“One solution is giving back to bank creditors the job of policing bank risk-taking. Roll back deposit insurance, for instance. We may not be able to see the future, but we can incentivize caution as a general matter. And we can improve the odds that, when banks make mistakes, they won’t all make the same mistake at the same time.”
— Holman Jenkins, The Wall Street Journal, January 18, 2011
“…commercial real estate loans should not be marked down because the collateral value has declined. It depends on the income from the property, not the collateral value.”
— Ben Bernanke, Feb. 24, 2009, finally, if tamely, acknowledging the crucial role of mark-to-market accounting in the financial death spiral.
(via Brian Wesbury)
Among all the books, articles, and academic papers analyzing the financial meltdown, very few have pinpointed and exposed what I think was the accelerant that turned a problem into an all-out panic: namely, the zealous application of mark-to-market accounting beginning in the autumn of 2007. In this video, two of these very few — Brian Wesbury and Steve Forbes — discuss the meltdown, mark-to-market’s crucial role, and the stock market’s short and mid-term prospects. Wesbury and Forbes have also written two great books explaining the Great Panic, why it’s not as bad as you think, and how capitalism will save us.
Holman Jenkins today also picks up the theme of mark-to-market’s central role in the panic.
Good analysis from, of all people, George Soros. The credit default swap (CDS)/no uptick/mark-to-market/regulatory capital interplay has been a killer.
the CDS market offers a convenient way of shorting bonds, but the risk/reward asymmetry works in the opposite way. Going short on bonds by buying a CDS contract carries limited risk but almost unlimited profit potential. By contrast, selling CDS offers limited profits but practically unlimited risks. This asymmetry encourages speculating on the short side, which in turn exerts a downward pressure on the underlying bonds. The negative effect is reinforced by the fact that CDS are tradable and therefore tend to be priced as warrants, which can be sold at anytime, not as options, which would require an actual default to be cashed in. People buy them not because they expect an eventual default, but because they expect the CDS to appreciate in response to adverse developments. . . .
The third step is to recognize reflexivity, which means that the mispricing of financial instruments can affect the fundamentals that market prices are supposed to reflect. Nowhere is this phenomenon more pronounced than in the case of financial institutions, whose ability to do business is so dependent on trust. A decline in their share and bond prices can increase their financing costs. That means that bear raids on financial institutions can be self-validating.
Stock markets are up markedly after word spread the last few days that we would finally — finally — get some relief from mark-to-market, or “fair value,” accounting. The Financial Accounting Standards Board today, in a hearing before the House Finance Committee, promised new guidance on FAS 157 in the next few weeks. Many financial stocks are up 50-100% or more since Warren Buffett and many lawmakers commented on the need for reform at the start of the week.
The real credit, however, goes to Brian Wesbury, who’s been pounding away and comments on video here. To Steve Forbes, with his bold Wall Street Journal op-ed that opened the floodgates on the matter last week. And to David Malpass, who identified the mark-to-market problem over a year ago in early 2008.
The S&P 500 is up more than 10% since mark-to-market reform looked possible.
Bravo, Steve Forbes!
What is most astounding about President Barack Obama’s radical economic recovery program isn’t its breadth, but its continuation of the most destructive policies of the Bush administration. These Bush policies were in themselves repudiations of Franklin Delano Roosevelt, Mr. Obama’s hero.
The most disastrous Bush policy that Mr. Obama is perpetuating is mark-to-market or “fair value” accounting for banks, insurance companies and other financial institutions. The idea seems harmless: Financial institutions should adjust their balance sheets and their capital accounts when the market value of the financial assets they hold goes up or down. […]
Mark-to-market accounting is the principle reason why our financial system is in a meltdown. The destructiveness of mark-to-market — which was in force before the Great Depression — is why FDR suspended it in 1938. It was unnecessarily destroying banks.
Brian Wesbury and Bob Stein make yet another strong argument against the mark-to-market accounting regime:
The history seems clear. Mark-to-market accounting existed in the Great Depression, and according to Milton Friedman, who wrote about it just 30 years after the fact, it was responsible for the failure of many banks.
Franklin Roosevelt suspended it in 1938, and between then and 2007 there were no panics or depressions. But when FASB 157, a statement from the Federal Accounting Standards Board, went into effect in 2007, reintroducing mark-to-market accounting, look what happened.
Two things are absolutely essential when fixing financial market problems: time and growth. Time to work things out and growth to make working those things out easier. Mark-to-market accounting takes both of these away.
Of the Treasury’s long-awaited non-plan bank plan, Andy Kessler writes, “Mr. Geithner should instead use his ‘stress test’ and nationalize the dead banks via the FDIC — but only for a day or so.”
Then,
strip out all the toxic assets and put them into a holding tank inside the Treasury. . . . inject $300 billion in fresh equity for both Citi and Bank of America. Create 10 billion new shares of each of the companies to replace the old ones. The book value of each share could be $30. Very quickly, a new board of directors should be created and a new management team hired. Here’s the tricky part: Who owns the shares? Politics will kill a nationalized bank. So spin them out immediately.
Some $6 trillion in income taxes were paid by individuals in 2006, 2007 and 2008. On a pro-forma basis, send out those 10 billion shares of each bank to taxpayers. They paid for the recapitalization.
Each taxpayer would get about $100 worth of stock for each $1,000 of taxes paid. Of course, each taxpayer has the ability to sell these shares on the open market, maybe at $40, maybe $20, maybe $80. It depends on management, their vision, how much additional capital they are willing to raise, the dividend they declare, etc. Meanwhile, the toxic assets sitting inside the Treasury will have residual value and the proceeds from their eventual sale, I believe, will more than offset the capital injected. That would benefit all citizens, not the managements and shareholders who blew up the banking system in the first place.
Is Kessler crazy? Well, maybe. In his own creative and boisterous way. But not nearly so crazy as Washington’s fumble-bumble these last few months. I’d much prefer Kessler’s out-of-the-box plan to D.C.’s muddle.
What becomes clearer every day is that all the government’s efforts, from the AIG “bailout” to TARP 1.0 and TARP 2.0 onward, have essentially been efforts to get around the terribly destructive interaction of “mark-to-market” accounting and regulatory capital requirements. A few keen observers — David Malpass (I), Brian Wesbury (I, II, III, IV), Steve Forbes (I, II) — have made this point from the start. But the government and most economists clung stubbornly to “fair value” in an apparent attempt not to “let the banks off the hook.”
But what a time for an attack of conscience, a principled stand for supposed accounting purity! We’ll spend trillions and totally alter the nation’s financial landscape, but a minor (though powerful and free!) accounting change — relaxing mark-to-market — is a bridge too far? Explain that one. (more…)
Brian Wesbury expands on a chief cause of the vortex that took down the U.S. financial sector.
Suspending mark-to-market accounting will not keep institutions that took excessive risk from failing. Bad loans are still bad loans and there is no way to avoid the pain that they cause. It will, however, end the negative feedback loop, which drags everyone down. It allows time to see if the wind shifts and keeps the flames from spreading.
In the 1980s, loan problems took down thousands of banks, but because we did not force fair value accounting, the economy and stock market actually thrived. Every money center bank would have been insolvent in the early 1980s if they were forced to write down Latin American debt to 10 cents on the dollar. Add in bad oil loans which took down Pen Sqaure and Continental and bad S&L loans, and it is easy to see that the bank problems in the early 1980s were much more severe than those of the 2000s. But the rules were not as inflexible as their are today. Problems did not spread, many banks eventually recovered their principle on Latin American debt and the economy grew.
In contrast, today’s problems are expanding, and have now caused the government to put almost $4 trillion of taxpayer funds at risk to support the financial system. This is an amazing sum of money, equaling 28% of GDP, or 42% of total US stock market capitalization, or more than a quarter of all household debt outstanding, or nearly 40% of all private household mortgage debt, or three times the amount of subprime loans outstanding at their peak.
The government has tried multiple strategies. The only thing they have in common is that they are designed to offset or stop the damage caused by mark-to-market accounting.
Maximum Entropy