Wednesday, May 06, 2009

Mark-to-Market Rally? An Engineered Crisis?

The linked to the article above came out on March 12th. The market hit its bottom on March 9th. Its probable that the people at the FASB and SEC started leaking rumor of the relaxation of Mark-to-Market rules, formally known as FASB 157e a few days before this article was released and before the congressional testimony. Is it a coincidence that since the leaks started the S & P 500 has gone from 672 to over 900 (closing today at 919)?

I don't know, but I find it interesting that for months the call to relax Mark-to-Market had gone on for months and as soon as that relaxation looked to be a reality the market rallied by 37%.

I'm not passing judgement on Mark-to-Market, I actually think it serves some uses, but perhaps this crisis (though real) was partially manufactured by overly stringent accounting rules.

Here is an excerpt from Brian Wesbury and Robert Stein:

"The history seems clear. Mark-to-market accounting existed in the Great Depression, and according to Milton Friedman, who wrote about it just 30 years after the fact, it was responsible for the failure of many banks.

Franklin Roosevelt suspended it in 1938, and between then and 2007 there were no panics or depressions. But when FASB 157, a statement from the Federal Accounting Standards Board, went into effect in 2007, reintroducing mark-to-market accounting, look what happened.

Two things are absolutely essential when fixing financial market problems: time and growth. Time to work things out and growth to make working those things out easier. Mark-to-market accounting takes both of these away.

Because these accounting rules force banks to write off losses before they even happen, we lose time. This happens because markets are forward looking. For example, the price of many securitized mortgage pools is well below their value, based on cash flows. In other words, the market is pricing in more losses than have actually, or may ever, occur. The accounting rules force banks to take artificial hits to capital without reference to the actual performance of loans.

And this affects growth. By wiping out capital, so-called "fair value" accounting rules undermine the banking system, increase the odds of asset fire sales and make markets even less liquid. As this happened in 2008, investment banks failed, and the government proposed bailouts. This drove prices down even further, which hurt the economy. And now as growth suffers, bad loans multiply. It's a vicious downward spiral.

In the 1980s and 1990s, there were at least as many, and probably more, bad loans in the banking system as a share of the economy. The difference was that there was no mark-to-market accounting. This gave banks time to work through the problems. At the same time, the U.S. cut marginal tax rates and raised interest rates, which helped lift economic growth. Time and growth allowed those major banking problems to be absorbed, even though roughly 3,000 banks failed, without creating an economic catastrophe."

Was this crash caused by mark-to-market