Economic Outlook - March 2009

Mark-to-market accounting forces companies to value securities at their current market price, but some bankers want the rule changed, arguing that it undervalues assets and needlessly depletes capital. It even has been blamed for accelerating the U.S. financial sector’s meltdown last fall. Nonsense, says UNC Chapel Hill accounting professor Wayne Landsman, the sole academic on a panel the Securities and Exchange Commission convened in November to study mark-to-market — also called fair-value — accounting under the Troubled Asset Relief Program.

Did mark-to-market accounting hasten Wachovia’s downfall?

When you lend to borrowers that aren’t able to pay, it’s going to result in asset write-downs. Wachovia and many other financial institutions were making very bad loan decisions. They were taking on debt in this Ponzi scheme of being able to pass it on to someone else. But like all Ponzi schemes, it broke down eventually.

So bankers are making the rule a scapegoat for their mistakes?

Of course, they are. You have to write down. The only question is: What are you going to write it down to? Write-downs have been required under U.S. accounting rules for a very long time. The only thing new is FAS 157, which provides guidance for determining what a write-down might be for financial instruments that have lost value. It says if you use fair-value accounting, here is how you are to determine the value of an instrument. There are only a small number of instruments, so far, that are required to be marked to market. Loans that you issue and are sitting on your balance sheet are not marked to market. Those are at amortized cost. If they lose value because borrowers are unable to pay, they must be written down.

How does mark-to-market work?

If there’s an active market for the assets and there’s an available market price, you’ve got to use that price. But the Financial Accounting Standards Board says if you don’t have an active market, you can mark to model. Mark to model means make up the number, using a discounted cash-flow model with a variety of assumptions. Almost always, the mark-to- model number is quite a bit higher than the mark-to-market number, the number that is associated with the last trade.

Then why are bankers upset?

They claim their auditors, being conservative, force them to write it down to the lower market price even if nobody is buying. They complain bitterly about that. And FASB says, “Well, that’s between you and your auditor. We’re just giving you the rules. Don’t blame us.”

What happens if you use the lower price?

The write-downs won’t affect capital, as defined by regulators, unless they’re deemed to be permanent losses. If they affect regulatory capital and you fall under the capital ratio required by regulators, you’ve got to sell assets so you can pay back your debt.

Some say fair-value accounting worsens bad situations.

The problem is not the financial reporting. The reporting is correct and honest. The problem is the bank regulators. They have to loosen regulatory capital rules during down periods so banks don’t have to sell assets. If you’re dumping your assets on the market, what happens when the supply of assets increases and the demand stays constant? Prices fall. That makes other banks have to write down their assets because their assets are not worth as much. Then they have to dump their assets so they can get their capital back in line with what bank regulators demand.

William M. Isaac, a former FDIC chairman, wrote recently that President Obama should call on the SEC to suspend FAS 157, claiming that mark-to-market has destroyed billions in bank capital and is crippling the economy.

And it also caused the black plague. Seriously, there’s absolutely no proof at all of that. Bank values, bank market capitalizations, were destroyed by bad banker decisions.

He also says, “Market-value accounting has produced totally misleading disclosures by valuing specific assets well below their true economic value.”

What’s the true economic value? The made-up number that the banks want to report? That’s the true economic value? “Trust us”? “Trust us”? Come on.

One more: “Historical-cost accounting does not run market depreciation through the income statement and does not deplete bank capital unless the decline in value is considered permanent. …”

That’s right.

“… This system provides a more accurate financial picture of a bank and does not destroy bank lending capacity.”

Most of the write-downs that were occurring were permanent write-downs. They had very little to do with mark-to-market accounting. In fact, the only way mark-to-market accounting could have caused this problem is if banks were permitted to write up their assets substantially and it created a bubble where people erroneously thought the values were worth too much. They’re pointing fingers at everyone except themselves. They caused the problem by having stupid lending practices. People were getting loans with no income checks, 100% credit and no equity. In many cases, borrowers only had to prove they could make their first payment. That’s a crazy world. That’s the world that caused our current credit problems, not mark-to-market accounting.