I'm an accountant....and I'm sorry (Update)

Two excellent articles from the Wall Street Journal on October 1st concerning the "mark to market" accounting rule.

An excerpt from the first,

This paradox works both ways. Financial problems have not yet dragged down the economy, but it is also true that the economy is not the cause of financial-market problems. Most of the loans that have been going bad in recent months would have gone bad even if the economy had been growing twice as fast. So what is to blame for the "worst financial crisis since the Great Depression"?

The answer seems simple. Mark-to-market accounting rules have turned a large problem into a humongous one. A vast majority of mortgages, corporate bonds, and structured debts are still performing. But because the market is frozen, the prices of these assets have fallen below their true value. Firms that are otherwise solvent must price assets to fire-sale values. Not only does this make them ripe for forced liquidation, but it chases away capital and leads to a further decline in asset values.

For example, the prices of assets on the books of Washington Mutual, when it was bought by J.P. Morgan at a fire-sale price, were cited as a reason to mark-down the assets on the books of Wachovia. This, some say, forced the FDIC to arrange its sale to Citibank.

The same is true of what happened to Fannie Mae and Freddie Mac, which had positive cash flow when they were nationalized by the Treasury. Here's something you won't believe: Fannie Mae and Freddie Mac have not drawn a dime from the Treasury's $200 billion facility that was created to bail them out. It was the use of mark-to-market accounting that allowed Treasury to declare them bankrupt. On a cash flow basis, they were solvent.

Mark-to-market accounting causes so much mayhem because it forces financial firms to treat all potential losses as if they were cash losses. Even if the firm does not sell at the excessively low price, and even if the net present value of current cash flows of these assets is above the market price, the firm must run the loss through its capital account. If the loss is large enough, then the firm can find itself in violation of capital requirements. This, in turn, makes it vulnerable to closure, nationalization or forced sale.

And the second, appropriately headlined as "Mark to Mayhem?" is

OK, get out your NoDoz and let's wade in. Under current interpretation of accounting rules, banks can be obliged to value loan holdings based on their liquidation or fire-sale value, even if (as now) the fire-sale values are lower than might be suggested by the cash flow and payoff prospects of the underlying assets.

Now recall that accounting is a language of abstraction. In the normal case of a public company, whatever method it uses to value its assets, it merely provides a benchmark for investors to make their own judgments. Nobody takes accounting values as the final word.

Banks, though, are subject to regulatory capital standards and therefore can be rendered insolvent overnight based on an accounting writedown. At the moment, many banks are clinging to "market" values for loans that are higher than probable fire-sale values, and doing so on tenuous grounds. In kibitzing over the Paulson plan, indeed, one knotty question was how Treasury could buy such loans at a price "fair to taxpayers" without propelling the sellers into federal receivership.

Because of all this, the regulatory state finds itself in a somewhat absurd position -- its own rules could render many financial institutions insolvent in a manner inconvenient to the state.

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A mere accounting rule change won't reduce foreclosures or raise home prices -- then again, if spared drastic writedowns, banks might be more willing to lend, raising home prices and reducing foreclosures.

A mere accounting rule can't alter the underlying economics of a lending business -- then again, no longer worried about insolvency-by-accountant, investors might discover new confidence to inject capital and improve the underlying economics of a lending business.

No accounting rule is worth $700 billion. Then again, the essence of the Paulson plan was to raise the value of bank assets to help banks escape the regulatory equity trap. Does that mean we can change an accounting rule and save Congress from having to appropriate $700 billion?

Let's find out.

This is not the first time regulatory accounting rules has almost destroyed a financial industry. It was a couple of decades ago that the savings and loan industry was almost wiped out because congress changed rules that significantly contradicted previous rules that S&Ls had been forced to follow. All of a sudden, so many solvent institutions were considered insolvent. Accounting is not supposed to do that. Accounting is for clarity and transparency...or it should be. It should not be the instrument of wholesale destruction at the hands of regulators.