As Minnesota's chief banking regulator in 1990, I dealt with this nation's last major banking crisis. Thousands of banks and savings institutions failed nationwide, and with the assistance of state regulators, the federal government closed or merged those institutions and sold the distressed loans.
At the time, mark-to-market accounting for bad mortgages was a concept understood by few, and advocated by fewer, in the regulatory community.
Over the past six months, our financial system has seemed near collapse. Many of the causes (for example, leverage, investment banking risk, other high-risk investments) now are better understood but will take time to address. As a rather arcane accounting rule, mark-to-market accounting is less well understood, but recent changes adopted by the Financial Accounting Standards Board (FASB) will have an immediate and significant positive effect on bank capital.
Until recently, performing mortgages and other assets of banks held long term were valued at cost or book value (that is, the amount of the mortgage loan). Even in adverse real estate markets, loan carrying values were not written down (which negatively affects earnings or capital) unless the loan was in default and its collateral permanently impaired. A write-down would be taken only for the credit impairment (the difference between book and collateral value).
In the late 1990s, banks began investing significantly in mortgage-backed securities, which presented the accounting profession with a growing challenge -- how to value the securities holding those long-term mortgages.
In 2007, the FASB required that mortgage-backed securities available for sale be marked to market. In other words, marked to the market value they would fetch if sold today. The rule change was not controversial when asset values were rising. Indeed, it had little effect until the subprime mortgage crisis caused the values of both subprime mortgages and mortgage-backed securities to collapse. Purchasers for those loans and securities virtually disappeared, as did reasonable market values.
Write-downs required
Under the mark-to-market rules, mortgage-backed securities had to be written down on bank balance sheets for accounting purposes to values established by nonexistent markets; regulatory capital is not affected until a bank determines the loss in value is permanent. As a result, banks have taken huge write-downs on their balance sheets; this drop in values has led to steep and seemingly unending losses in market capitalization and investor confidence. Even massive government lending and injections of capital have not stopped the downward spiral.
With our banking system in crisis, credit largely unavailable, and the government throwing trillions of dollars at our economy in the hope that something will work, the FASB clarifications adopted Thursday are both a low-risk and low-cost policy tool that can be implemented quickly and have an immediate impact on bank capital.
The mark-to-market concept originally was advanced as a way to increase transparency of asset values at lending institutions. It seemed sensible that investors would be better off knowing the current value of assets that might be sold by a bank in the short term, if necessary to raise cash or provide liquidity. The problem with that theory, as many recently have pointed out, is that while such disclosure made sense for the investing community, bank regulators have a somewhat different focus. They are more concerned with bank solvency than transparency.
Yet mark-to-market rules have made many banks near insolvent for accounting purposes, when they are truly quite liquid and have adequate capital. A bank with sufficient financing, adequate collateral, and cash-like assets is solvent for liquidity purposes. Mark to market forces a write-down of mortgage-backed securities as though they were sold, even when a liquid bank need not do so. It can wait to sell assets that have dropped in value until those values return.
A bank is insolvent for capital adequacy if it lacks sufficient equity to meet regulatory requirements. Many banks are failing capital adequacy tests merely because mark to market has forced asset write-downs more severe and more immediate than necessary.
FASB relaxes rules
Recognizing this disconnect, and under intense pressure from Congress, FASB has relaxed mark-to-market rules. This is a good thing.
None of the advocates of these rules imagined either a total collapse in the markets for these instruments, or the near catastrophic, downward spiral on bank capital. Mark to market has never been uniformly embraced by the accounting or regulatory communities. It has always been controversial -- now more so as banks struggle to value assets in totally dysfunctional markets. Treasury's recent proposal to permit banks to sell toxic mortgage pools at auction addresses the same issue. Its purpose is to provide a market and market pricing for assets where today there is neither.
A second feature of the Treasury plan allows banks to use certain mortgage-backed securities to collateralize new Federal Reserve lending. Some argue that providing a more reliable market for toxic loans and assets might discourage banks from participating in these auction and lending programs. With the pressure off bank balance sheets because of the relaxed rules, it is argued that banks may hold loans to maturity rather than selling loans at auction.
At this stage, it is unclear whether the clarifications will encourage or discourage participation. Some banks, undoubtedly, will be forced by regulators to participate. Others may feel more comfortable exiting at reliable market prices, rather than at distressed, unreliable values.
While the merits of mark to market are debatable, its impact in this economic environment is not. It has profoundly affected the regulatory capital, market capitalization and perceived safety and soundness of our banks -- an effect never contemplated by its drafters. Thankfully, clarifications have been adopted. This could have an immediate, positive impact on our financial institutions without another trillion dollars in taxpayer expense.
