I was a regulator in the 1980s, during the savings and loan crisis when all kinds of depository institutions failed in numbers second only to the Great Depression's toll.
During this time I heard one Federal Deposit Insurance Corp. official say they generally lost about 20% of asset value when liquidating a bank. Some people wondered whether, by that measure, banks should be required to hold 20% more capital to cover potential liquidation losses. If so, there would be virtually no solvent banks. Of course, that is not an appropriate standard because it presumes every institution would be liquidated — and value is lost in liquidation that is preserved in a going concern.
Yet that in a nutshell describes mark-to-market accounting, which the Financial Accounting Standards Board, or FASB, decreed as the accounting standard for all U.S. financial institutions, beginning in 2007. This rule says assets held by a bank or other type of lender have no value other than what they can be sold for each day — an appropriate measure for common stock but flat-out wrong for income-producing assets such as loans and interests in loan pools.
A bank has options when markets become dysfunctional, as they are now. Lenders do not have to sell loans. They can always hold their receivables and live off the payments. The payment streams have real value well above their sale value in the current market. The mark-to-market standard assumes that the value of the payment streams is inherent in the sale price. What this does not take into account is market disruptions during which buyers will not pay full value for a loan.
As a result, mark to market undervalues income-producing assets during a market downturn and severely undervalues them during a severe disruption like today's. The so-called "toxic assets" corroding many banks' balance sheets consist mostly of performing loans that would not be written down at all under the accounting standards that served us well before 2007. These rules valued loans at their unpaid balance less reserves.
The mark-to-market writedowns are what most of the Tarp money has been used to cover. The losses in turn spook the markets, which then dive lower, requiring more writedowns, and so on. This vicious cycle is almost entirely caused by marking to market, not real economic losses.
Mark to market is fueling the current crisis in other ways. It is a primary reason that banks are not lending. Mark-to-market accounting requires that even a new loan be booked at its value if sold (unless the bank commits itself at the outset never to sell the loan). Most new loans today could only be sold at a discount. So the bank takes a hit to its capital every time it makes a loan. This encourages banks to virtually stop lending.
It is the primary reason the stimulus programs have not worked. They may be stimulating demand, but the current crisis is really due to a deficient supply of credit. Banks and other lenders will not start lending until the markets recover or mark-to-market accounting is repealed.
To be sure, mark to market did not start the current crisis. It began with the collapse of the securitization markets. What mark to market started and now sustains is the persistent cycle of massive writedowns that has grown into a full-blown financial crisis.
Mismanagement explains investment banks' collapse. Mark to market explains why the crisis is now engulfing lenders.
Mark-to-market accounting for income-producing assets must be repealed as quickly as possible. This single act would do more to boost the financial system and the stock market than anything else we now can do. Some analysts have predicted a 20% to 25% jump in the stock market if repeal occurs. It would reverse most of the losses reported by banks in recent months and, overnight, restore the nation's banks to nearly normal.
The reluctance to do this is mostly a result of not understanding the effect of this accounting rule or a fear of appearing to cook the books. But this is not a situation in which reverting to the old rules would conceal losses; it is the very opposite. Undervaluing assets as the mark-to-market rules require is the problem, and there could be no better reason to repeal them.
FASB has finally announced that it will study some revisions in the rules and possibly announce them this quarter. This is irresponsible to a staggering degree. This lethal rule is literally gutting out the U.S. economy right now, and it needs to be repealed immediately.
Indeed, it would not be unreasonable to give the FASB the credit it really deserves by naming the current economic crisis the "Mark to Market Recession" or perhaps even the "FASB Recession." Or will that become "depression"?