Summary
undefined undefined Listen to the message and don’t shoot the messenger if you think it’s bad news. And don’t endorse public policies based on deceptive reporting. undefined undefined
Analysis
I don’t know the context in which Senator McCain offered up his comment, so I cannot fully analyze what he might have meant. However, I have heard a great many others in the banking industry say even worse.
It is entirely possible that mark-to-market (MTM) accounting really has exacerbated the crisis. That doesn’t mean that it created the crisis, nor does exacerbate mean that it made the crisis worse than it really is. What I mean is that the truth revealed in the financial statements through MTM made it clear to the capital markets that the existence of extreme risk and the consequence of partaking in it are more widespread than anyone realized. To put it another way, mark-to-market did exactly what it is supposed to do: reveal the bad news as well as the good news.
As a student observed to me not long ago, blaming MTM for the credit crisis is like blaming the X-ray machine for your broken leg. The bad news is your leg is injured; the good news is the X-ray reveals the nature of the injury. The next step is to confront the bad news, and take steps to get it fixed. If you deny you have a broken leg by telling people, “No really, I’m fine,” the certain outcome is that you’ll do more damage and make it even harder to fix.
Does MTM force banks to use estimated prices? Of course, it does, and there’s nothing wrong with that, except that bankers may not want to report their estimates.
But look at it this way: if the bankers don’t report estimated prices, the outcome will be that financial statement users will have to substitute their own estimated prices for the bad loans and investments. The certain consequence of that effort will be very cautious estimates that are extremely low. It would be far better if the bankers made realistic estimates and then carefully explained how they were produced.
It would make no sense whatsoever to report original cost simply because it isn’t an estimate. Cost is not reliable for describing the banks’ current holdings. Anyone who wants to report that number simply desires to propagate meaningless numbers in hopes that users will believe them. That is utter nonsense.
Should companies be allowed to suspend MTM?
If they want to cut off their noses to spite their faces, fine. But, why would they want to make the capital markets guess about what the investments are worth? It would be an outrageous decision to adopt that policy, and it would be even more outrageous for regulators to endorse a practice that is misleading and incomplete.
Does a downturn force banks to recognize losses and impair capital?
The tone of the question strikes me as a bit askew. The purpose of financial reporting is to provide the capital markets with access to useful information about what has happened and about what might happen in the future, based on the present situation.
The accounting method doesn’t force the writedown. What it does accomplish is getting more truth into the statements and into the capital markets. What forces the writedown is management’s investment and financing policies that used extreme amounts of leverage to buy extremely risky investments without doing their homework. Because their capital ratio is low (say 4% of assets), taking only a small loss (say 5%) of asset value is enough to wipe out the capital. Putting the bank in that position is totally irresponsible behavior. And it’s that behavior that forces writedowns and the impairment of capital. MAKE NO MISTAKE ABOUT IT: the losses and the impaired capital already exist. All that MTM accounting does is reveal that result. And all that suspension of MTM would accomplish is a thinly veiled cover up.
Does capital impairment trigger a “fire sale”? I wouldn’t think so, but, even if it did, you couldn’t blame the accounting rules for the bank’s getting into this situation. They merely revealed that the bank is in a desperate situation because of malfeasance on the management’s part.
TWO MORE THING WITH REGARD TO SUSPENDING MARK-TO-MARKET:
I am totally convinced that calls to suspend MTM are (either wittingly or unwittingly) calls to endorse deceptive reporting as a suitable public policy. If MTM reveals truth about investments, then suspending it must be intended to keep truth out of the statements. There is no justification for that kind of a policy.
The second point is that such a policy is based on a faulty premise. That premise is that the capital markets make decisions based on reported numbers and reported numbers alone. It is totally facile to think that bank stock prices are linked directly to reported earnings and capital balances. No one can (a) make capital market participants use numbers that they know are not truthful or (b) keep those participants from using other data (including their own estimates) in place of the reported numbers.
In summary, calls to suspend MTM are at worst malevolent and misguided. At best, they will do nothing but increase noise and friction in the capital markets and produce LOWER stock prices, not higher ones.
