Alice in Wonderland’s Mark-to-Market Adventure

From The New York Times:

If mark-to-market accounting is to blame for the current financial crisis, then the National Weather Service is to blame for Hurricane Katrina; if it hadn’t told us the hurricane hit New Orleans, the city would never have flooded.

This is the logic the bankers are using, and they are getting sympathetic ears in Congress. The bankers have gotten two members of Congress to introduce a bill to establish a new body that could suspend accounting rules for financial institutions.

Edward L. Yingling, the president of the American Bankers Association, says the proposal addresses “systemic risks that accounting standards can have on the economy.”

Steve Forbes, the publisher and erstwhile presidential candidate, goes even further. “Mark-to-market accounting is the principal reason why our financial system is in a meltdown,” he wrote in a Wall Street Journal op-ed piece.

They say the problem, in short, is not that the banks acted irresponsibly in creating financial instruments that blew up, or in making loans that could never be repaid. It is that someone is forcing them to fess up. If only the banks could pretend the assets were valuable, then the system would be safe.

On Thursday, members of a House subcommittee joined in demanding that the rules be suspended. It was a bipartisan lynching of the accounting rule writers.

The panel’s chairman, Representative Paul E. Kanjorski, Democrat of Pennsylvania, said the accounting rule “does provide transparency for investors,” but that “strict application” of the rule had “exacerbated the ongoing economic crisis.”

Then he issued the threat. “If the regulators and standard setters do not act now to improve the standards, then the Congress will have no other option than to act itself.”

Sadly, a victory for the bankers would not help them much. Even if it were true that banks would be held in higher regard now if they had not been forced to write down the value of their bad assets — and that is, at best, debatable — changing the rules now would be counterproductive. Would you trust banks more? Would other banks be more inclined to trust banks?

It is true, as the bankers argue, that valuing illiquid instruments is tricky. And it is true that markets can overshoot. Some of these securities may well be undervalued now. But the solution is not to go to what Robert H. Herz, the chairman of the Financial Accounting Standards Board, calls “mark-to-management” accounting.

I call it “Alice in Wonderland” accounting, after Humpty Dumpty’s claim in that book that “When I use a word, it means just what I choose it to mean, neither more nor less.” After Alice protests, he replies, “The question is, which is to be master — that’s all.”

Although you would not know it from the angry complaints, the accounting board’s Statement 157 did not require mark-to-market accounting. That was already required under earlier rules. What it did do was clarify how such values should be determined. That stopped banks from defining “market value” as meaning whatever they chose it to mean.

Conrad Hewitt, who was chief accountant at the Securities and Exchange Commission when it conducted a Congressionally mandated review of the issue late last year, said at a recent Pace University accounting forum that he asked all the complainers if they had a better way to determine market value than the one prescribed by Statement 157. None did.

That statement set out procedures for dealing with illiquid markets and distress sales, and the board is now at work on setting out more guidelines on how to do that. You can bet that its efforts will not satisfy the banks.

But there are three steps that could improve the situation.

First, the regulators could make it clear they are committed to what is now called countercyclical regulating. They could ease capital rules when things are bad, and require more capital as the economy improves. As Ben S. Bernanke, the Federal Reserve chairman, said this week, regulations should allow capital “to serve its intended role as a buffer — one built up during good times and drawn down during bad times in a manner consistent with safety and soundness.”

In other words, accept that market values are low and report the facts to investors. But give the banks a break by not acting as if that will last forever.

Of course, many will doubt that the regulators will really get tough when things improve. They stood by mutely while the banks went on the binge that created this crisis. But we can hope.

The second step would be to force banks to disclose — to the public and to the other banks that trade with them — just which toxic assets they own.

The bankers assert that those assets are now trading for less than they will be worth at maturity. In fact that is unknowable, which is one reason we have markets. If the current deep recession turns into Great Depression II, then even today’s market values may prove to be too high.

But if we knew which securities each bank owned, and where it was valuing them, we could go over each security and reach our own conclusions as to values. We could also see which banks seemed to be more or less optimistic in their estimates of market value.

When I suggested that to a top official of one big bank, he dismissed the idea, saying it would damage his bank’s trading position to advertise what it had. Of course, he also complained that there was virtually no trading going on, so I’m not sure what the damage would be. But if the banks want to disclose the information with a three-month delay, so that there is no way to know if they still own the securities, that would be fine with me.

The final step would be to get the market for such securities functioning. Right now, it is largely blocked by the Obama administration’s slow efforts to design a program to stimulate such sales by offering generous financing and partial guarantees to buyers. No one wants to buy now if a much better deal might be available next week. The Treasury Department needs to get the details out, and then see who is willing to buy, and at what price.

Of course, any such government-subsidized market would need to make widely available what was on offer, to assure that the price received was the best one possible. It’s not a market price if market participants cannot bid.

It is possible that there will be few trades even then. Edward J. Kane, a finance professor at Boston College, suggests that banks, particularly those that know they need a miracle to regain solvency, will be unwilling to sell. “Cheap volatile assets with a huge upside are precisely the kinds of optionlike investments that clever zombie managers are energetically looking for,” he said. If they soar, the banks’ stock may be worth something. If not, the taxpayers will take the loss.

Next time you hear a banker denounce mark-to-market rules, ask if he runs his business that way. Will he offer you a mortgage loan based on what you think your home should be worth, which you can repay only if you make a lot more money than anyone will pay you? If so, then perhaps the bank should be able to use “Alice in Wonderland” accounting on its own books.

Or maybe that is not such a good idea. The banks already tried that, with liars’ loans. Those loans did not work out so well.

5 thoughts on “Alice in Wonderland’s Mark-to-Market Adventure

  1. Which brings to mind an old saying……..

    “I used to be disgusted…….. Now, I’m just absolutely amazed.

  2. And they think they can fix the thing that they are bankrupt by showing that they are not bankrupt? Well there is a big 2 by 4 called time waiting to smack them on their heads.

  3. I’m very disappointed you removed the link that Patrick put up here regarding the deception that is being perpetrated on this country and the world under the guise of change.
    Are you part of the problem or part of the solution?

  4. I would prefer that people post long comments of whatever they want to say, but not dominate with multiple comments by one person. That makes people think there are many people participating when in reality it is only one person. So craft your long comment, put what you want in it, but try not to make a particular post filled only with your comments.

  5. Sorry Michael. I just spot interesting articles & share haphazardly. Seems i will have to put a little blog of my own pretty soon so i don’t end up spamming o.p. blogs.

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