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Saturday, January 29, 2011

Removing mark-to-market accounting rules is the exact opposite of what we should do (published in the Santa Barbara News Press in February of 2009)

Mark-to-market accounting is essential to our financial system, and to the health of our economy.  Recently, many have called for relaxing or the complete abandonment of mark-to-market accounting rules.  They feel that the only way to get us out of the financial calamity we find ourselves in today is to remove the requirement that firms place the correct value of assets like mortgage-backed securities held by banks, on their financial statements, no matter how low those values may be. 

The idea is that by removing this requirement, the banks and other financial institutions will not be forced to write-down the value of these troubled assets, which in turn will not force them to go out and raise more capital.  The problem with the write-downs is that the falling value of these assets reduces the shareholder’s equity section of the balance sheets of these firms, which is the basis for their borrowing ability, and affects the covenants on their existing debt.  If their equity ratios fall beneath a certain level, they may violate these covenants, which could force liquidations and potentially bankruptcy.

My position on this issue is simply this: Two wrongs don’t make a right. Changing the rules and reducing regulations because the current system of regulation failed to prevent a catastrophe is the exact opposite of what we need right now.  The problem is not that financial institutions were required to properly account for the value of their assets; it’s that they created and purchased so many of these securities that the system couldn’t handle the gargantuan amounts of debt and subsequently imploded.  Now that these firms took-on all of this risk, wiped out ten years of prosperity, and cost taxpayers hundreds of billions of dollars, some want to change the only mechanism we have in place that provides any hope of understanding exactly how bad the current situation is, and how much risk there is in the system. 

We need to know what these assets are truly worth.  There is no sense in deluding ourselves any further.  The financial firms have done that for us for long enough.  What we need right now is more regulation, more disclosure, more transparency, and a more accurate accounting of what is out there and how much risk it all entails.  By telling firms they don’t have to report what their toxic assets are really worth, we will only act to prolong the financial crisis, and will send the wrong message to these firms, which is that they can screw-up, and we will not only bail them out, but we will turn a blind eye to what they have done.  This is not the America I know.  When you make a mistake here, you take responsibility for it, and you take significant steps so that you don’t repeat the same mistake. 

We need to force these firms to take responsibility for buying these assets in the first place, and we need to understand the magnitude of the problem we are facing.  Most importantly, we need to put rules in place to ensure that the chances of this happening again are significantly reduced. 

The recent discussions about establishing a “Bad Bank”, which Treasury Secretary Tim Geithner discussed this week, have sparked this mark-to-market debate.  The idea of a bad bank is that troubled assets could be purchased from financial institutions by the bad bank, or that these assets could be deposited with the bad bank in exchange for cash that the institutions could then use to make loans.  The problem arises when these transactions take place because the financial institutions that sell or deposit the toxic assets with the bad bank must account for these transactions.  The question is: What price do they place on the assets? 

If they mark them to market, meaning they account for the assets at the price they are given for the assets, they may be forced to take even more extensive losses than the write-downs they have already taken, which have resulted in the massive price declines of their stocks that we have already witnessed.  These additional write-downs will no doubt have a devastating impact on their ability to operate, and may be so significant that they offset any positive impact that the money they get from the bad bank might have.  If the additional losses equal or exceed the cash they get from the bad bank, then they are no better off and could be worse off, and there would be no point in doing any of this in the first place.

This is the reason some are calling for the “relaxing” of the mark-to-market rules, so that financial institutions which take money from the bad bank can avoid writing-down the value of their troubled assets further.  While there is logic to this argument, the underlying problem still remains, which is that ignoring risk is what got us into trouble in the first place.  The value of these assets is what they are worth in the open market—it’s what a free market buyer of these securities is willing to pay, period.  If we simply ignore this basic tenet of free market capitalism, and try to artificially price these securities, or worse, ignore their value, we are setting ourselves up for even more severe economic consequences to come. 

I have seen this happen too many times.  It is no different than when countries try to artificially support or constrain the value of their currencies.  One need only look at Latin America where too many times, countries tried to peg their currencies to the U.S. dollar, only to have their entire economies collapse when the currency eventually devalued drastically under the weight of this manipulation. 

We got into this mess because regulators were asleep at the switch, and didn’t understand the complexities and systemic risks associated with all of the new derivative investment vehicles created during the real estate boom.  Sufficient rules were not put in place, and those that were, failed to capture the true risk within the financial system.  Many off balance sheet investment vehicles, like CDSs, or Credit Default Swaps, were not accounted for at all on company financial statements because they are private contracts.  With a private contract, there is no active market for these securities, so there is no way to accurately price them.  The failure of a large number of these contracts was a key reason that the financial system failed.  How can it possibly make sense to move closer to a system where securities, like CDSs are not properly accounted for on financial statements, and therefore the inherent risk of these securities cannot possibly be known? 

This is what those who are proposing to abandon mark-to-market rules are advocating, and it is a recipe for more disaster.  The answer is to force firms to recognize the true value of all assets, including CDSs, and if there is no market mechanism for valuing these contracts, then a new active market must be established where these contracts can trade so that we can understand what they are worth and what their true risks are; not just to the individual companies that own the CDSs, but to the system as a whole.  Only by understanding the true risk to the entire system can we hope to avoid a repeat of the financial crisis we find ourselves in today.  And, if this happens again, the magnitude will likely be so great that no amount of government intervention will be sufficient to save the world economy.

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