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It's a longstanding US Government tradition that when an agency really fouls up, they're punished by being forced to take a massive budget increase. When the CIA and the FBI overlooked the 911 terrorists, their budgets were nearly doubled and a massive new bureaucracy was created in Homeland Security. When the CIA messed up and said that Iran was not producing an atomic bomb, their budget went up yet again.
This happens in other areas too. When the Securities and Exchange commission overlooked the accounting fraud that led to the collapse of Enron, WorldCom, Tyco and other billion-dollar business failures, a new law called "Sarbanes-Oxley," also known as SOX, was passed in 2002.
SOX imposed all kinds of new accounting requirements on publicly-traded businesses. It gave the SEC more powers and created a new oversight board to make sure that accountants always did what they were supposed to do.
There has been much debate about how much SOX reduced our international competitiveness by making it cost more to operate a business in the United States. It's certain, however, that costs went up.
We have a friend who climbs poles and fixes wires for a power company. Before SOX, they had to account for each bundle of cable ties they used. After SOX, their accountants required them to account for each individual cable tie. These ties cost less than a cent apiece, but they have to be counted and documented individually or the workers get in trouble.
There's another certainty - the extra accounting oversight required in SOX didn't help the SEC catch Bernie Madoff and did nothing to keep Fannie and Freddie from wrecking our financial system.
Despite these unfortunate experiences and the inherent flaws in the very idea of government regulation, Congress has passed a 1,000+ page bill adding more and more layers of expense in complying with financial regulations.
Although farmers are already starting to worry that the new rules will make it much more expensive for them to use the futures market to protect themselves from wild swings in the price of agricultural commodities and car dealers are wondering if they'll be able to make auto loans, the actual effects of these new regulations won't be known for years. We've recently seen, however, that the "mark-to-market" rules which were imposed by the SEC were very damaging during the financial crisis.
There are lots of different ways that companies can report the value of assets they hold. Traditionally, large companies recorded the purchase price of any real estate they owned and carried those assets on the books at that value. This "book value" could greatly understate the value of the company if the land or buildings had gone up in value - just compare the present value of Rockefeller Center with the relative pittance it cost to build - or book value could greatly overstate the value of the company if the assets had gone down in value as has happened to Detroit real estate.
"Mark-to-market" requires that each asset be priced at its "fair market value." Market value can change unpredictably as Judge Learned Hand recognized when he declared, "The market value is what a willing buyer will pay a willing seller on any given day." [emphasis added] It's a great deal simpler to carry an asset at book value, particularly if you have no intention of selling it.
Guessing what you could get for, say, the Chrysler Building in Manhattan or Caesar's Palace in Las Vegas provides much work for accountants and lawyers. Companies naturally preferred to record their assets at book value and avoid all that expensive guesswork, but mark-to-market became part of the U.S. Generally Accepted Accounting Principles (GAAP) in the early 1990s.
As mark-to-market spread, but before it became popular, it offered opportunities for fraud. Part of the Enron scandal involved placing unrealistically high values on assets which were hard to value. This made Enron seem more profitable than it actually was, as assets which had been bought cheaply were given vastly inflated values for bookkeeping purposes.
There's an inherent flaw in mark-to-market - what happens to "market value" when the market is so uncertain that there effectively is no market? Is the value zero at that point?
Suppose that a small-town bank has issued mortgages on, say, 10 houses. Let's say that these houses are each worth $100,000 so the bank's mortgage portfolio is a cool million dollars.
Now suppose the local auto plant closes, throwing several thousand people out of work. Suddenly, nobody wants to move to the town, so nobody wants to buy houses there. The market for houses has collapsed - those houses can't be sold at all, so their "fair market value" is zero even though people are still living in them.
What about the bank's portfolio? Their mortgages are backed by the value of the houses and the value of those houses has gone down.
Nine of the people to whom the bank had loaned money kept their jobs, however, and are still paying on their mortgages. These people wouldn't try to sell even if the market hadn't collapsed - where would they live? 90% of the bank's mortgages are performing in that 90% of the checks are coming in, every single month.
What's the bank's portfolio worth? $900,000 because 90% of the loans are performing? Or zero, because none of the houses which secure the mortgages could be sold at the current moment?
If the bank tried to sell the mortgages, someone might be willing to bet that the real estate market in the town would eventually recover, but they'd pay only a fraction of face value. If the bank would get only 50% of face value if they had to sell the mortgages, their portfolio is worth $500,000. Since they don't intend to sell any of them, however, there's no way to determine actual market value; it's all a series of guesses.
This matters because the bank has borrowed money against these mortgages to make other loans. Having loaned a million dollars to 10 home owners, the bank put up those mortgages as collateral and borrowed $700,000. This is called "leverage."
Loan agreements of this type have what's called a "margin call" clause. Suppose the bank which borrows against its mortgages is required to have a 20% cushion, or margin. This means that the value of the underlying mortgages can't fall below $840,000. If it does, the counterparty who lent the $700,000 no longer has the required 20% margin and can call the loan, demand extra money, or do whatever else the contract calls for. This is known as a "margin call" and it's usually bad news for both parties.
If the value of the mortgage portfolio is based on cash flow, it's still $900,000 because 90% of the buyers are still making their payments. With this valuation, the bank that holds the mortgages is OK because there's still enough margin and its counterparty can't do anything.
If, on the other hand, the portfolio value is based on the underlying mark-to-market value of the houses, it's zero because none of them can be sold at this moment. Valuing the mortgages in this way means that the local bank is in big trouble with its counterparty.
Even if the bank could get 50 cents on the dollar by selling the mortgages, the value is $500,000 and the bank is $340,000 shy of meeting its loan covenant.
To sum up: with mark-to-market accounting, the value of financial instruments can collapse or vanish entirely even if the monthly checks generated by that instrument are still coming. Does this seem sensible or fair?
Mark to market sounds sensible and fair, but it has the unintended side effect to literally bankrupt financial institutions overnight before anything bad happens to cashflow.
This is precisely what happened to AIG. AIG had sold some mortgages and guaranteed their value. When the crash came, the mortgages couldn't be sold to anyone. Their "market value" was very low because there effectively was no market at that moment. AIG's loans were under water because they were in violation of their loan covenants.
The counterparties wanted to be paid. Morgan Stanley, who was owed billions by AIG, had good connections to the US Treasury, so the government spent billions paying off AIG's counterparties at 100 cents on the dollar. This was unusual - when there's a rescue, the counterparties usually have to share some of the pain, but Morgan Stanley's Treasury connections were good enough for them to get 100% from Uncle Sap.
What happened in the end? It turns out that AIG had made sound loans: just about all of their mortgages are being paid off to this day. If they could have valued their mortgages on the basis of whether the loans were being paid as opposed to the price they could get if they tried to sell the loans, AIG would not have needed a bailout and all that hoo-hah about paying bonuses to the traders who'd made money for AIG would not have happened.
The problem was that the financial standards did not distinguish between assets such as vacant land which don't generate income and assets such as mortgages which do, they valued assets only on the basis of what they might fetch if they had to be sold. This led to what some have called "mark to make-believe," and it greatly worsened the financial crisis. CNBC quoted the former FDIC Chair William Isaac:
"The SEC has destroyed $500 billion of bank capital by its senseless marking to market of these assets for which there is no marking to market, and that has destroyed $5 trillion of bank lending," he said. [emphasis added]
"That's a major issue in the credit crunch we're in right now. The banks just don't have the capital to start lending right now, because of these horrendous markdowns that the SEC's approach required."
Although some of the underlying mortgages are in default, of course, the banks had already sold the really bad mortgages to Fannie Mae and Freddie Mac - that is, to the government - and most of what's left are being paid off on schedule. The Wall Street Journal said essentially the same thing:
The most disastrous Bush policy that Mr. Obama is perpetuating is mark-to-market or "fair value" accounting for banks, insurance companies and other financial institutions. The idea seems harmless: Financial institutions should adjust their balance sheets and their capital accounts when the market value of the financial assets they hold goes up or down.
So although banks have twice the amount of cash on hand that they did a year ago, they lend only under duress, or apply onerous conditions that would warm Tony Soprano's heart. This is because they know that every time they make a loan or an investment there is a risk of a book write-down, even if the loan is unimpaired. [emphasis added]
There is debate on just how much of the financial disaster was caused by "mark to make-believe" and what was due to other causes, but it's clear that mark-to-market was of no help either anticipating the crisis or in helping to cure the crisis. It remains to be seen how many brand-new land mines are hidden in the recent 1,000+ page reorganization of our financial system.
Based on Congress' track record in regulating businesses, we don't expect anything good.