“Mark-to-market accounting needs to die. It should be stabbed in the heart with a cedar stake, shot through the temple with a silver bullet and then buried under six feet of garlic powder. Like the evil killer in a horror flick, we need to make sure it never gets up off the floor ever again,” Brian Wesbury and Robert Stein at The Institutional Risk Analyst writes in a commentary.
“While we do not agree with everything Ben Bernanke is doing these days, his comments, which finger the impact of accounting rules and conventions on the economy, are right on the money.”
Institutional Risk Analyst
“Commercial real estate loans should not be marked down because the collateral value has declined. It depends on the income from the property, not the collateral value.”
Ben S. Bernanke
(February 24, 2010)
It would have been much better for the economy if Chairman Bernanke had been this clear about mark-to-market accounting back in 2008. If he had been, the US might have avoided the Panic of 2008. But it’s never too late, and now that mark-to-market ideology is affecting the ability of the Federal Reserve to exit its quantitative easing, he’s finally onboard.
In November 2007, FASB reinstated mark-to-market accounting for the first time since 1938. This rule uses bids (exit prices) to value assets. So far, so good. However, in 2008, the market for asset-backed securities dried up. The prices of bonds that were still paying in full fell by 60% or 70%, and those losses were often driven through the income statement. This wiped out regulatory capital, caused bankruptcies and created a vicious downward spiral in the economy. In retrospect, it is clear that this accounting rule was a potent pro-cyclical force behind the Panic of 2008.
Finally, on April 2, 2009, FASB allowed banks to use “cash flow” to value bonds when the market was illiquid – exactly like Bernanke said last week. This fixed the immediate problems in the system, and the economy and financial markets have been on the mend ever since. In fact, the stock market bottomed on March 9, 2009 – the very day markets found out that Representatives Barney Frank and Paul Kanjorski would hold a hearing to force FASB to change the misguided accounting policy.
However, over-zealous bank regulators are now enforcing their own version of mark-to-market accounting by using the appraisal process. Regulators are forcing banks to write down loan values and increase loan-loss reserves by using appraiser-driven valuations. Yes, that’s right; these are the same appraisers who over-valued properties five years ago. Now, because they often use foreclosures and distressed sales as comparable recent transactions, they undervalue properties.
To the regulators, it does not matter if the loan is still being paid on time. And it does not matter if the lower valuation of the collateral will force an already stressed borrower to come up with more cash. Regulators have decided that they want banks better capitalized and the way they can do that is to reduce the value of a bank’s assets and then force these banks to raise money from shareholders.
This, in turn, is undermining bank lending, hurting small business and making it more difficult to reduce unemployment. The worst part is that it is not necessary. Banks are better capitalized today than they were in the early 1980s when banking losses were significantly worse. Back then, we did not have mark-to-market rules forcing banks out of business; instead we allowed the actual performance of loans to determine the viability of these institutions.
Banks could not “make-up” loan values in the 1980s and 1990s. In fact, more than 2,700 banks and S&L’s eventually failed even though we did not have mark-to-market accounting. Mark-to-market accounting does not solve problems, it creates them by acting as a pro-cyclical force. Milton Friedman understood this and wrote about the devastating link between mark-to-market accounting and Great Depression bank failures. Franklin Delano Roosevelt finally figured this out in 1938 and suspended the rule. The Depression ended soon after. Coincidence: We think not.
Similarly, in 2009 with mark-to-market rules in place, two stimulus bills totaling over $1 trillion, a $700 billion TARP, zero percent interest rates, and trillions in other Fed and Treasury actions did not turn the market around. Private money did not flow into the banking system until FASB finally allowed cash flows to be used to value assets (when markets were illiquid).
Once the rule was changed, banks were able to raise $100 billion in private capital. And since then, TARP has been repaid by institutions that were forced to take it, while PPIP never got off the ground. It was mark-to-market accounting that created the Panic of 2008, not a failure of the capitalist system.
But these overly strict accounting rules still have many adherents, bank regulators among them. And as long as it remains a threat to the system, the system will not fully heal. For example, a viable market for the securitization of asset-backed loans is highly unlikely to reappear until mark-to-market accounting is dead and buried. Why would anyone buy asset-backed securities when there is the potential (readily witnessed over the past few years) for market-driven declines in value to undermine the ability of the financial system to hold them even if cash flows are not impeded?
If you don’t believe this, read the following exchange from last week (February 24th) between Fed Chairman Ben Bernanke and Congressman Kanjorski (D-PA).
Rep. Kanjorski: I’m particularly interested in the commercial real estate problem. Could you give us your assessment of that problem and if there’s any action we in the Congress should take.
Chairman Bernanke: Congressman, it remains probably the biggest credit issue that we still have. Yesterday, Chairman Baird talked about the increase in the number of problem banks. A great number of those banks are in trouble because of their commercial real estate positions. The Fed has done a couple of things here. We have issued guidance on commercial real estate, which gives a number of ways of helping, for example instructing banks to try to restructure troubled commercial real estate loans, and making the point that commercial real estate loans should not be marked down because the collateral value has declined. It depends on the income from the property, not the collateral value. We’ve also, as you know, had this TALF program which has been trying to restart the CMBS – commercial mortgage-backed securities – market with limited success in quantities. But we have brought down the spreads and the financing situation is a bit better. So we are seeing a few rays of light in this area, but it does remain a very difficult category of credit, particularly for the small and medium sized banks in our country. [Our emphasis added.]
While Mr. Bernanke did not directly link accounting rules with his attempt to “restart” the CMBS market, it is clear that if mark-to-market accounting remains alive, this market will not be resurrected easily. No matter how much money the Federal Reserve throws at the market for securitized assets, the private sector will remain skittish if there is the potential for an accounting rule to wreck the market again.
This is very important for the Fed’s exit strategy and for the growth of the loan market in the years ahead. Without securitization, bank lending will continue to drag and the Fed will be worried about its withdrawal of support for the system. The US needs a viable securitization marketplace and mark-to-market accounting remains a stumbling block.
Mark-to-market accounting needs to die. It should be stabbed in the heart with a cedar stake, shot through the temple with a silver bullet and then buried under six feet of garlic powder. Like the evil killer in a horror flick, we need to make sure it never gets up off the floor ever again. While we do not agree with everything Ben Bernanke is doing these days, his comments, which finger the impact of accounting rules and conventions on the economy, are right on the money.
Hopefully, the SEC, Treasury, the FDIC, Congress, and FASB were listening.
By Brian Wesbury and Robert Stein
The Institutional Risk Analyst