Below is an e-mail that was sent to me from one of our local politicos. It was sent to him from a local conservative politician, who I have had several ("collegial") conversations over other issues in the past.
In a few words what's posted below is an argument designed to get congress, and the American public, to legislate market prices out of the market. The writer is arguing that we need to suspend Mark-to-Market, which is little more than a scam to inflate portfolios and bonuses in the financial sector.
Because of bailout guarantees taken on by the Federal Reserve you and I will eventually pay for inflated portfolios and bonuses (in the form of higher taxes or inflation). Simply put, professional market players are banking on our congressional representatives, and the American public, being too stupid to figure this stuff out. My response to this argument follows. If you can't follow the logic of the argument (you're not alone) just jump to my response, which explains what these people are really trying to do.
Here's the argument as it was sent to me ...
Apparently, public policy hath no fury like a CPA scorned.
In late 2007, the Financial Accounting Standards Board (FASB) imposed mark-to-market accounting on the US financial industry. This required financial firms to value securities at market prices, and then account for any gain or loss as a change in regulatory capital. Within a year, the US was in the middle of the worst pure financial panic in a hundred years. Coincidence? We think not.
On its surface, market-to-market or "fair value" accounting makes some superficial sense. Markets usually provide transparent and verifiable prices, so companies can't just contrive numbers to make their earnings look good.
The problem with mark-to-market (MTM) is that it makes no accommodation for the fact that market prices for securities often deviate - sometimes substantially, but always ultimately temporarily - from the underlying fundamental value of the assets. Since markets are forward looking, MTM forces financial firms to take hits to capital over something that "might" happen in the future, but has not happened yet. It's like forcing homeowners to come up with more capital when a hurricane approaches because their house might be destroyed.
This, in turn, creates a vicious downward cycle as capital constraints hurt banks, undermine the economy and drive prices lower, and then destroy more capital. In 2008, when markets for mortgage-backed securities became extremely illiquid, the financial crisis intensified. This drove away private capital and enticed government to flood the system with liquidity. This government activity helped cause panic and a recession. But all of these government programs were just a way to work around the accounting rules.
As former FDIC chairman William Isaac has repeatedly said, if mark-to-market rules had been in place in the early 1980s, the Latin America debt crisis would have destroyed every money center bank in the US. Thank goodness that did not happen. Instead, the system was given time to heal. That's what should have happened in 2008. Instead, FASB stubbornly stuck to its guns over MTM accounting.
Finally, in mid-March 2009, with stocks at new lows, Congress started to twist arms on the issue. FASB was forced to loosen up its rules and allow cash flow to be used when markets were illiquid. Just this small change did the trick. Banks were finally able to raise new capital, $100 billion or so, and the stock market surged. In fact, things have improved so much that the Federal Reserve and Treasury are finding less and less interest in the programs they designed to "save" the financial system.
But now, like a horror flick monster that just won't stay dead, FASB's accountants are proposing to expand the application of mark-to-market accounting rules across the board, to include all financial assets, including regular loans. The outcome of this debate is extremely important.
MTM accounting, because it ties the balance sheet of an institution to its income statement, and then its capital accounts, creates unnecessary volatility. There is no real market for bank loans and the value of any loan is always in the eye of the beholder. As a result, "who" is doing the beholding determines the viability of an institution and maybe even the health of the economy.
If that power is given to accountants, who have no actual responsibility for running financial institutions, but can be tarred with some of the liability (think Arthur Andersen), the result will be a more tentative banking system that takes less risk. That may sound good these days, but imagine watching a football game played by accountants who stop running because they might get a broken leg when tackled. Fair value accounting needs to be fully suspended - now.
The following is my response to this nonsense. And, yes, it really is nonsense.
... Thanks for sending me this. Let me start with this: Suspending MTM does little more than legislate the market price out of the market. It's a bad idea ...
What I see in the piece you sent me ... is terribly slanted and bereft of any real understanding of how markets are supposed to work. Mark-to-market (MTM) is what helped blow the lid off of the incredibly stupid things that some of the financial institutions were doing. Suspending MTM until "market" prices recover in a heavily bailed out and subsidized economy is a bad idea. That's like asking a bookie to suspend the debts owed until the bettor can find enough money from his rich uncle to cover his old bets, so he can start anew.
Look, good market players know how to (or should know how to) account for "temporary" deviations in prices. The reason the U.S. financial system collapsed was not because MTM exposed temporary deviations. The financial system collapsed because derivative, CDO, and CDS markets had grown so large that they dwarfed the entire value of the stock and housing market. The nonsense had to stop some time. The CDS and CDO market were badly inflated, poorly capitalized (as to their ability to pay out), and dependent on bad debts in the housing markets. These contracts - good and bad - were then bundled together and sold as a "new" investment instrument. We knew this wasn't good stuff 10 years ago (see the intro of chp. 12 in my book) and eventually became exposed because of MTM, which is a good thing.
The piece also makes reference to how the market for mortgage backed securities (MBS) became "illiquid". Look, the MBS market became "illiquid" because the market was inflated and based on faulty-bad assumptions from the beginning (artificially low interest rates, No Doc loans, NINJA loans, poorly vetted CDO-CDS market instruments, etc.). Once market players saw the lid blown off they became spooked. Lending stopped because banks and other investors didn't trust one another, or what they had on the books (which they now want to reinflate). This was compounded by the fact that many of those who were putting money into the market were "bad" debtors that Hyman Minsky would have categorized as Ponzi-scheme investors. As we saw during the market collapse, these CDO-CDS-MBS market players were not hedged, or even good speculators (see p. 207-208 in my book).
Also, I find it interesting that the author would reference former FDIC chairman William Isaac and the Latin American debt crisis (which came to light in 1982). Several U.S. banks had lent Latin America (but in this case especially Mexico) so much money that it exceeded total bank assets. How smart was that? This was not a Latin American debt crisis. It was a Western lending debacle (we could get into the flow of Petrodollars, and corruption levels, but I'll leave that for another day). The system was given "time to heal" during the debt-loan crisis because people needed time to digest the incredible stupidity of lending so much money to corrupt regimes because of false assumptions. Keep in mind that his government-escorted bailout occurred under Ronald Reagan.
The result? "Too big to fail" entered our political and financial language permanently. We saw banks "recover" under a U.S.-escorted recovery program that led to an explosion in the secondary market (for debt securities) that, in many respects, helped create the conditions for the CDO-CDS market we have today.
Finally, I'm not sure what to do with this comment: "... in mid-March 2009, with stocks at new lows, Congress started to twist arms on the issue. FASB was forced to loosen up its rules and allow cash flow to be used when markets were illiquid. Just this small change did the trick. Banks were finally able to raise new capital, $100 billion or so, and the stock market surged." Cause and effect is assumed and, more to the point, aren't substantiated here. Look, more money became available because of political pressure and because the Federal Reserve created so many programs, and encumbered so many financial obligations, that the U.S. taxpayer is now on the hook for anywhere between $7-9 trillion dollars (more if you look at other areas). Freeing up $100 billion is a drop in the bucket when you've got access to trillions that's backed by Fed guarantees.
At the end of the day, suspending MTM is a bailout gimick designed to perpetuate "too big to fail" long into the future. It's a market subsidy that Lenin would have embraced when he introduced NEP. In this case, the American taxpayer ("the peasants") retain commercial autonomy while the "commanding heights" of the economy (war, banking, etc) remain dependent on the state for favorable legislation and "centralized allocations" of resources when necessary (again, see what the Fed has encumbered). And, was the case under Lenin's NEP, while financial institutions are instructed (allowed) to operate commercially, they are not expected to deliver output according to state mandated quotas.
There's more, but the piece you sent me is really little more than a Wall Street apologists attempt to perpetuate what got us into this mess. The increasing use of the state for favorable legislation and to achieve market goals says much about the chasm that exists between the theory and reality of today's free market proponents. These guys are on no firmer intellectual ground than Lenin or Stalin.
There's more to the argument which I didn't address, but I'm sure this is enough for now. My sense is that congress will cave and give the financial institutions what they want. I hope not. Because of the collapsed CDO-CDS markets the costs could potentially reach into the trillions.
And you thought public welfare was expensive before the meltdown.
- Mark
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