Boy, doesn’t that sound just too exciting for words? (Don’t drool all over your keyboard in anticipation.)
See, here’s the thing. On the one hand, an old friend had made a comment in response to my recent post about the top news stories of last year, with a link to a piece from AlterNet calling into question just how serious the problems on Wall Street really were. And I read that with some mild interest, but didn’t really follow up on it… until he shared that same link on Facebook, kicking off what became a lengthy discussion thread.
Meanwhile, on the other hand, on New Year’s Eve an entirely different old friend and I were having a semi-intoxicated discussion about the current economy, and he put forward the proposition that much of the blame for the downward spiral (on Wall Street, at least) should be pinned on mark-t0-market accounting. It was all a bit slurred, however, and didn’t quite dovetail with what I thought I knew about the subject, and I pretty much forgot about it… until the subject popped up again when he linked to an article about it in that very same Facebook discussion.
And it was off to the races!…
Now, for the record, I’m a big admirer of Facebook. I wasn’t even a member a year ago, but at this point half my social life seems to rely on it; it’s an incredibly convenient way of staying in touch with people, and has reconnected me with any number of long-lost old friends as well. But… it’s just not really the ideal vehicle for ongoing, in-depth discussions, in much the same way that, say, a BMW Z4 Roadster convertible, while snazzy in its own right, just isn’t the ideal vehicle for a cross-country road trip.
I jumped into that discussion thread late, but even so, well before it reached its current length of 68 posts—every one constrained by Facebook’s absurd and arbitrary limit of roughly 1,000 characters—I realized that if I wanted to express myself with any sense of satisfaction at all, I’d just have to post about it here.
Friend A‘s AlterNet piece, in a nutshell, quotes columnist David Sirota and economist Dean Baker to argue, regarding the TARP program, that “the whole credit crunch narrative is false,” and that
Whether good borrowers can’t get credit from banks because the latter are hoarding cash or lending has stopped because of a drop-off in demand for new loans is not some wonky academic debate; it’s of crucial significance. Because if lending to qualified parties has truly frozen, then even if the specific implementation of the Paulson Plan was deeply flawed, its broad approach — “recapitalizing” banks in various ways, buying up some of their crappy paper and guaranteeing some of their transactions — is fundamentally sound.
If, on the other hand, the primary problem is that people are broke and maxed out on debt, and firms aren’t looking for money to expand, then the kind of massive stimulus package being considered by the Obama transition team and congressional Dems — largely designed to stimulate demand from the bottom up, with public works projects, tax cuts for working families, aid to tapped-out state and municipal governments and new money for unemployment and food stamps — is obviously the best approach to take.
The thing is, I don’t necessarily see this as an either/or scenario. I think the second paragraph above stands on its own as a valid statement about “Main Street” economy at this point, no matter what is true about “Wall Street.” As for the first paragraph, it’s true (as the article describes) that demand for consumer credit has dropped, and it cites research data from the Federal Reserve Bank of Minnesota to support its argument that lending has merely followed suit; but then as a counterpoint it also acknowledges that “commercial paper issued by financial institutions has declined,” and cite the Boston Federal Reserve “arguing that the use of aggregate data doesn’t fully reflect the dysfunction in specific subsectors of the economy, nor does it adequately reflect the decline in new loans,” meaning that “some qualified firms may, indeed, have trouble raising cash in the near future.” It also quotes both Sirota and Baker (from whom I’d like to read more on this topic, but no specific links are included) to the effect that, yes, maybe banks really are hanging on to more of their capital now rather than lending it out.
So, is it the case that the main problem was always with the banking system, and that’s all that needs fixed? Clearly not. But is it true that the banking system is actually just fine, and taking taxpayers for a ride? That would be just as audacious an overstatement. It seems safest to say that Paulson’s TARP plan, while too narrowly focused on Wall Street to prevent spillover effects, has at least helped staunch the bleeding in the investment sector.
But, umm, wasn’t there something in the title about accounting methods? Yes, and that gets to what led to so much bleeding in the first place.
Friend B linked to an article (.pdf) from First Trust Portfolios (an investment firm) also arguing that the “credit crunch” was overblown… but from a completely different angle. It alleges tha
…the government is unwilling to address one of the root causes of investor fears — mark-to-market accounting.
…the downward spiral of asset prices, and fair value accounting, [are] harming the financial system. …
Suspending mark-to-market accounting would still be the single most powerful tool in the government’s tool kit if it really wants to end the problems we face today.
This December article appears to be inspired largely by the work of two economists (one from the New York Fed, one from Princeton) in a September 2007 paper… or perhaps on the coverage of it in last February’s Financial Times, arguing that “fair-value accounting ‘could even further increase the euphoria in a financial bubble or the panic in the markets in a time of crisis’.” Former FDIC chair William Isaac also echoed this idea in October.
Put aside any though, though, that these two arguments might perchance overlap, since the political underpinnings are as different as John Maynard Keynes and Milton Friedman:
- Friend A’s item notes disparagingly that “the economic crisis may have woken up Washington’s political class when it hit the banks, but it remains a product of long-term imbalances in the economy”…
- while Friend B’s item is aghast at “normally stalwart free market thinkers” who now seemingly “trust government solutions more than private sector solutions,” even though “government interference in free markets undermine[s] growth.”
Friend B’s piece made some cogent points, but also set off some red flags for me. A little background is probably in order. Or in other words,
Say, what is this “mark-to-market accounting” stuff, anyway?
Well, it’s like this. When a company holds an asset (say, stocks or other securities), it naturally wants to be able to say what that asset is worth. When said company reports that value according to what someone else would pay for it on the open market (rather than, say, what it cost you, or what income stream it’s expected to produce), that’s called marking it to market.
Contrary to the implications of the FTPortfolios piece, MTM accounting is not something the government came up with. Private sector institutions invented it all on their own, as a way of capturing the “market value” of assets without actually having to sell them. It’s not necessarily mandatory, although securities regulations eventually made it so for certain kinds of institutions holding certain kinds of heavily-traded assets. If it’s elected optionally, it has tax implications. And roundabout the 1990s, some companies started to figure out that it was an open door to cooking their books… and some of them practically became professional chefs.
The thing is, not all kinds of assets are traded regularly. As the Motley Fool financial site neatly sums things up,
- Level 1 assets have market prices.
- Level 2 assets don’t have market prices; they’re marked at fair value based on a model. The model is fed with inputs for which there are market prices (prices of similar securities, interest rates, etc.).
- Level 3 assets don’t have available market prices for the model inputs, forcing the people preparing the financial statements to make assumptions about those inputs’ values.
And when a company doesn’t have real market inputs, naturally it’s inclined to use models (and assumptions) that are (ahem) as favorable as possible. Thus we get situations like the scandal at Enron, which became famous for financial statements based on what was callously called “mark to make-believe.”
So time passed, as it is wont to do, and various problems became apparent, and in 2007 the FASB (Financial Accounting Standards Board—itself a private institution, but quasi-official given its recognition by the SEC as the arbiter of corporate accounting standards) issued a regulation called FAS 157. Basically, FAS 157 was all about ensuring that MTM, when used, is used in a way that’s consistent, reliable, and transparent, both to companies holding assets and to investors investing in those companies. It redefined “fair value,” required new disclosures, and ranked the quality of inputs used to determine market value.
This was all well and good so long as markets were going up. Demand kept increasing for things like mortgages, mortgage-backed securities (MBSs), and more exotic derivates, meaning that they could be valued at higher prices, and thus (A) investment bank balance sheets showed larger capital reserves, allowing them to lend out even more money leveraged by that capital, and (B) of perhaps greater importance to the actual decision-makers involved, everyone got nice juicy quarterly bonuses.
But the market hasn’t yet been invented that always goes up, as we all seem to have to keep learning every few years. So the argument now is that, just at MTM created a feedback loop that fueled the bubble, as market values drop it’s also creating a feedback loop that’s exacerbating the downturn, valuing securities at less than their actual underlying worth (on the premise that not all mortgages are going bad, and those that don’t still have future cash flows attached, and those that do still at least have real estate behind them).
Now, on the one hand, this is probably true. It’s a relevant, perhaps even significant, factor in the current multifaceted economic clusterfuck which we’re all watching with stunned looks on our faces.
On the other hand, it’s not even remotely the primary cause of the problem, much less the key to its solution, as Friend B and his articles suggest. What we have here is really just some players in the financial sector who were happy to ride up to the top of the roller-coaster using this accounting method, but now that it’s plunging them downhill they want to change to a method that lets them apply the brakes. It’s a pretty blatant argument for a double standard, really… and an even more blatant attempt to shift blame to the government for their own shortsightedness.
Besides which, they’ve already had more than one loophole offered to them, although you’d never know it from the complaints. Way back in March 2008, even before things got really bad, the SEC issued an opinion letter informing companies that
Fair value assumes the exchange of assets or liabilities in orderly transactions. Under SFAS 157, it is appropriate for you to consider actual market prices, or observable inputs, even when the market is less liquid than historical market volumes, unless those prices are the result of a forced liquidation or distress sale. Only when actual market prices, or relevant observable inputs, are not available is it appropriate for you to use unobservable inputs which reflect your assumptions of what market participants would use in pricing the asset or liability. Current market conditions may require you to use valuation models that require significant unobservable inputs for some of your assets and liabilities. As a consequence, as of January 1, 2008, you will classify these assets and liabilities as Level 3 measurements…
IOW, if you have a margin call or your market otherwise dries up, it’s fine to go back to using made-up values… so long as you admit you’re doing so by classifying the assets as Level 3.
And then, come September, as things grew even worse… (I’m quoting Wikipedia here):
…the SEC and the FASB issued a joint clarification regarding the implementation of fair value accounting in cases where a market is disorderly or inactive. This guidance clarifies that forced liquidations are not indicative of fair value, as this is not an “orderly” transaction. Further, it clarifies that estimates of fair value can be made using the expected cash flows from such instruments, provided that the estimates reflect adjustments that a willing buyer would make, such as adjustments for default and liquidity risks.
IOW, if the market’s too topsy-turvy, forget any attempt at determining market values whatsoever: just use forecasted cash flows!
Plus, the law that Congress passed in October—the same one that created the TARP—required the SEC to conduct a study about MTM’s effects, and authorized the agency to suspend MTM accounting completely if it deems it “in the public interest.” But the SEC hasn’t actually done it just yet, so the hypocritical complaints continue.
Friend B insists that these clarifications aren’t clear enough, and so institutions “in practice” are still interpreting them overcautiously, allegedly even writing some assets down to zero. In response to this, I can hardly do better than to point to the remarks of Wall Street market strategist and CNBC commentator Barry Ritholtz:
Many banks, brokers, and funds chose to invest in certain “financial products” that were difficult to value and were at times thinly traded. If you are looking for the underlying cause of why some arcane accounting rule is an issue, this is it. …
While [my firm] may have been tempted by potential greater returns that some of these other products offered, we simply could not justify the risk of owning hard to value, thinly traded, hard to sell items. And, we never had to rely on the models of the individuals who created and sold us these products in the first place, to determine an actual price. If ever a product was rife with self-interested conflicts of interest, this one is it.
…A decision was made to bypass the broad, deeply traded traditional markets (Equities, Fixed Income, Commodities and Currency) and instead create new markets for new products. No one should be surprised that the net result was a flawed system of garbage paper, with too little room at the exits in case of emergency. …
Recent actions of corporate titans in the financial sector are essentially an admission that their business model was deeply flawed. No one would invest any capital for a ROI of 50 bps per year. They of course knew this — so they leveraged up that 50 bps 35X or so, creating the false appearance of more attractive returns. This higher risk, potentially higher return paper was part of that misleading process.
Suspending FASB 157 amounts to little more than an attempt to hide this broken business model from investors, regulators and the public. Its not just getting through the next few quarters that matters; Rather, its allowing the market place to appropriately reallocate this capital to where it will serve its investors best. That is what free market capitalism is, including Schumpeter’s creative destruction.
So on the one hand, the argument is that using MTM accounting is artificially depressing balance sheets; on the other hand, the rebuttal is that switching accounting rules in the middle of the game would artificially prop up those same balance sheets. And is there genuine, trustworthy value to be found somewhere in the middle? Nobody’s quite sure… which is of course the real foundation of the problem here.
Beneath that problem lie not just MTM rules, but exotic financing arragements, and automatic securitization of the otherwise illiquid loans that resulted, and lax credit rating agencies overseeing those securities, and increased leverage ratios based on them, and an ongoing disregard for risk. These were all self-reinforcing feedback loops… and beneath all of them lies simple human greed.
As Friend A points out, taking the eight-mile-high view of this dispute, it’s absurd to accuse a rule or regulation of being a “distortion” or “intervention” in the market only when it harms your bottom line. “The market” doesn’t exist in some abstract state of nature (despite what a few laissez faire ideologues may think), nor is “efficient market” theory, the idea that it’s the perfect reflection of all current knowledge, taken very seriously any more. What the market is is a social construct, a framework, nothing more nor less than the end product of all the rules and regulations that are collectively agreed upon for its operation. It’s defined by them; without rules you can’t have a market, any more than you can have a football game. And for markets (unlike for games), the only sensible way to arrive at those rules is through democratic political processes.
Very few rules are every crystal clear, of course; there’s always room for differing interpretations, and some people will always try to be free riders, and there are inevitably unanticipated consequences… even if they amount to nothing more than working consistently on both sides of the business cycle. But pointing to any single rule as more subject to these problems than others, much less trying to shift blame to the government rather than recognizing it as the enabling force for the market’s very existence, doesn’t take us any closer to solutions. It takes us farther away. It tries to exculpate private participants in the market from culpability for their own short-sighted choices.
There’s simply no such thing as an unregulated “free” market (nor does MTM accounting assume there is). There’s a certain critical threshold of “freedom” necessary for a market to perform its central purpose, which is to allocate goods and services efficiently… but even as it does so a market will inevitably undermine itself in any number of ways, creating monopolies and bubbles and panics and “corrections”… and a great deal of human suffering along the way… defying the good intentions of even the market’s most rational actors following individual incentives.
No particular version of the rules is intrinsically more “interventionist” than others… so it’s hypocritical for a market’s players to embrace interventions that improve the balance sheet, but decry those that decrease it. The best we can do (and it will never be perfect), is to try to manage things with a light touch, adjusting for new inputs as we go, and trying (pardon the mixed metaphor) to keep the playing field as level as possible. And in that regard rules that define an accounting method to encourage transparency, and value assets by methods that are clear and fair to all participants, are probably a good thing.
Unless, of course, the method was equally “distorting” when it was pushing values up the hill of the roller coaster… in which case the proper regulatory response would have been to eliminate it then. Of course, the voices raised in complaint now made nary a peep at the time.Tags: bailout, economy, FASB, financial crisis, investing, mark-to-market