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City Journal Home.
Nicole Gelinas
Mark-to-Market Isn't to Blame
Blaming fair-value accounting for banking misadventures is like
criticizing the newspaper for reporting a murder.
25 September 2008
The credit meltdown has spawned a few false villains, and one is
"mark-to-market" accounting. Too many observers- including Congress's
Republican Study Committee- think that if we just suspend the
accounting rule that requires financial firms to report certain
investments at fair market value, then the crisis will go away. But
accounting isn't the culprit here.
You may ask: What the heck is "mark-to-market" accounting? The people
who write and enforce our national accounting standards mandate that
publicly traded financial companies must report some of their assets
(things like mortgage-backed securities) and liabilities (like money
they've borrowed from other institutions) at "marked-to-market"
values. That is, if you bought a certain security at $100 last year,
but you can't find anyone to buy it this year for more than $40,
you've got to report its worth as $40, since, unless you plan to build
a time machine, that's the "fair-value market price" it would command.
Contrary to popular belief, mark-to-market accounting isn't new.
Financial institutions have reported many financial instruments this
way for decades, usually because they wanted to. Their desire makes
intuitive sense. If much of your business is borrowing huge amounts of
money and then buying and selling securities to exploit and magnify
small price changes in those securities, then you've got to have a way
of telling the world how much money you've made this quarter doing
just that. Informing your investors that Joe's mortgage is still worth
the same $250,000 it was 10 years ago (when somebody else lent him the
money), minus Joe's previous payments, doesn't advance that goal. But
telling them that you made $50 million on Joe's mortgage and thousands
of others like it this month by exploiting small changes in
interest-rate expectations does.
Financial institutions even fought for, and eventually won, the right
to report some of their really long-term assets at day-to-day "fair
values." Firms like Macquarie report the value of toll roads on such a
basis so that they can take regular profits from them. Enron won the
right to report long-term energy contracts on a "fair-value" basis,
allowing it to do much the same thing, with a big dose of fraud mixed
in. This stuff sounds crazy (and it might be), but it's what the
industry wanted. Especially over the past decade or so, banks thought
that anything- whether it's a toll road in the first world or a power
plant in India- could be monetized and treated as a perfectly liquid,
instantly tradable financial instrument, like 100 shares of Exxon
stock.
But contrary to another popular belief, no financial firm has to
report all of its assets at "fair value." What must be reported that
way are things like derivative securities, securities purchased
temporarily- or what an institution hoped was temporarily- through
constant trading techniques, and securities that companies have
designated as "available for sale." This, too, makes sense: if a bank
always planned to sell a particular security pretty fast, and was, in
fact, depending on the money from that sale to continue funding its
operations and churning out profits, it should value that security at
what it's worth right now.
When it comes to most long-term investments, financial firms have more
discretion. If a bank had always planned to hold a security "to
maturity"- that is, hang onto a mortgage-backed security for the entire
life of all of the mortgages bundled into it, for example- it doesn't
have to pay much attention to those fair values. There is a big
exception, though: if the bank believes that that long-term investment
is permanently impaired, it must subtract that impairment from the
long-term value. A security could go bad like this for many reasons:
if the market thinks that 40 percent of the borrowers in a
mortgage-backed security are going to default, that's a permanent
impairment, because the institution holding the security will suffer
those losses even if it holds the security until maturity. But even
then, an institution doesn't have to write these long-term securities
down to immediate market values; it only has to write them down to,
say, the expected value of the remaining good mortgages in the
security.
So what's all this talk about fair-value rules being new and somehow
precipitating or at least exacerbating the current crisis? In truth,
the only new wrinkle came last November, when the accounting-standards
people issued new guidelines for how to measure fair value. First,
they reminded people that though companies usually have a choice about
whether to report an asset in a "fair-value" category, once they
decide to do so for a particular investment, they can't change their
minds. Second, the standards folks told companies how they should mark
affected assets to "fair values" when there wasn't much of a market
for them. The board assigned three simple categories. "Level one"
denoted assets that financial institutions could accurately compare
with identical assets trading in active liquid markets, meaning that
investors could feel confident that the "fair value" prices were
current and reasonable. "Level two" contained assets whose fair values
were harder to determine, but for which institutions could still find
somewhat comparable assets trading in somewhat active markets. This
designation gave companies a way to warn investors that they should
treat those prices with some skepticism. "Level three" designated
assets for which there was no market activity- like lots of
mortgage-backed and derivative securities, starting last year.
If a company labeled an asset "level three," it was a signal to
investors that it was next to impossible to assign a fair value to
that asset. The companies didn't have to report such values as zero,
though. They could still provide their best guess as to the
securities' value, as well as the reasoning behind that guess. But the
accounting board clearly meant for investors to treat any such "level
three" asset values with a large helping of salt.
Around the same time, of course, the markets for the most opaque,
complex securities were seizing up, and hundreds of billions of
dollars' worth of residential mortgage securities, commercial mortgage
securities, and the like have moved straight from the sterling "level
one" corner office to the dreaded "level three" basement. Whereas once
you could instantly find thousands of buyers for mortgage-backed
securities close to the prices at which the securities were issued,
nobody wants them anymore- at least not without weeks of scrutiny, and
certainly not at the price the banks want to sell them.
In demonizing fair-value rules, critics say that the standards have
spawned write-down after write-down, causing yet more losses at
financial institutions that use their peers' values as guidelines, and
causing more investors to flee, escalating the losses and causing big
firms to fail. No one doubts that we're experiencing a crisis in
confidence in asset values, but fair-value accounting didn't cause it.
It could have been stopped only by the banks themselves. They could
have chosen, starting more than two decades ago, to be in the
long-term investment business rather than in the short-term,
exotic-security creation and trading business. People who say that
it's not proper to value a long-term asset at today's value miss the
point. Most such assets were never meant to be long-term investments
for the banks that had just issued them or still held them when the
credit crisis struck.
Moreover, fair-value accounting isn't exacerbating the crisis, and
suspending the rules won't slow it. First, the problem for investors
isn't that banks are blindly, slavishly adhering to some arbitrary
rules. It's that with or without the rules, nobody knows what certain
securities are worth. Investors didn't short Lehman Brothers' stock
because it had written its "level three" securities down to zero (it
hadn't). They shorted Lehman partly because they didn't think that it
had written such securities down far enough- some were still valued at
70 percent of original value, while Merrill Lynch had sold what seemed
to be similar securities at 22 percent of their original value.
As for the charge that it's ridiculous to value some mortgages at 22
percent on the dollar, and that fair-value accounting helps to create
the absurdity: maybe, maybe not. The stark truth is that when you
consider that banks wrote mortgages against houses that may have been
more than 100 percent overvalued, and when you consider how much it
costs such institutions to foreclose on a house and maintain it for a
few months or longer before sale in a tough market, it's easy to see
how values get down to less than half. Subtract some more money for
uncertainty- which markets do all the time- and you're down to 22
percent, more or less.
Finally, even if standard bearers and regulators suspended fair-market
rules today, banks would still be wedded to fair-market principles, at
least until all of today's complex securities are unwound. Consider
credit-derivative securities, a form of insurance against debt
default. AIG, which holds half a trillion dollars in such obligations,
would have gone bankrupt last week without government help. But AIG's
problem wasn't some accounting rules. Even without them, AIG's trading
partners would have demanded higher cash collateral from the firm as
ratings agencies downgraded the firm, due in part to their own private
assessment of the chance that AIG would actually have to pay out on
those claims. The same was true at firm after firm: risks increased
and counterparties demanded more cash, as called for in private
contracts. Changing the accounting rules midstream can't change that.
In the end, the only thing that was wrong with "fair value" accounting
was that it was a mirror of the modern financial industry. Financial
institutions thought that they could trade anything, anywhere, at any
time, safely and virtually risk-free and for an instant profit. It
turns out that they couldn't. Fair value's sin was in exposing that
failure spectacularly.
But the anti-"mark-to-market" crowd may well get its wish, not because
the accounting and regulatory world will throw away fair-value rules,
but because investors will regard the business behind such rules much
more carefully. After all, financial institutions needed money from
the outside world to create all of those fair-value investments in
everything from mortgages to toll roads; it's unlikely they'll
replenish their now-depleted coffers in the future, because investors
now understand what complex securities and assets structured to trade
instantaneously do not only on their way up- but on their way down.
Nicole Gelinas, a City Journal contributing editor and the Searle
Freedom Trust Fellow at the Manhattan Institute, is a Chartered
Financial Analyst.
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