"An Adverse Dynamic"--How Accounting is Hijacking Economics

Last April, Federal Reserve Chairman Ben Bernanke spoke to a gathering of business people in Richmond, Virginia. During the Q&A session following his remarks someone asked him about the impact mark-to-market accounting was having on the credit markets. (Mark-to-market accounting is the requirement that value of securities held on a firm's balance sheet be reflected at the current market price.) Bernanke's responded as follows:

"It's also true in the current context, that mark-to-market accounting has been sometimes destabilizing in that sales of assets into very liquid markets had led to reductions in prices, which have caused write-downs which have sometimes caused firesales, and you get into an adverse dynamic which has caused problems in some of our markets." (If you want to read the full article, click here.)

In other words, marking-to-market liquid assets in our current destabilized financial environment is causing many of the problems we are now experiencing in the credit markets and the economy. This is a very important point and investors need to understand it. It has enormous ramifications for the decisions we are making as we navigate these stormy seas.

A Little Background
Mark-to-market accounting has long be a practice in the futures market, but became common practice among corporations and financial institutions in the early 1990's with the advent of certain account regulations. While the idea of reflecting current market values is appealing, it also has some problems. For example, how do you determine the correct "market value" of an asset when there is no active market for it? The answer is that firms were allowed to build models to determine their own value for the asset. This gave rise to several abuses and scandals. Remember Enron?

In response to these problems, the accounting profession has become very conservative in how it allows market prices for liquid assets to be determined. (None of these firms want to be the next Arthur Andersen.) The result is a tsunami of wealth destruction that makes losses suffered by Enron shareholders look pale in comparison. As the accountants respond to the dislocations in the financial markets, they require even more conservative values for assets. This leads to further writedowns, which create further dislocations, and even more conservative valuations. The cycle goes on and on creating Ben Bernanke's "adverse dynamic."

Accounting vs. Economics
A very important point to remember in all this is that the underlying economics of the assets have not changed. The vast majority of these written-down assets are sound, including most of the mortgage securities that get blamed for the debacle. They continue to pay principal and interest and will mature without any problem. But the accounting practice at the moment is requiring that they be marked at outrageously low levels. Accounting has hijacked economics.

You may ask, why don't they sell these assets in the market? The answer is because the markets are broken. Financial firms who would normally be ready buyers are up against the ropes because of their own mark-to-market problems. Other buyers like hedge funds are facing their own problems as investors react to the ongoing accounting-induced trauma. Some private equity firms and so-called vulture funds have stepped into the breach, but many are still waiting for the lower valuations the "adverse dynamic" promises to deliver.

The Way Out
Several solutions to this debacle present themselves. Some have been tried (such as putting up huge sums of public money to bailout firms caught in this vortex,) but have not worked. Maybe it is time to look at the the most simple and potent antidote. Maybe we should temporarily suspend market-to-market accounting and allow these firms to carry the assets at book value. Allow these firms to write up the value of the non-impaired assets, thereby repairing their balance sheets and putting the market back on an even keel. In the calm that will follow, we can take a more considered look at how mark-to-market accounting is implemented. It is time for economics to reclaim control from an accounting principal that has run amok.