Accounting Rules at Heart of Bank Crisis

At the heart of the current financial crisis is the near-elimination of lendable capital in the hands of the financial industry.  Unfortunately the federal government’s response has been the partial nationalization of our largest insurance and banking firms.  This is leading to the politicization of our credit markets. Rather than such an invasive response, an effective and simple way to reduce the effect on the economy of the collapse of the collateralized debt obligation market would be to suspend mark-to-market accounting in determining the regulatory capital of financial institutions.

Mark-to-market accounting basically assigns a value to a financial asset based upon its current trading price, that is, its value is marked — and kept on the company’s books — at the market price. Problems arise when the financial asset becomes thinly traded, recent trades are at distressed prices, and the financial asset is part of the amount of capital a regulated institution, such as a bank or insurance company, is required to hold to support their provision of credit.  

The current financial crisis has been aggravated by banks having to mark down the value of their required capital reserves when they or a competitor have to sell a mortgage-backed security at a fraction of its face value.  The problem is that banks are required by regulation to keep a certain amount of capital to support their credit and lending activities. When forced to use mark-to-market accounting to lower the value of their required capital due to the effect of distressed sales banks have to suddenly either contract the loans they have outstanding or try to raise new capital. The ripple effect of the contraction of the marked value of the banking system’s regulated capital has had broad and unanticipated effects.  

This is not the first time even in recent history that a credit crisis has occurred. As one example, in the spring of 1994 the Federal Reserve, after a long period of low short term rates, raised them unexpectedly.  This led to the failure of Granite Capital and institutional investors suffered losses.  Complex collateralized debt obligations sold at steep discounts to their fair value.  This however, did not lead to a collapse of the capital of financial institutions in general.  Had mark-to-market accounting been required by the financial regulators, this collapse in the CDO market could have spread throughout the entire banking industry

Today the collapse in bank capital has led to a severe contraction of lending, in good part because mark-to-market accounting forced banks to write down and reclassify assets that are required reserves.  This destabilized credit and increased the demand for capital by financial institutions in an uncertain environment.  A 2008 study by economists at the New York Federal Reserve Bank found what may now seem obvious, “that mark-to-market leverage is strongly pro-cyclical.”  It seems sensible that before we place more billions of taxpayer dollars into our banking and insurance system and talk of nationalizing our financial industry, we should try suspending the accounting rules that are pushing us further into a situation where political power determines who gets loans and at what rates.

There is a considerable amount of discussion as to how to attach a market price to the mortgage based securities currently held by financial institutions.  As in most cases, getting back to the basics can provide an insight.  Trade occurs when one person values an object more than the person who is currently holding it.  For example, if I value my house at $300,000 and you value it at $400,000, then there will be a trade and we will observe the $400,000 value.  But if I value my house at $300,000 and you offer $200,000 then there will not be a trade.  If there is no trade we do not assume that the house has no value.  And if my neighbor sells you his house for $200,000 it does not mean that I now value my house at $200,000.  My house still has a value of $300,000 since I won’t trade it to you for less but we will only observe my $300,000 value when someone else values my house more than $300,000.

If the market is broadly traded, such as Apple stock, then we can be pretty sure that there will be someone who is willing to buy the stock at a price close to the one that it just traded at, and that there will be a willing seller at that price. In other words the spread between the bid price and the ask price will be relatively small.  But in a market that is thinly traded, such as is the current situation with mortgage backed securities, then the bid and ask prices can be quite far apart.  Who is to say which is the correct price?

One of the problems with the purchase of so-called toxic assets is that the owners of the assets value them more than those who would wish to purchase them.  Thus we have the situation described above: if a bank sells even a portion of its mortgaged-based securities at a price below the underlying present discounted value of the revenue stream of the mortgages, then all of its similar assets will have to be marked to that lower price.  This will be true not only of that bank, but all other financial institutions will have to write down their assets as well, even though they value them above the market price of the asset sold.  This requirement to mark-to-market adds to the thinness of the market, because sales can lead to required reductions in the value of the remaining assets.

Suspension of mark-to-market accounting for the capital requirement of financial institutions would be entirely reasonable. It would recognize that the value of these assets differs for those institutions that wish to hold them to maturity and those who wish to sell them.  It would expand the market for the mortgage backed securities since their sale would not jeopardize the remaining capital of the financial institutions.  As long as the financial institutions were transparent in how they value thinly traded assets, depositors, stockholders, bondholders, and lenders would be able to judge for themselves the viability of the institutions and the risk involved in putting their money into them.  

This would be far superior to nationalization of banks, or sending billions of taxpayer dollars into banks that will be judged solvent or not by government bureaucrats who  will “stress test” them and decide if further government intervention into the banking system is warranted.   The current situation creates uncertainty about the rules of the game and drives down all asset values.  For example, the private sector may be reluctant to invest in Bank of America if it is only one bureaucratic decision from being nationalized.

More than 80 years ago, Ludwig von Mises pointed out that government intervention leads to unintended consequences that lead to additional government intervention. Mark-to-market accounting requirements for regulated capital have created an unintended consequence that has led to worsening the financial crisis rather than stabilizing it.  Rather than using this crisis to expand government, let the market decide what is the required amount and type of capital that is sufficient to generate deposits and determine the solvency of banks.