Wednesday, October 01, 2008

Did accounting rules fuel the crisis?

Washington Post:
Some economists are attributing much of the current financial crisis to something as mundane-seeming as accounting.

The Securities and Exchange Commission and the Financial Accounting Standards Board have just made an announcement that, dry as it sounds, may mean a great deal: "When an active market for a security does not exist, the use of management estimates that incorporate current market participant expectations of future cash flows, and include appropriate risk premiums, is acceptable."

The SEC is not telling holders of hard-hit mortgage-backed securities that they can willy-nilly slap any value on them they want.

What the SEC is saying is: You can take other factors into account when valuing them.

There is no market right now for the worthless mortgage-backed securities -- that's one of the reasons we're in this crisis. That means financial institutions that are holding them must value them well below their former value, sometimes near zero. That makes the institutions themselves worth much less.

Accounting is not something that ordinary taxpayers think about much, but it could hardly be more important to businesses: It's the value they place on what they own, what they owe and what they can sell.

An odd-sounding accounting phrase at the heart of this is something called "mark-to-market" accounting. Many think that if this requirement were ended, the crises could be eased.

Simply put, mark-to-market accounting requires companies to set the value for the assets they own at the price they could fetch on the open market right now. The prices must be "marked to market;" hence the phrase.
The government believes that those assets will be worth something soon -- that's why they want to buy them in the $700 billion Wall Street rescue plan. But under mark-to-market rules currently required, they are worth almost nothing, threatening those who hold them with insolvency.

If I understand the argument correctly, there was an appropriate realization in the market that mortgage backed securities were, on average, overvalued and populated with more lemons than previously believed. The market for MBSs has dried now because buyers are afraid they are being sold a lemon -- an MBS whose fundamentals worth less than the average value of MBSs. In this environment the underlying average value of the MBSs as a whole is greater than the market price at which they trade. Mark-to-market may be a market-based accounting rule, and that sounds good; but it isn't in this environment.

Update, October 3. A Tyler Cowen reader turns up a paper from 2006 that argued mark-to-market can lead to adverse and unnecessary contagion.


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