The solution du jour to the financial crisis is now the suspension of fair value accounting and the mark-to-market principle. The supporters of this proposal claim it is the most cost effective way to stop the downward asset price spiral, get credit flowing, and the economy going again—essentially the perennially popular free lunch. And like all mythical free lunches, it will not stave off real hunger, in this case hunger for robust information and for bank capital.
Rather than rely on prices from markets that do not function properly right now, bankers and company executives would be granted discretion to use alternative valuation methods that better capture the "fundamental true long-term economic value" of an asset. The claim is made that only such suspension will stop the relentless pressure on asset prices caused by the required bookkeeping of companies' assets at so-called "temporarily undervalued fire-sale prices." Otherwise, the argument goes, the banks will be wiped out.
Of course, if these bankers' assessments of the true risk and return of these now impaired "toxic assets" had been correct in the first place, they would not have to own up now to the very simple fact that they vastly overpaid for stuff they did not understand. There is no reason to believe that allowing bankers and company executives to decide what any toxic asset is "truly worth" today will be founded on anything other than naked self-interest and thus would not alleviate the financial turmoil we currently face.
The basic principles of economic policy are to go after problems directly, to let market signals determine prices where possible, and to try to rectify market failures. Suspending mark-to-market accounting would contravene all of these principles: It would deal with a lack of bank capital by pretending capital losses do not matter; it would respond to a lack of information by providing false signals; it would turn the lack of market from distressed assets into a problem of more expensive, weaker banks that no investors will want to take over.
This is not a matter of theory or ideology but of fact. Previous experience shows that suspending fair value accounting will only limit disclosure, decrease market transparency and thus further lower confidence in potential counterparties. Right now, global credit markets are plagued by a lack of trust in counterparties. Banks will not lend to one another, let alone to nonfinancial businesses, because they fear that the loan recipient might not be around to pay it back tomorrow, and that fear is based on suspicion that the balance sheet of counterparties is unknowable. Making stuff up will reinforce this fear, not create liquidity.
Allowing losses to be covered up will only prolong the credit-crunch, as it lets banks and other companies deny and hide their problems. This is precisely what kept Japan in crisis throughout the 1990s, and what led to the US Savings and Loan crisis in the mid-1980s. In both of these cases and others, removing discipline by regulatory forbearance—having regulators suspend the market-based criteria in hopes the market will turn around—led to accumulation of more bad assets and continuing decline in asset values.
Furthermore, should we really believe that there will ever again be a liquid market, let alone higher prices, for many of the mortgage-backed securities that are at the heart of this crisis absent government intervention to restructure these securities? That banks gaining a ‘virtual capital injection' by a redefinition of their losses will suddenly start to buy more of these assets rather than all selling them? That others will buy them at inflated prices where they have not at current discounts?
The problem is not just that US housing prices have fallen, which should have been priced in, but that the risk attributes, opacity, and legal complications inherent in these securities make them illiquid and toxic. Suspending mark-to-market does not change that reality.
Finally, since the root of this financial turmoil was the absence of proper banking supervision, it makes little sense that further erosion of discipline on banks will be helpful. Some have a romanticized memory of the Latin Debt Crisis of the 1980s, where the US government and Federal Reserve did engage in forbearance from mark-to-market to keep the major American banks open when their capital was eroded by foreign debt defaults. That is a perverse interpretation of history. Yes, that was the policy. And it had the following costs:
- Limited new lending to businesses when banks kept the bad assets on their books (remember Latin America's lost decade when capital ceased to flow south?);
- Diminished competition among US banks for those with the overvalued assets on their books;
- Lowered income to people on fixed incomes and small savers since de facto cheap capital for banks meant low returns on deposits;
- Rewarded those bankers who made the terribly misjudged loans to Latin America, who then went on to repeat their mistakes and to hire more people lacking in judgment;
- Transferred wealth from taxpayers to bank shareholders without any return of equity or upside to the taxpayer;
- And eroded the relative standing of US investments and financial markets in the world.
Only when the US government, through the creation of so-called Brady Bonds, bought the bad Latin loans at a discount and restructured them to bring them to market as securities, getting the loans off the books of commercial banks, did the problem ease. Echoes of today.
One of the reasons that the United States has so far suffered less real economic damage from the financial turmoil to date is because mark-to-market accounting has forced the banking system to take write-offs, pursue new private capital, reveal which banks are more stable than others, and force the issue of toxic mortgage-backed securities. Fair value accounting is today sending a very powerful market signal. It may also signal that the US financial sector is undercapitalized and needs to shrink. Bankers of course want to deny that, but wishing does not make it so. And removing mark-to-market is just wishing.