Mark-to-Market Doesn't Destroy, It Reveals Destruction
Back during the Internet IPO boom, companies ranging from Netscape to Priceline to Expedia went public with no earnings to speak of whatsoever. Retail giant Amazon.com was jokingly referred to as 'Amazon.org' due to its lack of profits. Despite their heavy losses, investors bought into the aforementioned concepts based on the belief that in the future, their losses would turn into gains.
This is notable today given all the talk about mark-to-market (MTM) accounting. To its opponents, MTM lies at the heart of our economic difficulties. MTM naysayers argue that an accounting measure which requires firms to value assets at market prices discovered in very thin markets is in particular driving banks into insolvency. If a more liberal form of accounting were applied, presently insolvent banks would be healthier on paper and solvent.
The above is an appealing thought, but it seems mark-to-market’s opponents blame a rational theory of accounting for the real issue weighing on banks. In this case, accounting isn’t driving them into insolvency, but the federal government’s distortion of market prices is.
Going back to last spring when former Treasury secretary Henry Paulson asked mortgage lenders to “voluntarily” reduce contractual mortgage rates, the market for mortgage-backed securities has never been the same. That is so due to the basic truth that the housing and mortgage industries have long been protected and subsidized by the political class in Washington, so when Treasury asks for voluntary changes, the ask is in fact a demand.
Moving to last fall, Paulson rushed the Troubled Asset Relief Program (TARP) through Congress, and its initial purpose was to remove the toxic mortgage assets off of bank balance sheets through purchase of same. But as we all know now, the latter never came to pass. And with TARP’s mission changing seemingly on a weekly basis, the value of the toxic assets corroding bank balance sheets became even more uncertain. Investors blanch at uncertainty in the way that vampires run from the Cross, and with governmental intention with regard to toxic mortgage securities a moving target, their value withered even more.
Then two weeks ago, in another blow for these down-and-out assets, President Obama announced a $275B mortgage relief plan, the details of which included the empowerment of federal judges to rewrite existing mortgage contracts. So while the federal government has been handing out free money to weak banks with one hand, with the other it has been taking through rulings meant to reduce the value of their frozen mortgage assets even more.
The above in mind, is it any surprise that banks with mortgage securities on their books are presently struggling? No doubt horrendous lending and investment decisions have played a major role in this regard, but when governments play with prices, they by definition create disorder such that markets freeze.
As the Wall Street Journal reported just yesterday, “bond investors worry the government’s repeated modifications to its financial-rescue packages are undermining the very foundations of bond investing: the right of creditors to claim their assets first if a borrower defaults. Without this assurance, the bonds of even the most stalwart institutions are much riskier to own.”
The Journal story begs the question of where we might be had the federal government never intervened in mortgage markets to begin with. If not, it’s easy to suggest that the supposedly toxic securities would be far more liquid for a great deal of uncertainty with regard to government intervention having been removed. In a market free of governmental machinations, what investors refer to as toxic assets would be naturally priced, and mark-to-market accounting would be essential for revealing investor views on their future viability. In that case, it’s pretty easy to see that rather than a problem of accounting, we have a situation whereby accounting is showing how governments can turn down-and-out securities into assets that are untouchable.
Mark-to-market opponents could still point to regulations that make banks insolvent on paper, and there they have a point. But just as the Internet darlings of another era were able to raise cash amid real paper losses, there’s nothing keeping banks from raising capital against assets that are presently mispriced. Furthermore, solvency rules speak to a problem of regulation over solvency rather than a problem of market-based accounting.
In the end, it has to be asked if mark-to-market’s opponents aren’t mistaking cause and effect. Indeed, assuming a suspension of MTM, is it realistic to suggest that investors would somehow believe the numbers wrought by a less draconian form of accounting meant to make bad assets look better on paper? That seems a reach. Federal intervention in the mortgage markets has made admittedly weak securities toxic and illiquid, and no accounting fix is going to change this reality.
As we know from the Internet companies of a past economic era, investors will always buy into a positive commercial future no matter how ugly the present appears. Sadly, this in no way describes the assets on bank balance sheets, the “value” of which changes with each alteration of government policy.
So rather than an accounting theory that is destroying banks, mark-to-market is merely a window into the real destruction of financial institutions by other, governmental means.
