Big news on mark-to-market accounting

Yesterday was a momentous day. The press chose to focus more on the emotionally-charged story of Bernie Madoff pleading guilty to a Ponzi scheme and being sent (at last) to his new jail cell, but the bigger story was about an accounting rule that few Americans really find interesting or understand completely. This accounting rule has caused far more havoc in their lives than Bernie Madoff, however.

Yesterday, Congress finally revealed bipartisan willingness to remove the mark-to-market accounting rules that have played a pivotal role in choking the financial system to a point that the entire economy was thrown into an unnecessary recession. See the video clip above.

It's been a long time in coming. In fact, we have been warning for exactly a year that this misguided rule could cause firms to go under -- see this post from Friday, March 14, 2008. The weekend after that was published, Bear Stearns collapsed.

Some will argue that the mark-to-market rule, which is part of a type of accounting called "Fair Value" accounting, is necessary for bringing transparency to the market. In fact, it is a relatively recent accounting development, with its final phase being implemented in November 2007 -- which all by itself helps to reveal the role it played in causing the financial panic of 2008. We have discussed why the events of 2008 should be seen as a financial panic that led to a recession in previous posts, such as this one and this video.

In the above video clip, economist Brian Wesbury explains very clearly that mark-to-market accounting forces banks and other financial institutions to bring forward potential future losses and book them immediately, because the market price to which they are being marked right now is irrational, or nonexistent. Far from creating transparency, this actually prevents a sober assessment of the value of assets.

It is as if, because of an unusual situation such as a forest fire in the adjacent county, someone came up to you and offered you $5 for your house. Knowing that your house is worth far more than that, and realizing that even if the house does burn down the land is worth more than that, you would be wise to tell that person "no, thanks" -- especially since it is not certain that the fire will even reach your house. But mark-t0-market forces you to write your house down to that price (since that is the only "market offer" you can get right at the moment), and then to use your new lower "net worth" as the benchmark for evaluating your credit rating.

Mr. Wesbury has been tireless and articulate in his efforts to educate investors and politicians about the dangers of this misguided accounting rule. See for example his videos explaining the problem in greater depth here, here and here.

Former FDIC head William Isaac has also been an articulate advocate of removing the mark-to-market rule. We linked to one of his explanations of the issue in this post from November 2008. Yesterday he went before Congress and explained the problem again, which he also explained in an interview yesterday available here.

The removal of these misguided accounting standards will be a very positive sign. The leadership of the Financial Accounting Standards Board, under pressure from Congress, said yesterday that it will be able to address the issue within three weeks. Let's hope they come up with a wise solution.

While accounting rules are not very exciting to most members of the general public, this is a significant issue that we would urge everyone to examine and understand. If this problem can be fixed and the banking system allowed to begin to return to healthy operation, we believe the economy -- and the markets -- can recover much faster than most investors realize.

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For later posts on this same topic, see also:


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