Accounting rules exacerbate crisis

In the year since the credit crunch began, reading the financial
pages has become a bit like perusing a medical journal. Market
epidemiologists speculate where the financial "contagion" will strike

First it hit subprime mortgages and mortgage-backed
securities. Then asset-backed commercial paper and auction-rate
securities. Then the epidemic spread to whole financial firms like Bear
Stearns, Fannie and Freddie and Lehman Brothers. This past week the
insurance giant American International Group got the inoculation of an
$85 billion federal loan, and now there is talk of creating a giant
government agency to buy billions of dollars of illiquid debt from
various financial firms.

The method of disease transmission is
still somewhat of a mystery. The latest mortgage delinquency rate is
just 6.4 percent — historically high, but not anywhere close to the
mortgage default rate of more than 40 percent in the depths of the
Great Depression.

Helping to spread the contagion is a relatively new accountingaccounting,
meaning that a loan would be booked at its cost at the time it was
made. Payments would be recorded as they came in, and the book value of
the loan would only change if it was sold or became impaired, perhaps
because of default. method called "mark to market." For decades, lenders used historical cost

The pressure to change this method came after the collapse of U.S. savings and loans in the 1980s and the Japanese banking crisis of the ’90s. Regulators and accounting bodies argued that traditional accounting
allowed banks to hide bad assets on their books, and that financial
instruments needed to be valued based on what they would trade for in a
market today.

So during the past decade, various mark-to-market accountingrules became part of the official U.S. Generally Accepted Accounting
Principles (GAAP) and began to be required by the Securities and
Exchange Commission, bank regulatory agencies, credit rating agencies
and in the Basel II international framework for measuring bank

This supposed reform is exacerbating the crisis.
Markets for individual loans are still much thinner than for stocks and
bonds. The market for securitized loans with unique features is even
thinner, and a disruptive event can cause these markets to virtually
disappear. As a result, if a highly leveraged bank sells a
mortgage-backed security at a steep discount, this becomes the "market

Financial Accounting
Standard 157, which regulatory agencies put into effect last November,
requires accountants to look at market "inputs" from sales of similar
financial assets even if there isn’t an active trading market. That
means that less-leveraged 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.

finance Professor Gary Gorton wrote in a paper presented last month at
the Federal Reserve’s summer symposium: "With no liquidity and no
market prices, the accounting
practice of ‘marking-to-market’ became highly problematic and resulted
in massive write-downs based on fire-sale prices and estimates."

These write-downs, based on accounting
standards, can jeopardize balance sheets and solvency — much like a
spreading contagion. In effect, a single bank’s fire sale can decrease
the "regulatory capital" (or the total dollar value of assets that
government regulations require banks and other financial institutions
to keep as a reserve to immediately make good on their obligations to
depositors and other creditors) of others.

So "partly as a
result of GAAP capital declines, banks are selling … billions of
dollars of assets — to ‘clean up their balance sheets,’" notes Gorton,
creating a "downward spiral of prices, marking down — selling —
marking down again."

These rules
also affect credit insurance of the type that AIG was providing. As
Barron’s reported earlier this year, because of the ongoing fire sales
of mortgage instruments, "accountants were forcing AIG to boost its
fourth-quarter write-down of the value of its credit insurance on a
large mortgage security portfolio from $1.6 billion to $5.2 billion."
Barron’s also noted that AIG was "likely looking at even bigger
mark-to-market hits" later on.

Treasury Secretary Henry Paulson
has pushed through many creative measures attempting to shore up the
financial system. But he won’t budge on mark-to-market accounting.
"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," he
declared in a speech at the New York Public Library in July. Financial
firms, he said, shouldn’t expect much relief.

But relatively simple changes to mark-to-market rules, like suspending the rules
for illiquid but performing loans if a firm meets other solvency
requirements, would lead to more accurate information and could quell
demands for more "emergency" bailouts such as that of AIG. This kind of
reform should be a top priority of any new administration promising

John Berlau is director of the Center for
Entrepreneurship at the Competitive Enterprise Institute in Washington,
D.C. CEI associate Al Canata contributed to the commentary. Originally
published in the Wall Street Journal. E-mail comments to [email protected].