Steve Forbes has been beating a drum over the last month, repeating his call to suspend mark-to-market accounting rules. I think that I have finally been fully convinced that this is a good idea. Not permanent suspension, but perhaps a two year holiday from these requirements.
As an employee of one of these bailout blackholes, I have seen the damage to my firm from these kinds of rules. If it were not for them, I suspect that we would never have needed a single dime of government money. Companies with positive cashflow should not be going insolvent because the market value of assets that have not defaulted and they do not intend to sell have lost value.
Why is mark-to-market good?
It forces companies to report what the actual value of their securities are, and not just what they paid for them (like under book value accounting). As an analogy: Say Bob is applying for a new $2 million construction loan to build an apartment complex. He is using his existing complex, which he bought 3 years ago for $2 million as collateral. The problem is, that his old complex has been condemned by the city for health code violations. His collateral would only sell for $1 million on the open market as of today.
Corporations sometimes do the same thing. They buy assets at price X, those assets plummet to price Y, yet they report the value and solvency of the company based on a depreciation model or book value based on price X.
Why is mark-to-market bad?
When fears of corporate defaults are more random, it is fine. If it is feared that Company A will default, then companies B – Z write down any assets they held in company A. Fortunately, those losses are spread across a large number of companies. There is damage, but it isn’t that bad. Mind you, this can occur under the fear of defaults, and not actual default.
When fears of corporate defaults are widespread, it can cause a cascading effect of failures. If it is feared that companies A-I default, then J-Z have to write down those assets. Because of the large write downs by companies J-Z, fears of wider defaults grow. A vicious cycle develops, what we’ve dubbed “contagion”. A critical mass of write downs can lead to total meltdown like we’ve seen.
Using another analogy:
Imagine that you bought a house for $500,000. You had $100,000 down, so you borrowed $400,000. Imagine too that everyone in your city has done the same thing. Due to current market conditions the value of your homes fall by $200,000. Everyone in town now owes around $400,000, but has homes that are only worth $300,000.
As it is right now, the vast majority will just ride it out. They will keep paying their mortgages and prices will eventually rise over the coming years and you will all be back in the black some day. My parents did this during the Oil Bust here in Houston during the 80s.
Now, let’s assume that all home loans required mark-to-market accounting. That is, if your home lost value, you were required to post more collateral to cover the loans. Everyone in town now had to come up with $100,000 of assets to add as collateral. Anyone who failed to do so within 3 months would have their homes repossessed.
What do you think would happen to this town? As repossessions soared, prices would fall further, requiring even more assets to be posted. The town would be destroyed. Virtually no one would be able to keep their home.
In short, I think Mark-to-Market is good 95% of the time, but it creates a systemic risk during a financial slowdown. I agree with Steve Forbes, and I think there should be a 2-year suspension for most firms.