Mark-to-Market Accounting May Be Chinese Handcuffs

The financial crisis seems to be once again causing a market meltdown. The solutions offered to date, such as bank nationalization or some permutation of TARP, all would entail a massive writedown of bank assets according to the rules of mark-to-market accounting. That would render many of the nation’s leading banks, such as Citigroup and Bank of America, insolvent. Consequently and somewhat ironically, our efforts to free ourselves of this crisis could actually make a bad situation worse. The obvious if taboo course of action should be to reconsider the merits of mark-to-market accounting rules and examine their role in contributing to our financial mess.

Dissenters say that tinkering with the rules would be conveniently covering up fundamentally flawed bank business models and that it would be distorting reality to say that assets are worth more than indicated by those rules. However, the rules may be at the root of the problem. Experienced bankers know intuitively that a distressed market under duress does not function properly and does not produce true market values. Banks strapped for cash have dumped loan portfolios current in their payment obligations and collateralized by real assets for mere pennies on the dollar, as private investors line up and raise billions in capital to buy those assets. Mark-to-market accounting rules are forcing low-ball values today just as plainly as they over-inflated those same values a few years ago. Is that the reality we should be seeking?

Changing the rules for the sake of expediency makes no sense, but, by ignoring market conditions, the rules have dictated extreme short-term asset prices that bear no resemblance to their longer term and more realistic values. Also, changing the rules now may help us recover from the current crisis and as important prevent it from recurring in the future. Our goal should be to put in place a process that encourages willing buyers and sellers to freely trade assets. So long as mark-to-market rules provide private investors the possibility of “stealing” assets from banks at fire sale prices they will have no incentive to bid up those prices. Relaxing the accounting rules to take a longer view of asset values may enable banks and investors to trade assets at prices that both can live with, which will lead to true value, and ultimately free our financial system from its Chinese handcuffs.