Maybe the Banks Are Just Counting Wrong

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 week the insurance giant American
International Group got the inoculation of a $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% — historically high,
but not anywhere close to the mortgage default rate of over 40% in the
depths of the Great Depression.

Helping to spread the contagion is a relatively new accounting
method called "mark to market." For decades, lenders used historical
cost accounting, 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.

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 over the past decade, various mark-to-market accounting rules
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 solvency.

This supposed "reform" is exacerbating the current 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 price."

Financial Accounting Standard 157, which U.S. 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. Yale finance Prof. 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 Mr. 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 "change."

Mr. Berlau is director of the Center for Entrepreneurship at
the Competitive Enterprise Institute. CEI associate Al Canata
contributed to this article.