While spending and investing billions of dollars-or is it trillions?-trying to heal the sick credit markets, the government continues, inexplicably, to ignore the low-hanging free fruit of suspending or modifying mark to market accounting. We are hoisting ourselves on our own petard by adhering strictly to accounting rules that unnecessarily threaten to put thousands of viable financial institutions out of business.
Financial institutions will fail, not because of actual losses, but because of rules requiring drastic write downs of securities that could be held to recovery or maturity because the market for them is temporarily frozen. On mortgage backed securities, for example, even those containing mostly performing and cash-flowing underlying mortgages have to be treated as a virtual total loss because the market for them is not functioning. The loss isn't prorated; it's total. Ironically, if the individual mortgages contained in the security were owned separately, the write down would be minimal.
So what? The so what is that an institution's capital must be reduced dollar for dollar with the write downs. As capital approaches zero, the regulator or insurer will close them to protect the insurance fund. What the "let them fail" crowd doesn't seem to get is that this is all unnecessary, is based on hypothetical losses rather than real losses, and does not result from wrongdoing or bad management.
I've been harping on this for months. I do see more people coming to realize the implications of this self-imposed financial suicide, but nobody in charge seems to be listening, although I did hear Treasury Secretary Paulson refer to mark to market as pro-cyclical in a recent speech.
I don't know why he doesn't follow through and do something about it.
Whenever the case is made, someone always brings up the presumed negative effect on transparency as a deal killer. Since I'm not an expert on accounting, my response has been that surely there must be a way to fix the problem and preserve transparency. That should be easier because it isn't the marking to market that's so deadly, but its translation dollar for dollar into a capital reduction.
One approach that has been suggested by representatives of PricewaterhouseCoopers – not known as Cowboy Accountants – would involve continuing the markdowns, but have them count against current income (and capital) only the portion to be lasting and attributable to credit impairment. The portion of the markdown related to illiquidity could be counted in another account-one that would not immediately impact regulatory capital.
Splitting impaired assets into a credit-loss component and a liquidity/market component could still allow the credit losses to impact regulatory capital, but the liquidity/market component could run through a different account that would still affect equity but not regulatory capital. Investors would still have their transparency, but exaggerated hypothetical losses would not bring the institution down.
There must be many variations on such a theme, and the accountants are best suited to find them or invent them. They should serve their country by helping to save its financial institutions rather than watching the calamity of crucifying the financial system on the cross of mark to market accounting.