Either it’s the moon — full today — or the approach of a House Financial Services Committee hearing scheduled for Thursday, but the baying over “fair value” or “mark-to-market” accounting rules has really intensified in recent days. Late last week, a bill was introduced in Congress to create a board to review the application of accounting principles, including mark-to-market rules. Apparently these elected officials, one from each party, do not understand that’s what the Securities and Exchange Commission does — or that the SEC is to U.S. GAAP what the man behind the curtain was to the Wizard of Oz. On Monday, the anti-fair-value lobby (the usual suspects: the American Bankers Association, the Independent Community Bankers of America, the Mortgage Bankers Association and the U.S. Chamber of Commerce) passed its letter to the leadership of the House Financial Services Committee to L.A. Times blogger Tom Petruno. Petruno reports that the letter calls for “immediate action” to halt the “spiral of accounting-driven financial losses.” Also on Monday, Warren Buffet (Monday on CNBC) called mark-to-market rules “gasoline on the fire.” Now, Fed chair Ben Bernanke’s remarks on the subject (Tuesday, in a speech to the Council on Foreign Relations) have been fed into the press particle accelerator as a call to relax fair-value accounting rules. The New York Times writes that Bernanke “stoked a new controversy by endorsing more flexible accounting rules.” The Washington Post said Bernanke “advocated changing accounting methods he said have exacerbated the financial crisis.” Not that the truth matters when there’s controversy to stoke, but what Bernanke really said was much more cautious:
we should review regulatory policies and accounting rules to ensure that they do not induce excessive procyclicality–that is, do not overly magnify the ups and downs in the financial system and the economy.
In his speech, he gave equal attention to the pro-cyclical effects of regulatory capital requirements and deposit insurance funding mechanisms. He didn’t, as the New York Times asserted in its coverage, say that “regulators should consider relaxing so-called mark-to-market accounting rules that require financial institutions to value securities in their portfolio on the basis of their current market price.” What he did say was, given the difficulties of valuing “illiquid or idiosyncratic” securities or setting appropriate levels of loan loss reserves over the cycle:
further review of accounting standards governing valuation and loss provisioning would be useful, and might result in modifications to the accounting rules that reduce their procyclical effects without compromising the goals of disclosure and transparency. Indeed, work is underway on these issues through the Financial Stability Forum, and the results of that work may prove useful for U.S. policymakers.
If you’re wondering, the Financial Stability Forum is composed of the senior representatives of national financial authorities (e.g., central banks, supervisory authorities and treasury departments), international financial institutions, international regulatory and supervisory groupings, committees of central bank experts and the European Central Bank. This body ponders more slowly than the FASB, which should give you some idea of how quickly Bernanke would expect a further review to modify anything. The Times’ gloss of Bernanke’s remarks may be too glib, but the reporter –- Edmund L. Andrews –- does get at least one thing partially right: Easing accounting rules is a form of “regulatory forbearance” a phrase, he rightly notes, that became “an epithet among policy after the savings and loan crisis of the early 1990s.” (Except for the whole 1990s S&L thing. Actually, Times fact checkers, the crisis started in the late 1970s and was deeply extended by regulatory forbearance through the early and mid-1980s, until the S&L deposit insurance fund was deeply in the red and the entire industry was restructured by an act of Congress in 1989.) In fact, a major impetus for mark-to-market accounting standards came from the fact that the accounting treatment banks prefer –- amortized cost –- concealed the fact that, in economic terms, thrifts were insolvent. Thrifts were sunk when their funding costs soared in the late ’70s and early ’80s, while their assets –- largely mortgage loans and investment securities with much longer maturities than their liabilities –- paid low fixed rates. Negative interest rate margins were allowed to eat book capital to zero, while the liquidation value of the institution was negative. By the time policy makers dealt with the problem, the cost to taxpayers of “resolving” failed thrifts was multiplied by a commercial real estate bubble (fed in part by untrammeled thrift CRE lending), aggressive relaxation of residential mortgage underwriting and outright fraudulent exploitation of thrift charters and federal deposit insurance. This time, the problem isn’t that rising interest rates have lowered the value of debt securities, it’s that no one really knows whether the MBS and ABS securities will be repaid according to the contractual terms of the security. There are exceptions — but in the case of most mortgage and asset-backed security structures, the best that can be said is that the probability of being repaid increases the more senior a particular bond is in the credit structure of the securitization. Models designed to come up with mathematically robust estimates of that probability are built on historical data that is increasingly irrelevant in the current crisis. Those investors that do buy these securities at “distressed” or fire-sale levels are placing bets. Banks complain that fair value rules assess their security holdings at “liquidation value” rather than the value they would have in a going concern that can wait to see if they repay in full. But what else than “liquidation value” could the government require if it is going to continue to invest in, stabilize or otherwise resolve the holders of these securities? All the research and testimony on how fair value rules contributed to the current crisis cannot change the fact that the crisis is fully upon us. Even if fair value accounting led to this crisis, getting rid of it now won’t get us out. Instead, it will raise the uncertainty for taxpayers on the hook for bailouts and for those investors willing to put private capital to invest in banks and other financial institutions holding “distressed” securitizations. And more uncertainty for private capital means less private capital will flow into the financial system at a higher cost to the financial institutions. Put it this way: would Citigroup (C) be worth more today if its subprime, CDO and other leveraged credit investments had not been written down? How can united punditry be so smart as to call for Citi’s nationalization, but not insist on ruthless market valuations of the same investments in all the other balance sheets? The anti-fair value and banking lobbies also argue that fair value losses stopped banks from lending. This assertion is specious. First, the public rhetoric does not distinguish between unrealized losses on available-for-sale securities and losses realized when a determination is made the contractual cash flows will not be received or the holder can’t or won’t hold the security until the contractual cash flows are received (the security is deemed “other than temporarily impaired” or OTTI). The unrealized losses do not reduce regulatory capital and, as such, should not stand in the way of making good loans. On the other hand, FASB has already adjusted OTTI rules (effective for fiscal years ending December 31, 2008 or later). Nonetheless, opponents of fair value accounting still conflate the two issues. Second, and probably more to the point, banks are not lending because the risk of default has risen. If banks were convinced they would make money lending to jumbo home borrowers, for example, wouldn’t they be making those loans? Unfortunately, the loans they do have on their books (and their burgeoning inventories of foreclosed houses) provide them with ample evidence that real estate loans are not performing well. The historical politics of mark-to-market accounting have pitted the “free-market” conservatives against the “regulation loving” liberals. It is, I think, ironic that the free-market forces are now trying to use the liberals’ populist anger at banks’ reluctance to lend to push through some dilution of mark-to-market reporting. Editor’s note: Linda Lowell is a 20-year-plus veteran of MBS and ABS research at a handful of Wall Street firms. She is currently principal of OffStreet Research LLC.
