There has been a huge controversy among economists, politicians, regulators, and bankers on how to deal with bank assets that have lost value. There is a FASB rule (Statement 157) that requires public companies (i. e., banks) to value some of their capital assets on their balance sheets at fair market value. This is the mark-to-market (MTM) rule. Banks want to change the rule to allow them to value these assets at what they think the values should be (Statement 115).
This is important to banks because it determines the amount of capital they have in relation to their ability to lend a multiple of that amount. Because of fractional reserve banking, a bank can lend up to 10X or 20X or even 50X the amount of their capital base, depending on who’s looking.
Many banks bought subprime securities which became a part of their capital base. Their values have collapsed and banks are complaining that MTM unfairly requires them to value these assets at fire sale prices. If they don’t have to carry them at cost their balance sheets would still look good, they wouldn’t have to come up with additional capital, and their ability to lend wouldn’t shrink.
The controversy has been that this rule has helped cause our financial crisis. When credit supposedly has dried up, the MTM rule compounds the problem the critics say. It is pro-cyclical because it magnifies financial problems by requiring them to value these assets at prices that are too low, thus impairing their ability to make loans. According to Brian Wesbury of First Trust Advisors in Chicago, it’s as if a house is burning down in your neighborhood and your lender says because of that fire your house’s value is now diminished and they require more equity to support your existing loan.
Not a very good analogy. Better: you started a slow fire in your brand new McMansion and finally it caught the drapes and your house in burned in the conflagration. Then you whine about it.
It’s interesting that many on the right have rallied around this issue. Their argument is that the government has implemented another stupid regulation without understanding the consequences and now it has hurt the banks and turned the crash into a financial disaster. If only the SEC would suspend the rule everything would be OK.
Everyone knows that it’s a good financial practice for lenders to properly value their assets. Otherwise how would you know if your deposits are safe at any bank? Now, I certainly don’t question the government’s role in causing this crisis (see, Law of Unintended Consequences). But let’s examine the MTM rule. It was adopted by the SEC because it was adopted and recommended by the Financial Accounting Standards Board (FASB), a private association of financial accountants and industry people who self-regulate accounting standards. So, even if the SEC didn’t adopt this rule, companies would have had to adhere to the MTM rule. If they didn’t no one would lend them money.
In an article by Nicole Galinas of the Manhattan Institute, MTM isn’t something new. And companies only have to MTM those securities that are held for short-term investment or derivatives like subprime based securities. If securities are going to be held to maturity, they don’t have to MTM unless they believe that it is “permanently impaired.” Even then, they must only mark down values of the bad mortgages.
I therefore don’t see anything wrong with MTM.
Why should MTM be suspended in times of financial crisis? This is precisely the time when we should demand that banks should MTM.
Banks for years have been making bad financial decisions and now they want to paper it over as if they shouldn’t pay the penalty for their mistakes. Bruce Wasserstein of Lazard says says, “Accounting has now become an exercise in creative fiction,” he said. “Saying assets are worth a lot doesn’t make them worth a lot.” The problem is not MTM but bad decisions. And they know this. If you had bought a subprime security with money borrowed from them, I can assure you that they would require you to MTM and pay down the loan.
Let’s face it: they bought risky securities that aren’t worth what they paid for them. They then used their inflated balance sheets to lend far more than the underlying economic reality of their asset base should have allowed. This only added to the instability of the economy. If we let them avoid MTM now, then more instability will result because now we know they have over-leveraged their capital base.
There is a reason that we need to allow this debt to fall to its true value. Until all the bad assets of the boom years are properly valued (i.e., reduced to fair market value) the crisis will continue because no one will trust bank balance sheets. By propping up banks with phony values, the government will only create continued instability in the financial system. Instead of “pro-cyclical” revaluation being bad, it is actually good for the economy. The sooner it happens, the sooner we will be out of this recession/depression. This is nothing but a bailout of banks for making bad decisions. The interference of the government in this revaluation of bank capital is one of the things Japan tried. They turned their crash into a 15 year nightmare.