Mark-to-Market Didn't Cause the Crisis

Last September, when investment bank Lehman Brothers' looming failure was said to threaten the broad financial system, Stephens Bank CEO Warren Stephen sent a memo to his staff in which he wrote, "One thing I know for sure, this crisis will not affect Stephens Inc." While Lehman's balance sheet was leveraged up to 30-to-1, Little Rock-based Stephens Inc. could only claim leverage of 2-to-1.

With its list of assets and liabilities nothing if not prosaic, Stephens would not suffer collateral damage from Lehman's collapse. But some financial institutions, including Citigroup and Bank of America, saw their share prices go into freefall after Lehman's bankruptcy, and in Citi's case, a government bailout was crafted in short order.

The financial carnage that seemingly began eighteen months ago with the near-bankruptcy of Bear Stearns has predictably generated lots of discussion as to its causes. And in particular, mark-to-market (MTM) accounting has been fingered by some as the match that lit the fire.

This theory seems wanting. Fair market prices don't so much distort as they put a mirror on business and investment practices. For the financial institutions that acted in ways risky, MTM revealed poor investment decisions. For the institutions that were more careful this decade, MTM proved less problematic.

The debate. In the latter part of 2007, the Financial Accounting Standards Board (FASB) changed the definition of MTM rules, and with financial firms suddenly required to use "observable" market prices to value securities, the U.S. soon found itself in what economists Brian Wesbury and Robert Stein termed "the worst financial panic in a hundred years." To Wesbury and Stein, the new accounting rules and the horrific financial crisis that ensued were related.

Notably, not all commentators shared their point-of-view. Economists Steve Hanke and John Tatom argued that "an asset is only worth its price in the marketplace, which is the only objective measure of value." Hanke and Tatom concluded that far from the cause of banking problems, MTM was "part of the cure" because it would "help accelerate the end of the current crisis and reduce its cost." Financial institutions that made poor decisions should be allowed to go bankrupt so that their operations could be acquired by more prudent banks eager to expand their market share.

Former hedge-fund manager Andy Kessler observed as much last October. As he wrote then, MTM "probably has saved us from 10-plus years of gloom and doom." To Kessler, "Mark to market just accelerated the inevitable, the write-down of bad loans. For the system as a whole, it is always better to take your lumps post-haste." If not, if accounting sleight-of-hand makes the insolvent solvent, the essential process whereby economies adjust and start growing again is delayed.

Why accounting rules at all? One question that has perhaps not been asked enough is why we even have enforcible accounting rules? Accounting is merely a theory, so it could be argued that all businesses should be free to account for profit and loss as they see fit.

Arguably the long-term result of a more laissez-faire approach might be that markets themselves would divine the best way for companies to balance their books. At first some firms would choose to be opaque, while some might choose to be wholly transparent. Ultimately investors would force the ideal accounting practices through their ability to commit capital based on comfort with the accounting standards put in place.

Defenders of MTM might object to a lack of standards based on the presumption that businesses could use liberalized accounting methods to make debased assets look better, but this objection doesn't hold up to greater realities. Put simply, all investors mark balance sheets to market, so whatever the rule, poor loan or investing strategies would be difficult to hide no matter the rule.

Back in 2001 Enron used all manner of accounting techniques to obscure its mistakes, but investors weren't fooled for long, nor would they be today. As the Manhattan Institute's Nicole Gelinas noted last fall, investors didn't short the shares of Lehman Brothers because it had marked its assets to their fair value, "They shorted Lehman partly because they didn't think that it had written such securities down far enough."

Objections to mark-to-market accounting. It's fair to assume that many who dislike MTM don't so much object to the requirement that financial institutions mark assets to their observable value, as they dislike the regulatory implications of doing so. Banks of course have capital requirements, and as happened last fall, despite possessing securities that were by all indications performing, MTM rules required them to be marked to levels that made banks insolvent on paper. This insolvency essentially crippled their ability to lend money, thus exacerbating what some termed a "credit crunch."

In that sense, some say a sensible solution might be for banks to mark to market alongside more liberalized accounting rules for regulatory purposes. On its face, this seems like a fair solution. Transparency combined with regulatory ease so that banks can continue to serve the needs of the public through more lending.

It all seems appealing but for one thing: banks that take customer deposits benefit from an FDIC subsidy in the form of deposit insurance. In that case, customers know they can deposit money in any FDIC-insured bank, and regardless of said bank's lending/investment practices, they'll be made whole if the institution collapses.

Looking at banks that would like to combine MTM with liberalized capital requirements, they can't have it both ways. If they desire the subsidy that makes depositors more comfortable placing money with them, then it's folly for them to object to the very standards meant to ensure their solvency. So long as bank operations are insured by other financial institutions and taxpayers, it's quite something for them to demand in times of distress that market values-no matter how thin the market-be ignored. As deposit taking institutions, they should be solvent, with assets easy to liquefy in case customers seek to withdraw their funds.

Mentioned earlier was the frequent objection among gasping banks that they were being forced to write down the value of assets that continued to perform. As has been pointed out frequently amid the crisis, securities prices sometimes deviate - albeit temporarily - from the underlying fundamental value of the assets. But if that is true, an opportunity existed last fall for healthy financial institutions to do what investors have always done: buy up debased assets and institutions on the cheap.

What this argument seems to ignore, however, is that an asset's present performance is not what concerns the discerning investor. Instead, investors are trying to understand what the future looks like. As individuals, assuming we're 100% current on our debts, if we suddenly lose our jobs without being able to find something new, our ability to continue to pay what we owe is compromised. In light of the financial picture last fall, investors perhaps correctly assumed that unemployment was set to skyrocket, and as such, what was performing in the present did not accurately reflect a more dire future of 9.7 percent unemployment. Investors also had to price in mortgage resets that would make performing loans less viable due to higher interest rates.

In questioning MTM, Wesbury and Stein observe that it's the equivalent of "forcing homeowners to come up with more capital when the weather man forecasts a hurricane because their homes might be destroyed." So true, but it's easy to see where the aforementioned example elevates the worth of mark-to-market. Last fall the looming hurricane was layoffs, and beyond governmental attempts to force "voluntary" rewrites of mortgages, investors had to price the future performance of assets amid much higher rates of joblessness.

Former FDIC chairman William Isaac has regularly pointed out that if mark-to-market had been in place in the early 1980s, the Latin America debt crisis would have destroyed every money center bank. If true, far from a reason to suspend MTM, Isaac's example speaks to the certain value of mark-to-market. Indeed, had faulty, non-economic lending to profligate Latin American governments forced banks under, MTM would have served as a flashing market signal to cease this kind of lending sooner than they did. Furthermore, loans of the type Isaac describes were not securitized back then, and as such, we're not marked to market to begin with. The comparison itself isn't apt.

It's also argued that if it had been the rule in the late '80s, MTM would have forced a great deal more S&Ls and banks under in the aftermath of loans made to dodgy real estate opportunities. If so, broader financial institution insolvency might have been painful to Americans at the time, but when we consider the results of ghastly lending decisions made in the property sector this decade, it's a fair bet that had MTM been the accounting standard twenty years ago, the problems of last fall would have been far less pressing.

Also mentioned earlier was how the application of rigid accounting rules forced banks to reduce lending at a time of low liquidity, but this too speaks to the value of marking assets to market. If it's agreed that toxic balance sheets among certain banks spoke to poor decisions on their part, then it's also true that far from being economically stimulative, their loans simply destroyed capital. In that case, what better for the broader economy than reserve requirements meant to slow the issuance of awful loans?

Nineteenth century French political economist Fredric Bastiat frequently wrote of the "seen" and "unseen," and while the "seen" is how much the U.S. economy grew in the '80s, '90s and part of this decade, the "unseen" might be how much growth was lost due to liberal accounting rules that facilitated poor lending decisions on the part of banks. What will be forever unknown is how many Microsofts and Intels never saw the light of day thanks to accounting rules that allowed lenders to throw so much good capital after bad.

Conclusion. Stephens Bank survived, and even thrived in the aftermath of Lehman Brother's implosion last fall precisely because it didn't make the kinds of mistakes that would have felled the firm had it followed Lehman's lead. This is what's supposed to happen in a free market, and if MTM speeds the process whereby failed businesses are starved for capital in favor of successful ones, all the better.

And while there's a good argument for no accounting rules at all, further relaxation of accounting rules at present would be a mistake. Rule relaxation now would represent a bail out like any other; one that would free up the banks that failed to potentially make more mistakes. Better to let them stand on their own, and if their operations and balance sheet merit further investment of the private kind, then their survival will be warranted.

The late writer Warren Brookes once observed that "Businesses, like people, seldom if ever fail solely because of lack of money. They fail because of lack of ability, judgment, wisdom, ideas, organization, and leadership. When these qualities are present, money is seldom a problem." In short, accounting rules that forced the acknowledgement of market prices did not cripple the banks, but bad decisions did. To blame accounting rules for what happened in the last eighteen months is in the late Walter Wriston's words the equivalent of cursing "the thermometer for recording a heat wave."