A lot of attention has been paid to mark-to-market accounting of late, with recent congressional hearings and proposals by the Financial Accounting Standards Board to modify impairment accounting and valuations.

But few know that there is even an argument that the decision to end this method of accounting for capital helped end the Great Depression. Disclosure of market marks, by contrast, is not a problem and, in fact, should be extended and enhanced. Using mark-to-market accounting in profit and capital calculations is the culprit: It contributes to a vicious spiral.

In 1938 the Office of the Comptroller of the Currency ended mark-to-market securities evaluations in banking, saying, "Bank investments should be considered in the light of inherent soundness rather than on a basis of day-to-day market fluctuations" (Federal Reserve Bulletin, July 1938). The remaining years of the 20th century did not suffer this contribution to exacerbating banking crises. Even the deep recession of 1981 and the subsequent savings and loan and banking failures were less disastrous because capital was not marked to market. Gradually over the last decade, the mark-to-market approach has come back into accounting theory and capital calculations — and with it extreme financial instability.

Going back further, financial history shows an irregular pattern of financial meltdowns every few decades throughout the 19th and early 20th centuries. The marked-to-market balance sheet was then thought of as a natural means to assess bank and trust company capital. But when markets become distressed, marking to market causes cascading financial failures. Every depositor tries to flee a bank that cannot sell its illiquid assets, and the institution fails.

This problem was recognized in 1931, and the regulators tried to mitigate the effect by reducing the impact of marking to market. It did not help until, in 1938, they repealed it.

Marking to market works like this: Securities have to be marked down through profits and capital at current market prices if there is a reasonable chance of a loss of any principal, even if these are fire-sale prices. The banks that invest in securities risk being rapidly made undercapitalized. They have to sell securities to reduce their capital needs and capital exposure. As distressed investors sell, security prices drop, prompting more distressed selling and risking more undercapitalization. The vicious spiral kicks in.

The phenomenon was well known in the Great Depression. Friedman and Schwartz, who wrote the definitive monetary history of the United States, put it this way: "Banks had to dump their assets on the market, which inevitably forced a decline in the market value of those assets and hence of the remaining assets they held. The impairment in the market value of assets held by banks, particularly in their bond portfolios, was the most important source of impairment of capital leading to bank suspensions, rather than the default of specific loans or of specific bond issues."

A contemporary observer, R.W. Goldschmidt, made the same point in the 1930s: "The depression of bond values, which started as far back as 1929 in the field of urban real estate bonds and reached foreign bonds and land bank bonds in the course of 1931, began to endanger the whole banking structure and notably the large city banks the moment first-grade bonds were affected in a most dramatic way."

Distressed prices are generally far below the expected payments (the "inherent soundness") that the investor will get over time. Risky, distressed securities must surrender a large risk premium.

But what of true marking to market? The complete marking to market (not just of financial assets) of all financial institutions' balance sheets should be reported quarterly (not just annually). It is not required or disclosed today for most banks or insurance companies. If it were disclosed, it might show that most major financial institutions in the country have negative marks. But what does that mean? Only that if everybody tries to sell at the same time, it can't be done.

It emphatically does not mean the institutions should be shut down. If they are generating positive cash flow, then they can borrow and lend and will probably generate good returns in the long term. The regulator can decide to shut them or not, making an assessment of long-term viability. But do not look at distressed asset prices as the only indicator.

Capital based on the mark-to-market approach is only an accounting theory, not a fact. Capital is widely misunderstood as being cash on hand, a stock of gold coins in some deposit box. Nothing could be further from the truth. Capital is an accounting concept that mixes accrual accounting for loans and liabilities with accounting for securities that is sometimes accrual but becomes mark-to-market when securities become distressed. So we get stability until markets melt down, then dynamic instability when the vicious spiral gets going.

Mark-to-market accounting is required to affect only securities assets, not loans and not liabilities. Half of financial intermediation happened through the securities markets until the meltdown began. Marking to market now stops securitization. Nobody can afford to invest in securities if they risk a mark-to-market hit to their capital.

Intermediation can only happen through loans or securities that have no realistic risk from marking to market (such as the mortgage-backed securities of government-sponsored enterprises). Bringing back securitization requires the end of capital marking to market, and rapid economic recovery needs a revival of the securities markets as well as expanded lending by banks.

The OCC said it well in 1938: "By severing appraisal of bank investments from current market quotations, it is believed that the banks will be encouraged to purchase securities of sound business and industrial concerns, whether large or small, for their true worth and not for speculative gains." And "as the banks avail themselves of the opportunity, the necessity will be diminished for the creation of government agencies to furnish credit facilities which the banks should provide."

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