Reuters reports that the Securities and Exchange Commission has eased the requirement that firms use mark-to-market (or “fair value”) accounting when valuing financial assets. Many analysts believe that these rules have played a large role in the deteriorating financial condition of investment and commercial banks.
According to the American Enterprise Institute’s Peter Wallison, fair value accounting “has been the principal cause of an unprecedented decline in asset values and an unprecedented rise in instability among financial institutions.” For an overview of the issue see Wallison’s article, “Fair Value Accounting: A Critique.”
Fair Value accounting generally requires accountants to value financial assets based on market prices. But, according to Wallison, in a declining market, such a valuation method produces a pro-cyclical feedback that makes the troubles worse:
As losses mounted in subprime mortgage portfolios in mid-2007, lenders demanded more collateral. If the companies holding the assets did not have additional collateral to supply, they were compelled to sell the assets. These sales depressed the market for mortgage-backed securities (MBS) and also raised questions about the quality of the ratings these securities had previously received. Doubts about the quality of ratings for MBS raised questions about the quality of ratings for other asset-backed securities (ABS). Because of the complexity of many of the instruments out in the market, it also became difficult to determine where the real losses on MBS and ABS actually resided. As a result, trading in MBS and ABS came virtually to a halt and has remained at a standstill for almost a year. Meanwhile, continued withdrawal of financing sources has compelled the holders of ABS to sell them at distressed or liquidation prices, even though the underlying cash flows of these portfolios have not necessarily been seriously diminished. As more and more distress or liquidation sales occurred, asset prices declined further, and these declines created more lender demands for additional collateral, resulting in more distress or liquidation sales and more declines in asset values as measured on a mark-to-market basis. A downward spiral developed and is still operating.
If Wallison and other critics are right, this step could be a major part of the fix for financial markets.