The international mark-to-market contagion — sending global markets in a downward
Bailouts. Global interest rate cuts. More bailouts. Global government liquidity injections into banks. Direct government buying of commercial paper. And even more types of bailouts.
But nothing seems to stop the downward spiral of equity and credit markets throughout the world that have been accelerating this week. But there is one intervention the governments of the world haven’t tried yet: Standing up to the high priests of the accounting profession and suspending requirements of mark-to-market accounting for illiquid assets.
Markets are more connected across the world than ever before, but, more importantly, so are accounting rules. Over the past decade or so the U.S. Financial Accounting Standards Board (FASB) and the European International Accounting Standards Board (IASB) — private professional organizations that basically have a monopoly on setting the accounting rules that government agencies adopt for regulations on the private sector — have worked on a project of “convergence” of accounting standards. This wouldn’t be so bad if it just amounted to mutual recognition of each others’ rules. But it often has meant mandating a one-size-fits-all-rule throughout the world. And this has meant a disaster with the flawed mark-to-market rule.
Despite the credit crunch being described as the spread of the “American flu,” the mark-to-market rules that are spreading it were hatched part of the Basel II international rules for financial institutions. It’s just that the U.S. jumped into the really icy water last November when our Securities and Exchange Commission and bank regulators implemented FASB’s Financial Accounting Standard 157, which makes healthy banks and financial firms take a “loss” in the capital they can lend even if a loan on their books is still performing, even when the “market price” an illiquid asset is that of the last fire sale by a highly leveraged bank. Late last month, similar rules went into effect in the Eurpoean Union, playing a similar role in accelerating financial failures.
And now the rules are a significant factor in the ongoing paralysis of global credit markets. Yesterday, a Bloomberg article quoted an attorney specializing in commercial financing as saying that “it dramatically affects the price at which companies can raise money” because “no bank wants to take the risk they’ve priced a loan incorrectly.” And the head of leveraged syndication at BNP Paribas SA in London told Bloomberg that the sell-offs“will inevitably have a knock- on effect on the mark-to-market for the rest of the loan investor community.” The panic is in a sense rational because since mark-to-market is used by regulators to measure solvency, financial firms know that even if they hold on to a performing loan they may still have to take a bigger paper loss in the future that would reduce their “regulatory capital,” thus further constraining credit.
As I’ve noted previously in Open Market, government purchases of loans through the recently passed TARP (I’m not even going to bother spelling out the acronym; in this case, it fits because it sounds like another word ending with “p” that is perfect to describe the bailout) will not solve this problem, and could possibly even worsen the mark-to-market contagion. Massive state purchases could trigger massive writedowns and cause credit to “crunch” even more.
And apparently, it turned out to be false hope that the accounting boards and regulatory agencies would suspend mark-to-market. As U.S. politicians from former GOP House Speaker Newt Gingrich to liberal Rep. Peter DeFazio, D-Ore., called for a suspension of mark-to-market rules instead of a bailout, regulators promised, promised, promised that they would act quickly on mark-to-market. But as economists Brian Wesbury and Robert Stein noted yesterday in National Reveiw, “news on September 30 of a potential change by the SEC to fair-value accounting rules fueled a 400-point rally in the Dow. This rally faded rapidly when the rumors proved false.”
It turned out the guidance the SEC issued was not a suspension but a mere “clarification” of mark-to-market rules, but one that didn’t clarify much. It restated that mark-to-market is the preferred method even for most illiquid assets, acknowledged that there were some “distressed” sales whre this valuation was inappropriate, but then stressed that the agency was in no way laying out a “safe harbor.” Basically it said to firms and their accountants, disregard mark-to-market at your own risk. Same as when FAS 157 was implemented.
And even if SEC did clarify something, we still haven’t heard from bank regulatory agencies such as the Federal Deposit Insurance Corporation, which have been argubably more consequential in this crisis in their implementaions of FAS 157 in the rules measuring bank solvency.
The crisis is often called a “market failure,” and the term “mark-to-market” seems to reinforce that. But the mark-to-market rules are profoundly anti-market and hinder the free-market function of price discovery. They are a form of what Competitive Enterprise Institute President Fred Smith calls “market socialism,” and like other regulatory scheme such as cap-and-trade that claim to utilize the market, they actually limit true market inputs. In this case, the accounting rules fail to allow the market players to hold on to an asset if they don’t like what the market is currently fetching, an important market action that affects price discovery in areas from agriculture to antiques.
And mark-to-market valuation for loans, credit default swaps, and other individualized contracts between a small number of parties — as opposed to stocks and bonds traded on an exchange where millions of parties have the exact same security — is inherently misleading. By definition, an indivualized contract has specific characteristics. By forcing banks to treat their individual loans like other banks loans, they are requiring banks to literally compare apples and oranges, and in many cases compare rotten apples with perfectly ripe oranges.
When the global financial regulators meet this week, someone should lock them in the room until they get the gumption to stand up to the accounting bodies and throw mark-to-market rules like FAS 157 in the dumpster where they belong.
For further reading, please look at this 2006 paper by Wharton School Finance Professor Franklin Allen and University of Frankfurt economist Elena Carletti that predicted that mark-to-market rules could cause a liquidity crisis. It didn’t forsee that subprime mortgages would be the catalyst, but was prescient in the many other ways it outlines how the contagion would occur. Godspeed.