There are certainly many factors causing the freeze-up in our financial markets. However, it is time to debate whether accounting policies are making the problem worse than it should be.
Are they adding fuel to the fire, rather than accurately measuring its heat? Are they, in fact, helping to build a feedback loop that causes a downward spiral?
Assets are being marked to market, but what is the right definition of the market, particularly when it is clearly dysfunctional? Many people believe that in some cases the assets behind the securities — mortgages, for example — are worth more than the mark-to-market valuations of the securities.
My car has an economic value generally based on its model, condition, mileage, etc. Ultimately, that value, which is set in the marketplace, is the price I could obtain if I sold the car. But if I had to sell it in the next 24 hours, I probably would not get very much. There would not be time for many buyers to look at it or to take it to a mechanic to evaluate.
And if buyers knew I had to sell the car, then the price would really go down.
Now suppose a large number of people were driven to sell their cars at the same time. Then add another wrinkle: Many of the potential buyers were told that if they bought my car, they would have to "value" it in the future according to the same set of circumstances.
Furthermore, the market for cars is fairly well established — there is the Blue Book, for example. But suppose there were no established price list, and instead there were a newly created market measurement, one that many suspected was "announcing" prices that were too low, because the market's bears were over-represented. Should that measurement be used anyway because it is available?
Is the potential sales price of my car, under these circumstances, the right way to value it? It could be. Maybe I should not presume I will have a month to sell it and a smooth market for my sale. On the other hand, that would seem to depend on my circumstances. If I have few assets, a lot of debt, and a not-very-secure job, I might have to sell quickly, but if I have a lot of assets, little debt, and secure income, I would not.
Though it is rough, my car analogy is very similar to the valuation model being used for many securities. They are being marked to what they could sell for right now and in a market where buyers have not had time to investigate the underlying assets, where buyers know the securities have to be sold (and many more may have to be sold in the future), where many institutions have little or no choice but to sell, where many potential buyers — publicly traded companies — might have to mark down the securities quickly to below what they paid, and where the public pricing mechanisms — credit market indexes — are widely believed to carry a serious downward bias.
For bankers, the problems have been exacerbated by efforts in recent years by accounting purists that often have resulted in reduced reserves for loan losses while downplaying long-term soundness issues.
There are many strong arguments for the current accounting methods. Objective measures are needed, and the most objective price is what a security can be sold for now in an arm's-length transaction. Leaving the pricing up to management discretion runs the real risk of manipulation.
Investors should recognize that there can be liquidity issues and factor them into product design and investment strategies, and current accounting policies force that recognition. It is important to find the bottom quickly and not allow losses to be hidden and strung out — look at what happened in Japan. And accounting should not be subject to political influences.
There are legitimate concerns about moving away from accounting purity, but it should be recognized that the proper definitions of "market" and "fair value" are debatable, and that there may be externalities that should be identified and discussed.
If, in fact, accounting policies and practices are based on erroneous definitions, causing excessive markdowns, creating negative feedback loops, and/or preventing potential purchasers from stepping in, those issues should be debated, and not just by the accounting gurus.
The issues go beyond the policies to applications. In the post-Enron, pro-litigation environment, are incentives making valuations too conservative?
Such a public discussion should focus not just on accounting in isolation, but also on the market impact.
Good accounting is not an end in itself, but a means to make markets work as well as possible. It is not necessarily the case that looking at the issues more broadly will result in conflicts with the best accounting practices and compromises away from such practices. Such a broad discussion may help identify a better way to determine the best approach.
It is almost certainly too late to have a debate that will affect the current situation, but the debate should begin now, because the structure and workings of post-crisis financial markets are already being determined.
