The Mark-to-Market Accounting Issue Is a Scapegoat!

If you are a dedicated reader of the financial papers you may have fallen for the line that mark-to-market accounting rules are a major contributor to the financial crisis. I caution you to examine that argument with a great deal of skepticism. Mark-to-market accounting rules did make things worse in the financial markets, but this ill-conceived rule was not the primary cause of the crisis.

Otherwise known as Federal Accounting Standard (FAS) 157, the mark-to-market accounting rule requires banks, securities firms and insurers to periodically reassess the value of their securities, portfolio or account, so that the most current and accurate value of these assets are reflected in a firm's financial statements. Though this accounting standard has been used voluntarily or through SEC mandate for a number of years in different industries, it became more widely used when the FASB made the rule effective for all banks, securities firms and insurance entities with fiscal years beginning after November 15, 2007.

This rule has been blamed for causing an uncontrollable collapse in the markets throughout the past two years. Many claim that if the rule had been repealed earlier we would not have seen such chaos and panic in the markets. Steve Forbes is on record as saying that the SEC should have rescinded mark-to-market accounting rules immediately because they "force a bank to show the impairment on its balance sheet from a loss it hasn’t taken yet."

Renowned hedge fund manager, John Mauldin chimed in on the mark-to-market issue more than once over the past year in his weekly newsletter, "Thoughts from the Frontline." In an issue entitled "The Law of Unintended Consequences," from March 6, 2009, Mauldin quoted Gary Townsend, a former federal bank regulator:

The Financial Accounting Standards Board has said that it will issue new guidance on the application of FAS 157. That’s encouraging, but can anyone recall when the FASB has been timely? The damage from this misguided rule is already huge, widespread, and growing daily. Mark-to-market accounting creates a powerful negative feedback loop. Actual or imputed FAS 157-related losses weaken capital ratios and undermine confidence in the financial system generally, which weakens the economy and adds pressure on loan pricing, causing more FAS 157 losses, and around we go. This cycle needs to be broken. Mary Schapiro? Tim Geithner? Are you listening?

The writers at The Wall Street Journal have also given the mark-to-market rule a great deal of blame for the banking crisis. In an article entitled "Congress Helped Banks Defang Key Rule," printed on Wednesday June 3rd, 2009, a WSJ reporter boldly claimed: "The accounting issue lies at the heart of the financial crisis."

The WSJ article and others that take on the mark-to-market accounting issue have given an overly simplistic explanation for the cause of this past year's market turmoil. They place the blame on stringent accounting rules – forgetting the myriad of additional obnoxious government interventions that deserve to be condemned. It is easy to be led astray by simple arguments that entail reforming one regulation that could act as the magic bullet to bring the banking crisis to an end. Unfortunately, the problems with the banking sector cannot be summed up in a one-liner about a troublesome accounting rule.

Even if FAS 157 had been the root cause of the financial crisis, our regulatory overlords have done a pitiful job of taking corrective action. Of all the many regulatory agencies we have, who should we rely on to push through regulatory reforms in a timely manner? The Federal Accounting Standards Board (FASB)?

Don't count on it. The FASB runs at a snail's pace – just as all bloated bureaucratic organizations do. On February 18, FASB said it didn't expect to complete its examination of mark-to-market accounting standards until late June. This was intolerably slow for Congress, so after intense hounding from legislators and lobbyists, the FASB rushed to make changes to FAS 157. The most recent update can be found in the "Proposed FASB Staff Position," (FSP) FAS 157-e.

This sorry excuse for reform came on April 2, 2009, after a 15-day public comment period. FASB eased mark-to-market rules so that financial institutions are still required to mark financial assets to market prices but only in a steady market. When the market is "inactive" or too turbulent, the rules do not need to be followed.

The reform simply involves changing the rules so that banks need only follow FAS 157 rules during "normal market activity." When markets are behaving abnormally, reporting entities are given the freedom to value their assets with their own in-house valuation models. Let's think about this…what is the probability that a firm's in-house models would give a more favorable valuation of the assets on its books than the market would? I'd say pretty high.

The FASB's response is an abysmal excuse for regulatory reform. They are allowing reporting entities to ignore the rule when it is too painful to comply with and muddying the waters further by letting them use their own discretion when valuing assets on their books. Why not abolish the rule altogether instead of making its use conditional? Better yet, leave the rule intact. According to James Chanos, chairman of the Coalition of Private Investment Companies and founder and president of Kynikos Associates LP., "Obfuscating sound accounting rules by gutting MTM rules will only further reduce investors' trust in the financial statements of all companies, causing private capital – desperately needed in securities markets – to become even scarcer. Worse, obfuscation will further erode confidence in the American economy, with dire consequences for the very financial institutions who are calling for MTM changes."

The so-called reform of the mark-to-market accounting rule is regrettably not an improvement, to say the least – so much for the FASB being an effective regulatory authority. And where has the SEC been? Under the Securities Exchange Act of 1934, it was given statutory authority to establish financial accounting and reporting standards for publicly held companies. The SEC proved itself to be a lame duck on this issue. It was seemingly incapable of doing anything about FAS 157 before the FASB made its' feeble attempt at reform.

What is also surprising is that you can't find anything resembling a coherent argument on the FASB website about the FAS 157 controversy. Accountants frequently joke about how it is nearly impossible to find anything on the FASB website unless you know the exact title or code of the document that you are looking for. This is a real shame. People have been complaining about FAS 157 for more than a year now. You would think that the crisis would have inspired FASB to post highly visible, comprehensive discussions about mark-to-market reform on their website.

To make the FAS 157 issue even more confusing, there is still an ongoing debate about whether mark-to-market accounting should have become a required accounting rule in the first place. The debate was not even close to being settled when FAS 157 was first issued in September 2006. Now we have a regulatory change that was rushed into because: "We had to do something!" How many bad cases of reform have we been given because of this pathetic argument?

Let me conclude by restating the message I wish to convey through this article – the bank's balance sheets are in terrible shape – no one denies that. Is it due to the fact that banks have to mark their assets to current market prices? Or, is it due to the fact that, thanks to the unsound inflationary policies of the Fed, the banks were seriously overleveraged in the first place? I'm in the overleveraged camp.

This accounting rule is indeed making the situation worse, but it is not the cause of the crisis. The cause is an overexpansion of money and credit by banks. The cure is a return to sound money and banking practices.

July 28, 2009