It Is Time to Follow FDR and Suspend Mark-to-Market as a Destructive Regulation

Mark-to-market ("fair value") is a major cause of the current financial disaster. It has accelerated and deepened the decline of asset values. It has crippled institutions that would have survived under a more honest and realistic accounting system.

Ironically, the flaws in mark-to-market are not new.

Since the 1930s, accountants and bank regulators have recognized the inherent weaknesses of mark-to-market accounting.

Dating back to 1938, the Federal Reserve recommended that accounting principles should be revised. President Franklin Delano Roosevelt heeded their advice, and quickly moved to repeal mark-to-market.

Despite the inherent weakness and procyclicality of mark-to-market accounting, the Financial Accounting Standards Board (FASB) capriciously reinstated mark-to-market in 2007 in effort to create more transparency. Under Financial Accounting Standard (FAS) No. 157, financial analysts are required to value an asset at the current mark rate even when there is no inherent market value.

Mark-to-market accounting continues to be cited as an exacerbating force in the current credit crisis.

Given the economic climate today, where stocks are selling pennies on the dollar, it is no wonder that many banks have had to take drastic write downs on their portfolios. Even if these assets continue to perform and deliver consistent cash flows, analysts still have to discount these assets to fire-sale, market prices. As a result, mark-to-market continues to be cited as an exacerbating force in the current credit crisis.

Steve Forbes recently noted that if, "this rigid mark-to-market accounting had been in effect during the banking trouble in the early 1990s, almost every major commercial bank in the U.S. would have collapsed because of shaky Latin American and commercial real estate loans. We would have had a second Great Depression."[1]

William Isaac, former Chairman of Federal Deposit Insurance Corporation (FDIC), also made the same point that, "If we had followed today's approach during the 1980s, we would have nationalized all of the major banks in the country, and thousands of additional banks and thrifts would have failed. I have little doubt that the country would have gone from a serious recession into a depression."[2]

It has become clear that FASB has not acted quickly enough to change this destructive rule.

Part of the problem rests with the nature of accounting regulation. Given that FASB sits under the Securities and Exchange Commission (SEC) which is then under the jurisdiction of Congress, the entire bureaucratic structure has become a bottleneck through which significant reform cannot escape and is permanently stifled.

For this reason, we submit this testimony in support of HR 1349, the Federal Accounting Oversight Board Act of 2009, which will create the Financial Accounting Oversight Board. Unlike the current regulatory structure, this new board will do a better job incorporating the input of all the relevant bodies in the financial communities.

By bringing together the Chairman of the Federal Reserve, the Secretary of Treasury, the Chairman of the SEC, the Chairman of the FDIC, and the Chairman of the Public Company Accounting Oversight Board (PCAOB), we will insure that accounting standards will no longer be relegated to a bureaucratic blind spot where no one has the power to change accounting rules that are destructive.

Officials from the Federal Reserve continue to voice their frustration over mark-to-market issues, but they lack the effective tools to initiate reform. In testimony in February before the Committee on Financial Services, U.S. House of Representatives, Chairman Bernanke acknowledged, in his own words, that the Fed has "heard a lot of concern about whether some assets are being mis-valued--too high or too low--based on the use of mark-to-market modeling or mark-to-market asset valuations."[3]

In fact, the Federal Reserve has been issuing warning for at least eight years since 2002. In testimony on behalf of the Governors of the Federal Reserve in 2002, Susan S. Bies cautioned:

"The FASB has stated that it believes that all financial instruments should be reported at fair value when the conceptual and measurement issues of fair value are resolved. ...The lack of reasonably specific standards for the estimation of fair values for non-traded, illiquid instruments could lead to problems for auditors and bank supervisors in verifying the accuracy of fair value estimates. ... Therefore, the Federal Reserve has questioned the usefulness of comprehensive fair value accounting for all financial assets and liabilities in the primary financial statements. (emphasis added)"[4]

Just this week, Bernanke reiterated his concerns about mark-to-market in stating:

"The ongoing move by those who set accounting standards toward requirements for improved disclosure and greater transparency is a positive development that deserves full support. However, determining appropriate valuation methods for illiquid or idiosyncratic assets can be very difficult, to put it mildly. As a result, further review of accounting standards governing valuation and loss provisioning would be useful, and might result in modifications to the accounting rules that reduce their procyclical effects without compromising the goals of disclosure and transparency."[5]

Yet given the cumbersome bureaucratic structure, the Federal Reserve has lacked the political clout to advance a mark-to-market reform.

In order to ensure that we never allow a financial accounting rule to have such a devastating impact on our economy, we should quickly pass HR 1349. Through this legislation, members of the financial regulatory community, like the Federal Reserve, will now have legitimate power to reform accounting standards.

President Ronald Reagan was the first president to enact significant regulatory reform based on sound, rational changes. This bill follows in his footsteps, by putting forth a smart policy change that will allow more timeliness and flexibility in setting accounting standards.

Given that seventy years have passed since FDR's repeal, we should act now by finally putting an end to the destructive impact of mark-to-market accounting.

This is not an esoteric or minor issue. Every day that mark-to-market remains unreformed, jobs are killed, values are driven down and institutions are further endangered.

This is one of the most important reforms which could help turn the economy around.

Congress should pass HR 1349 as quickly as possible and recommend mark-to-market is immediately reformed.

Newt Gingrich is a senior fellow at AEI. Emily Renwick is a research assistant at AEI

Notes

[1] Forbes, Steve. "Obama Repeats Bush's Worst Market Mistakes," Wall Street Journal, March 6, 2009.
[2] Isaac, William, "How to Save the Financial System," Wall Street Journal, September 19, 2008.
[3] Malpass, David, "Market Jumps after Bernanke Mentions Mark-to-Market and Uptick Rule," (Malpass transcription of Hearing before the Committee on Financial Services, U.S. House of Representatives, on February 25, 2009) distributed by e-mail February 25, 2009.
[4] Bies, Susan. "Remarks by Governor Susan S. Bies: Effective Accounting and Disclosure for Financial Transactions and Financial Institutions," At the National Conference on Banks and Savings Institutions, American Institute of Certified Public Accountants, Washington, D.C., November 7, 2002.
[5] Bernanke, Ben S. "Financial Reform to Address Systemic Risk," At the Council on Foreign Relations, Washington, D.C., March 10, 2009.

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