Marking to Market

Don't Do Right at the Wrong Time

Originally appeared in July 5th edition of:

Shortly after coming to the Lone Star State, I bought the classic book of Texas wisdom, "Don't Squat with Your Spurs On!" One of its many useful pearls was "No matter who says what, don't believe it if it don't make sense."

That's easier said than done, of course, when everyone seems to agree on something I'm still trying to make sense of. Many examples arise from the tendency of lawmakers and regulators to do during a crisis what should have been done earlier to prevent the crisis. Too-late smart may not be smart at all. Fixing the barn door after the horses escape doesn't do much good, and it may keep the horses from returning.

Example: The argument that we should raise gasoline taxes to help wean drivers from too much driving in their gas guzzlers. If that was ever a good idea, it was before the recent rise in gasoline prices. Now it would just make a bad situation worse. Suspending gasoline taxes this summer is probably not a good idea either, but it makes more sense than raising them, and is more consistent with the common sense of making hay while the sun shines.

In another example, the Fed and others have argued for years for reforms of Fannie Mae and Freddie Mac – including clarifying that their debt is not backed by the full faith and credit of the U.S. government, and capping their growth to limit the distortions caused by their artificially low borrowing costs and thin capital. The current reforms under way, including raising their capital, may have been needed. But they should be expedited to facilitate, rather than inhibit, the important role Fannie and Freddie can play in resolving the credit crisis. Let's postpone our hand wringing over their government-sponsored credit ratings and cost advantages, and take opportunistic advantage of them in the current crisis. We need them, as well as the Federal Housing Administration, to do more of what they do, not less.

To me, the most serious example of doing the right thing at the wrong time is overly strict adherence to "mark to market" accounting rules. Most of the write-downs of securities that are creating capital shortages in financial institutions don't result from actual losses, or even expected losses. They result from having to mark down assets, many or most of which could easily be held to maturity and redeemed at par. This includes securities issued or guaranteed by Fannie and Freddie and other investment-grade securities, especially those graded triple A.

Holders of mortgage-backed securities point out that marking them to market is currently impossible because there is no market. Moreover, identifying those that can easily be held to maturity, and classifying them as such, makes more sense than marking them down to levels that never need to be realized. Book losses if and when they are realized – not before. Eliminating unnecessary mark-to-market losses would go far toward resolving the current crisis.

While mine is no doubt a minority view, it is supported by William Isaac, former chairman of the Federal Deposit Insurance Corporation. He says that mark to market is overdone and is pro-cyclical, since regulators limit the ability of banks to reserve during good times, but insist on increased reserves during bad times. Even some supporters of mark to market acknowledge that it was not intended for over-the-counter, hard-to-value assets.

Accounting purists would call this forbearance and frown. But forbearance in shooting the sick and wounded with good recovery prospects is no sin in my book. The greater sin would be to let a "rules is rules" mentality continue to make a bad situation worse.