cost of capital for everyone."

The Center for Audit Quality, a Washington, D.C.-based nonprofit, has said that letting firms make more subjective valuations will "reduce the transparency that investors seek" and "would have significant unintended consequences."

One of the inadvertent effects could be that current methods, based on recent transactions, are rendered incomplete, forcing firms to spend time and money trying to assess what they have on their books. Investors will have to increase their own due diligence because reporting would be less standard and some firms might be more optimistic than others. "The ones who will benefit are the ones who push the envelope most," says Robak.

Another concern: The definition of "illiquid markets" isn't clearly outlined. This is problematic because so many different types of assets aren't being traded much from municipal bonds to many types of complex financial instruments. The proposal is meant to help de-clog balance sheets by addressing the issues of certain unpopular investments, but it doesn't limit the scope of the rule change.

Others argue that a far simpler way to help banks meet their capital requirements is to simply lower the capital requirements explicitly, instead of implicitly doing so by letting them fudge the numbers. That approach has its own perils.

Accounting, in the end, is about judgments and assumptions and, ultimately, convenient fictions. Accountants don't determine the real price of anything. Only markets can do that. But they have to be functioning normally to do so. When they are aren't fair-value accounting does more harm than good, but when order returns, we will be reminded why we need it.

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Intelligent Investing
Steve Forbes: End Mark-To-Market

What is most astounding about President Barack Obama's radical economic recovery program isn't its breadth, but its continuation of the most destructive policies of the Bush administration. These Bush policies were, in themselves, repudiations of Franklin Delano Roosevelt, Mr. Obama's hero.

The most disastrous Bush policy that Mr. Obama is perpetuating is mark-to-market or "fair value" accounting for banks, insurance companies and other financial institutions. The idea seems harmless: Financial institutions should adjust their balance sheets and their capital accounts when the market value of the financial assets they hold goes up or down.

Banks and life insurance companies that have positive cash flows now find themselves in a death spiral. Of the more than $700 billion that financial institutions have written off, almost all of it has been book write-downs, not actual cash losses. When banks or insurers write down the value of their assets, they have to get new capital. And the need for new capital is a signal to ratings agencies that these outfits might deserve a credit-rating reduction.

Mark-to-market accounting is the principal reason why our financial system is in a meltdown. The destructiveness of mark-to-market--which was in force before the great depression--is why FDR suspended it in 1938. It was unnecessarily destroying banks.

If the president really takes Roosevelt's legacy seriously, he should suspend mark-to-market accounting rules, restore the uptick rule and enforce the prohibition against naked short selling. If he doesn't, historians will look back in utter amazement at Mr. Obama's preservation of Mr. Bush's worst economic policies.

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Banks and accounting standards

Messenger, shot

Apr 8th 2009
From The Economist print edition

Accounting rules are under attack. Standard-setters should defend them. Politicians and banks should back off

 

Illustration by Claudio Munoz

IN PUBLIC, bankers have been blaming themselves for their troubles. Behind the scenes, they have been taking aim at someone else: the accounting standard-setters. Their rules, moan the banks, have forced them to report enormous losses, and it’s just not fair. These rules say they must value some assets at the price a third party would pay, not the price managers and regulators would like them to fetch. Unfortunately, banks’ lobbying now seems to be working. The details may be arcane, but the independence of standard-setters, essential to the proper functioning of capital markets, is being compromised. And, unless banks carry toxic assets at prices that attract buyers, reviving the banking system will be difficult.

On April 2nd, after a bruising encounter with Congress, America’s Financial Accounting Standards Board (FASB) rushed through rule changes. These gave banks more freedom to use models to value illiquid assets and more flexibility in recognising losses on long-term assets in their income statements. Bob Herz, the FASB’s chairman, decried those who “impugn our motives”. Yet bank shares rose and the changes enhance what one lobbying group politely calls “the use of judgment by management”.

European ministers instantly demanded that the International Accounting Standards Board (IASB) do likewise. The IASB says it does not want to be “piecemeal”, but the pressure to fold when it completes its overhaul of rules later this year is strong. On April 1st Charlie McCreevy, a European commissioner, warned the IASB that it did “not live in a political vacuum” but “in the real world” and that Europe could yet develop different rules.

It was banks that were on the wrong planet, with accounts that vastly overvalued assets. Today they argue that market prices overstate losses, because they largely reflect the temporary illiquidity of markets, not the likely extent of bad debts. The truth will not be known for years. But banks’ shares trade below their book value, suggesting that investors are sceptical. And dead markets partly reflect the paralysis of banks which will not sell assets for fear of booking losses, yet are reluctant to buy all those supposed bargains.

To get the system working again, losses must be recognised and dealt with. Japan’s procrastination prolonged its crisis. America’s new plan to buy up toxic assets will not work unless banks mark assets to levels which buyers find attractive. Successful markets require independent and even combative standard-setters. The FASB and IASB have been exactly that, cleaning up rules on stock options and pensions, for example, against hostility from special interests. But by appeasing critics now they are inviting pressure to make more concessions.

To reveal, but not to regulate

Standard-setters should defuse the argument by making clear that their job is not to regulate banks but to force them to reveal information. The banks, their capital-adequacy regulators and politicians seem to dream of a single, grown-up version of the truth, which enhances financial stability. Investors and accountants, however, think all valuations are subjective, doubt managers’ motives and judge that market prices are the least-bad option. They are right. A bank’s solvency is a matter of judgment for its regulators and for investors, not whatever a piece of paper signed by its auditors says it is. Accounts can inform that decision, but not make it.

Banks’ regulators have to take responsibility. If they want to remove the mechanical link between drops in market prices and capital shortfalls at banks, they should take the accounts that standard-setters create for investors and adjust them when they calculate capital. They already do this to some degree. But the banks’ campaign twant. But in doing so they must not compromise their duty to investors.o change the rules is making inevitable a split between two sets of accounts, one for regulators and another for investors. The FASB and IASB can help regulators to create whatever balance-sheet they want. But in doing so they must not compromise their duty to investors.

Whenever you find you are on the side of the majority, it is time to pause and reflect

                     --- Mark Twain

We have never observed a great civilization with a population as old as the United States will have in the twenty-first century; we have never observed a great civilization that is as secular as we are apparently going to become; and we have had only half a century of experience with advanced welfare states...Charles Murray

	Kella

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