As lawmakers consider a colossal plan to buy $700 billion dollars of failed mortgage assets, a smaller component of the bailout proposal could go a long in reviving financial institutions. Because "mark-to-market" accounting rules force banks to value assets based on their current market value instead of future cash flows, financial institutions have become especially vulnerable to losses from risky assets. These ineffective accounting rules have produced unrealistic valuations of many financial firms--as evidenced by astronomically high default probabilities for corporate bonds, demonstrating their destabilizing effect on financial markets.

Senior Fellow Kevin A. Hassett

The financial crisis is beginning to feel a lot like the "Lord of the Rings." Frodo and his friends wander from the safety of the Shire and confront dangers of ever-increasing severity.

First our heroes face one deadly "black rider" and narrowly escape his clutches, just as catastrophe was avoided when Bear Stearns Cos. collapsed. But then another black rider appeared (let's call him Fannie Mae), and another (Freddie Mac) and another (American International Group Inc.). Again, catastrophe is barely averted.

As the story progresses, eventually the struggle against evil seems hopelessly lost. The small contingent of men, dwarves, hobbits and elves stands before the mighty gates of Mordor, the home of the evil Sauron. As the gates open, out rushes an army of unimaginable size. The victory of good over evil seems impossible.

Just at that moment, Sauron's ring of power is destroyed in a volcano. With it goes Sauron and his legions, and evil is defeated.

Over the weekend, congressional leaders seemed to reach an agreement on the outline of an approach they hope will solve this mess. Lawmakers agreed in principle to deliver funding to the Treasury in three installments in order to allow the purchase of troubled mortgage-related assets. The bill also limited excessive executive compensation for companies involved in the plan, allowed the Treasury to take an ownership stake in affected companies and established an oversight board for the program. But hidden in the bill was a small provision--pressure on the Securities and Exchange Commission to end fair value accounting--that might be as effective a counter measure as the destruction of the ring of power.

To see the importance of this small measure, one must first understand how widespread the stress has become.

Higher Rates

Risky bonds traditionally have to pay a higher interest rate than rates on safer bonds, such as U.S. Treasuries. That compensates investors for the chance that the bond issuer will default on his obligation to repay. Any difference in interest rates reveals what markets think about the likelihood a risky bond will default.

To get the latest read on these default probabilities, I contacted Jim Reid and his colleagues at Deutsche Bank AG, and asked them to provide an update of the numbers that go into their influential annual credit-market analysis that has been mentioned before in this space.

In the spring, Reid's report revealed that implied default probabilities were far higher than anything in our historical experience. Credit markets back then were factoring in a calamity worse than anything we've seen since at least the 1970s.

Reid's latest analysis reveals that, since then, markets have become even more pessimistic.

Peaceful as the Shire

For the iBoxx Dollar Liquid Investment Grade Index, a leading general indicator of bond-market conditions, Reid and his colleagues estimated last spring that the implied probability of default for five-year bonds was 19 percent. The market expected that about one in five bond issuers would go belly up--an incredible number. The highest default rate for investment grade bonds in history was only 2.4 percent.

By today's standards, bond markets in the spring were as peaceful as the Shire. Reid estimates that today those same bond prices are consistent with an anticipated default rate of 30 percent.

Digging into the analysis, the numbers are scarier than trolls and goblins. The probability of default for 10-year financial-sector bonds is 66 percent. The probability that AAA- rated bonds will default over the next 10 years is 39 percent.

So the credit crunch is causing problems for everybody. The panic is widespread. There has been a fire sale on everything.

Key Provision

A number of experts, including my colleague at the American Enterprise Institute, Peter Wallison, and former Federal Deposit Insurance Corp. Chairman William Isaac, have discussed a flaw in our accounting rules that might account for the downward price spiral. They pointed out that our practice of so-called fair value accounting is sheer lunacy.

The problem is that when a run on a risky asset occurs, driving its value down, accountants then value the firm that holds that asset's financial position at the latest market price. As the value of risky assets plunges, firms are forced to sell into the declining market to raise cash. Those sales drive the prices down further, necessitating even more sales.

Downward Spiral

The default probabilities for bonds are so high because that downward spiral has occurred, causing firms to try and sell everything. While government can step before that train, which is the headline of the current deal in Washington, it could also stabilize markets with a complementary move: End fair value accounting.

If assets were instead valued on the basis of the cash flows they can expect to deliver, then the firm's net worth wouldn't drop so much in response to market volatility, and there would no longer be so many forced sales.

There is nothing imprudent or deceptive about such an accounting change. After all, nobody really believes that 39 percent of AAA firms are going to default.

Fortunately, the latest proposal took a big step in that direction. First, the bill reiterated to the SEC that it has the right to suspend fair value accounting. It is obscene that the SEC has yet to do so, and the push from Congress could well get the ball rolling. Second, the bill asks the Congressional Budget Office to provide a study of the matter. Should the SEC continue to be stubborn, it will doubtless be embarrassed or even humiliated by the CBO study.

It may be that government can throw enough liquidity into the market to stop this mess without changing the accounting rules, but doing so now would certainly reduce the cost to taxpayers.

Pressure to end fair value accounting may well be the most important part of this bill.

It's time for the SEC to toss the ring into the volcano.

Kevin A. Hassett is a senior fellow and director of economic policy studies at AEI.