Mark to Market By David Henderson

Economist Jeff Hummel sent out the following to a large e-mail list. I’m reprinting the whole thing here and appending my comments.

Jeff’s e-mail:

Mark-to-market accounting has received a lot of criticism during the

current financial crisis. But a recent email from Less Antman, a CPA and

financial planner, offers the best explanation I’ve seen of why

government-mandated capital requirements are the real source of the

problem. Economists now realize that reserve requirements, designed to

make banks more LIQUID, have the unintended reverse impact during a panic,

tying up cash that banks need to pay out in order to stem the panic. As a

result, reserve requirements are fast disappearing as a tool of bank

regulation. Similarly, capital requirements, designed to make banks more

SOLVENT, also have the reverse impact during a crisis. What follows is

Less’s analysis:

“Any discussion of mark-to-market accounting must differentiate between

the beneficial effects of honestly reporting assets at what they are

actually worth and the destructive impact of inflexible regulations that

utilize the principle. Current discussions have blurred the distinction.

“(1) The Financial Accounting Standards Board (FASB) determined that

securities held by a company which it intends to sell when funds are

needed for another purpose ought to be reported at fair market value

rather than historical cost. This seems eminently sensible to me.

“(2) The FASB allowed an exception for debt securities which would

eventually mature at a fixed price, and which the company had the positive

intent and ability to hold to maturity. Mark-to-market accounting is

specifically not required when the company elects to classify the security

as one to be held to maturity.

“(3) In spite of ignorant comments to the contrary, ‘market’ doesn’t mean

that the last trading price of a security must always be used, nor that a

security whose market has virtually disappeared due to unusual

circumstances must be valued at zero or near zero. The FASB EXPLICITLY

permits the use of alternative market measures in such circumstances, such

as the complicated derivative pricing model known as Black-Scholes. For

instance, Berkshire Hathaway (Warren Buffett’s company) has $8.1 billion

(at cost) of derivatives on its books, all carried under mark-to-market

accounting, but none of them currently priced based on the non-existent

market for those derivatives.

“I am fully supportive of the use of mark-to-market accounting on balance

sheets. It is clearly the most honest way to report derivatives. So what’s

the problem with mark-to-market accounting? I see the following

government-created problems associated with them:

“(1) Mark-to-market was adopted by regulators as the basis for determining

minimum capital requirements. Creating an inflexible regulation based on

an inherently volatile measure was always an accident waiting to happen.

“(2) While foresighted bank executives might have chosen to maintain

capital in excess of regulatory requirements so that a decline in value

wouldn’t trigger a crisis, it would have made no business sense to do so,

since it would have reduced their lending income and ability to pay

competitive rates on deposits or offer other benefits to attract

customers. In a free market, they would have been able to do so, since

they would have gained a reputation advantage from their greater safety,

but with FDIC insurance protecting all deposits, customers don’t shop

based on safety, as they assume they are protected by the government from

the loss of their deposits. Thus, only the rates and benefits offered by a

bank matter to a customer, not the reliability of the bank, thanks to the

FDIC.”

(JRH interjecting: I might add that Less’s point here is well supported by

the historical record. Prior to government deposit insurance, U.S. banks

voluntarily maintained capital-asset ratios in the neighborhood of 10 to

20 percent, way above current mandated levels.)

“(3) With banks thus always seeking to keep only the minimum required

capital, the problem was further exacerbated by the Basel capital

requirement formula, which requires less than half the capital if kept in

the form of AAA securities compared to high quality individual mortgages

(as I discuss in my article on Credit Default Swaps, forthcoming in the

April 2009 issue of THE FREEMAN). This caused an explosive increase in the

worldwide demand for AAA securities as a result of the needs of regulatory

arbitrage.

“(4) With capital of virtually every international bank invested as

heavily as possible in AAA securities critical to the financial

competitiveness of the bank, the problem was further exacerbated by the

ratings cartel created by the SEC in 1975, which effectively mandated that

companies obtain a rating from Moody’s, S&P, or Fitch, who were thus

effectively insulated from the destructive effects of reputational damage

by a system that made it impossible for them to be put out of business by

more accurate upstart rating services. This also prevented better methods

of risk measurement (such as Credit Default Swaps) from replacing ratings.

“(5) Fannie and Freddie fed the supply by creating AAA securities in

gigantic sums, initially from the securitization of high-quality

mortgages, then from lower-quality mortgages that had components

artificially improved in quality from the creation of ‘tranches,’ and

finally from lower tranches artificially improved in quality as a result

of Credit Default Swap protection from AAA-rated companies such as AIG

(also discussed in my CDS article). AAA ratings that were, in many cases,

undeserved.

“(6) It is also possible, although I haven’t thought this through, that

the mortgage lending boom itself was stimulated by the need for AAA

securities to satisfy regulatory arbitrage needs worldwide, and once it

was clear that low-quality mortgages could be turned into AAA securities,

the lowering of lending standards was inevitable, even absent the CRA and

FHA mandates.

“So, thanks to various government interventions, banks operated with the

minimum capital required by the mark-to-market application of the law,

consisting almost entirely of artificially created AAA securities

benefiting from artificially high market pricing resulting from sloppy

ratings. And then reality bit, and an honest revaluation of these

securities based on mark-to-market accounting, linked to inflexible

government regulations, brought down the banking industry. And that is the

extent to which I believe mark-to-market accounting can be blamed for this

crisis. ”

David’s addition:

Jeff’s comment above reminded me of George Kaufman’s article. “Deposit Insurance,” in the first edition of The Concise Encyclopedia of Economics. Note the following statement in the article: