Mark-to-Market Treasure In the FCIC Report
The Financial Crisis Inquiry Commission (FCIC) was ordered by a Democrat-controlled Congress and staffed with more left-of-center partisans than not, and the content and quality of its recently released report on the financial crisis reflects this. One commission member, however, stands out as the night watchman among this otherwise ragtag group.
Within Peter J. Wallison's dissent buried at the back of the report are some real gems on mark-to-market, the accounting regime recognized by the investment world, if not the pundit world, for its causal role in the crisis.
"The Commission majority did not discuss the significance of mark-to-market accounting in its report. This was a serious lapse, given the views of many that accounting policies played an important role in the financial crisis." (p. 480)
How important a role?
"These mark-to-market capital losses could be greater than the actual credit losses to be anticipated." (p. 479)
The significance of this statement cannot be overemphasized. If it is true, then the widely accepted paradigm that credit defaults up and down the mortgage chain caused the crisis is wrong on its face. If mark-to-market losses exceeded credit losses, then the mark-to-market regime better explains the financial crisis.
Some might object: But don't market prices always simply reflect the underlying health of the assets in question anyway? The answer is no-they do not and cannot reflect underlying conditions in cases where government force, such as the mandate to use mark-to-market, structurally interferes with asset prices.
"As one Federal Reserve study put it, ‘The financial turmoil...put downward pressure on prices of structured finance products across the whole spectrum of [asset-backed] securities, even those with only minimal ties to the riskiest underlying assets...[I]n addition to discounts from higher expected credit risk, large mark-to-market discounts are generated by uncertainty about the quality of the underlying assets, by illiquidity, and by price volatility...This illiquidity discount is the main reason why the mark-to-market discount here, and in most similar analyses, is larger than the expected credit default rates on underlying assets.' (p. 479)
Markets hit a bottom when unproductive assets are bought at discount prices by investors who can put the assets to more productive use. Investors will not buy those assets if prices are expected to continue falling. "The inability of financial institutions to liquidate their PMBS assets at anything like earlier values had dire consequences, especially under mark-to-market accounting rules, and was the crux of the crisis." (p. 480)
No need for the word "especially."
"Instead of a slow decline in value-which would have occurred if whole mortgages were held on bank balance sheets and gradually deteriorated in quality-the loss of marketability of these securities caused a crash in value." (p. 480)
How big of a crash?
"In January 2009, Nouriel Roubini and Elisa Parisi-Capone estimated the mark-to-market losses on MBS backed by both prime loans and NTMs [non-traditional mortgages]. Their estimate was slightly over $1 trillion, of which U.S. banks and investment banks were estimated to have lost $318 billion on a mark-to-market basis...In addition, Roubini and Parisi-Capone estimated that U.S. commercial and investment banks suffered a further mark-to-market loss of $225 billion on unsecuritized subprime and Alt-A mortgages...They also estimated that mark-to-market losses for financial institutions outside the U.S. would be about 40 percent of U.S. losses, so there was likely to be a major effect on banks and other financial institutions around the world...
"Losses of this magnitude would certainly be enough-when combined with other losses on securities and loans not related to mortgages-to call into question the stability of a large number of banks, investment banks and other financial institutions in the U.S. and around the world." (p. 480-481)
They would do more than that. They would call into question the role mark-to-market caused in creating all "other losses." If the credit supply continually contracts, then defaults must necessarily follow as an increasing number of individuals and institutions are unable to access the credit needed to continue meeting productivity goals or even basic financial obligations. In such conditions, there will be no one to purchase assets, regardless of how attractive prices are, because the capital or credit with which to purchase them is not available. Assets will remain on the market and continue falling in price.
What portion of credit losses could be attributable to this phenomenon? Probably anything over about $110 billion, a 2006 FDIC estimate of future losses on non-traditional mortgages from homeowner inability to repay or an underwater condition resulting from interest rate resets. This is an amount slightly less than, and over roughly the same time period as, the U.S. losses which the new Basel III capital regime is expected to cause.
The main body of the report contains very brief references to the malignance of mark-to-market, likely inserted by Wallison to the displeasure of his colleagues. It would be a displeasure because if the mark-to-market regime were found to be a necessary and sufficient condition for this crisis, then the government is 100% responsible for the crisis, which means the blame attributable to the private sector is 0%, whatever else anyone might wish to say about bankers.
This is a direct threat to statist ideology. If everyone knew these things, they would start to realize that crises of this magnitude are always caused by government systemic action and would rightly begin to wonder if regulation is ever necessary.
