The Right Wing Approach to Solving Wall Street Woes: Less Transparency

With the recent turmoil in the financial markets some economists and politicians are blaming an accounting rule for the stock market volatility. Known as "mark-to-market" or "fair value accounting," it is basically an accounting method that values assets at their current market value. A stock, option, mortgage, or other asset in an investment portfolio must be valued at the price it closes at during the day's trading. The assertion is that this accounting procedure causes an overvaluing of assets in a boom and an undervaluing of assets in a market downturn. This leads to both bubbles and bursting bubbles. This assertion is a smokescreen and the proposed solution is atrocious.

When an investor, whether it be a bank, brokerage, or individual, holds a tradable asset (such as a stock, option or mortgage); its value must be measured by the current market price. This is the definition of "mark to market." The rule was mandated in the 2002 Sarbanes-Oxley corporate governance law that sprung from the Enron/Worldcom scandals. Generally known as "SOX," critics claim it doesn't allow asset holders to value these assets at their true, long-term value. In a period of sharply rising values banks, for example, value those assets at the currently inflated price. This causes them to have a higher than true value which encourages the banks to lend even more. Likewise; as assets tumble bank losses look worse because they must show on their books the current value, not the "true value" when those assets start going back up.

Some economists claim that as much as 80% of banks' financial troubles are the result of this accounting practice. This has lead to calls from both left and right in Congress for suspending the practice so bank's bottom lines won't look so bad in the midst of the crisis. Ending mark to market is also the primary solution to the financial crisis proposed by Newt Gingrich. "...this simple rules change would immediately inject liquidity back into the market and potentially reduce the need for such a large bailout bill."

Those favoring this view are simply proposing smoke and mirrors as the solution

1. Newt Gingrich calls the federal bailout legislation horrible legislation that he reluctantly supports. If his own analysis is correct the federal bailout should be an incredible boon to the government and taxpayers. The government will be buying assets that are far below their market value and selling them at a later date when their value will be at a "truer" level. If Gingrich is right the government should easily bring a huge return on this investment. If mark to market is the only problem the government should buy up every mortgage it can get its hands on. It will be buying low and selling high. They might balance the budget with just this operation.

2. Blaming FVA relies on the ridiculous assumption that banks don't use any other analysis of their own asset value. While they have to report mark to market, they have their own internal models and historical projections. When property values are going up these models plainly show other scenarios for the value of their assets. In order to blame FVA it is necessary to assume banks give up studying any other models and blindly accept only current market value. If banks are continuing to stretch their margins they are doing this based on their own analysis. They are not being compelled merely by circumstances, as is being assumed. To blame FVA for the bubble is to assume banks and mortgage lenders are idiots, rather than greedy and profit-driven.

3. Another erroneous assumption is that FVA understates asset value in a declining market. This is the current problem according to all those favoring suspension of the rule. In reality, supply and demand determines the true value of assets so there is no reason to make the assumption that a declining asset won't decline further if demand continues to weaken. Historical models of property values show that it sometimes takes 5-10 years for values to recover from lows. Suspending FVA simply allows banks to overvalue their assets based on long-term historical models. This, of course, does not make a bank more liquid. It does not provide the bank more cash to loan. It simply makes them look better than they really are. The current problem is with bad debt - a high percentage of loans that end up in foreclosure. It really doesn't matter what someone says the value of those assets are. What matters is the actual amount of return the bank will receive. The problem is not with the assigned value of assets. The problem is with the true value of those assets. It is the bad loans that are causing the problem and papering over this fact merely compounds the problem by allowing weak lenders to appear stronger than they actually are. It is amazing how unwilling free-market proponents are to allow the markets to function freely in the midst of a decline.

4. If mark to market is suspended it is unclear what would, or should take its place. Letting asset holders assign a value to those assets on their own is what caused the 2001 corporate scandals as they used what is euphemistically called mark-to-make believe or mark-to-praying that it's true. Ultimately there has to be a measure for the value of assets. Anything other than free market value hides the true value of assets in a pile of models that are not exposed to public scrutiny. It makes it more difficult, not easier, for investors to determine the accurate value of bank and mortgage lender assets. Less transparency only benefits those wishing to deceive the public.

In a free market there are downturns. Those willing to accept an "anything goes" policy during up cycles must be willing to accept the process to work in reverse during down cycles. Turning on and off regulations based on market cycles simply creates the worst scenarios on both ends. Ultimately, the current problem stems from the basic fact that the fundamentals of this economy are not strong. Making them appear in a more favorable light by eliminating transparency only serves to hide this reality and will extend the downturn to even greater levels.