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Paulson bailout would worsen contagion-spreading accounting rules

My colleague Hans Bader is correct that most of the aims of Treasury Secretary Henry Paulson's $700 billion bailout -- stopping the "contagion" of securitized loans that have become illiquid -- could be achieved if mark-to-market accounting rules were "immediately relaxed by federal agencies like the SEC that enforce them." As I wrote in my Wall Street Journal op-ed this weekend, because the mark-to-market rules require writedowns of performing loans based on the last sale of similar assets, good "banks holding mortgages that haven't been impaired often have to adjust their books based on another bank's sale -- even if they plan to hold their loans to maturity." (And commenter "Topcat" misses the point of the post. Because agencies like the SEC and Federal Deposit Insurance Corporation use mark-to-market to measure the solvency of banks and brokerages, these firms are certainly not "free to disregard the regulatory rule for valuation and apply their own.")

But the bailout -- in addition to putting taxpayers on the hook and massively increasing government's role in the economy -- would likely make mark-to-market and hence the credit crisis worse, according to experts who have reviewed Paulson's plan. Paulson proposes a "reverse auction" approach by which government would choose the lowest selling price to by a financial firm's mortgage-backed securities. But unless mark-to-market rules were changed, this sale would force other firms to write down their assets to this price.

An Associated Press story paraphrases American Enterprise Institute scholar Vincent Reinhart, a former Federal Reserve monetary affairs director, as saying that "if the auctions set too low a price for mortgage-related assets, other institutions with bad debt may be forced to take the distressed valuation onto their books under mark-to-market accounting rules." A Wall Street Journal news article similarly observes that "buying for pennies on the dollar ... would further hurt financial institutions, since they would have to write down the losses and take additional hits to their balance sheets."

So if paying too low would add further risk to the credit market, and paying too high would add further risk to taxpayers, the rational thing would seem to be not to have a bailiout at all. It would also seem rational to instead put forth a bill preventing the SEC, the FDIC and other agencies from enforcing mark-to-market rules like Financial Accounting Standard 157 from the quasiprivate Financial Accounting Standards Board.

But Paulson, although frequently described as a "pragamatist," isn't being rational on this, despite condemnations of mark-to-market from officials of the Bank of England and academics from Yale and Wharton. Instead, he offered a staunch defense of mark-to-market rules in a July speech at the New York Public Library, saying, "I think it's hard to run a financial institution if you don't have the discipline which requires you to mark securities to market.”

Makes one wonder if Paulson really wants to save the economy or just build a Big Government that serves Wall Street