The Enslavement of the Accounting Profession, the Financial Crisis, and a Crisis in Philosophy

Wendy wrote: "If one’s means of knowledge is what other people say, it then becomes a question of whose consciousness reveals reality."

WOW! What an article. I'm not an accountant but enjoyed your wide ranging explanation of the real world, political and philosophical realities relating to mark to market, Rule 157.

In government, we allegedly have a balance between the three powers. There is no such balance between politics and real life. Politics always seems to steamroll real life solutions. What is politically expedient is far more important than the negative impact of quick, stupid political solutions. Getting elected and staying elected wins the day in American politics.

Very Good Artical. Like Rick Smith, I also am not an accountant, but was able to follow the logic of your explanations and to see the validy of your observations.

Ideas do have consquences and bad ideas have bad consequences--subjecing market forces to the power of the state being no exception.

Wendy for the first time I've read something about mark-to-market that makes me thing whoever wrote it knows whereof they speak. Sadly I still don't get it.

The key point you make (I think and you spoke at length) is that the rule says that the value of an asset must be set at fair market value. If I interpreted the rest of that paragraph correctly the rule doesn't allow a NPV calculation -- that is, the value at this moment of the asset must be marked. Future potential value doesn't count. All that one is allowed to put on the books is what one can get right now at a fire sale. True?

Example: Let's say I bought a fixer upper for $100,000. Let's further say that I've put $20,000 in materials and a bunch of sweat equity. Next week I will have the Sheetrock up and the walls painted. When that is done the house will be worth what comps in the area are selling for, say $150,000. According to mark-to-market, if I understand things, I can't claim $150,000 for the house as it isn't complete. At most I could claim $100,000 or (more likely) $120,000.

Other than selling the house there is no way to set a reasonable value. It would seem to me the real value of that house is $150,000 (comp price) less the effort to finish the job (say $5,000), and so $145,000 might be a fair valuation but one that I could not use because of this rule. Am I close to understanding this?

Houses and financial assets are two different animals, so I am uncomfortable making analogies.

With a financial asset, we are talking about a bond or some other derivative instrument that has a regular income to you the owner. It also has a fixed cost, based on your purchase price or liability on it. You buy it because you expect to make a significant return on your money from its amortized payments to you over time. This is what some experts call its economic value, and this is what you account for on your books. This is called historical cost accounting. It has always been the standard method. You would take losses on your books only if they defaulted on their payments to you. These would be actual losses, because you were supposed to get the money but didn't.

Under mark-to-market, none of this matters. All that matters is the current price of such assets on the market, because, mark-to-market proponents claim, that is its “true” value, and you may sell it. Instead of declaring total war on the FASB when it proposed this cockamamie idea, bankers politely asked why they should have to mark assets to market prices if they intend to hold them and continue to receive payments. The FASB simply responded by creating a special category called "Available For Sale" such that if you might be willing to sell them in the near future, then you would have to mark them to market. Thus, we now have both an illogical method of accounting for this type of asset and subjectivism in applying the method.

All this government force is bad enough, especially since it is pro-cyclical in that when market prices retrace, you are forced to take losses from this method even though the payments on your assets are current. But there is a characteristic of the financial sector that inexorably turns this situation into a financial crisis and eventually a Great Depression, and that is the concept of the fractional reserve.

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Banks "print money." They do this by extending credit to borrowers at a multiple of the equity they have on the books. So for every dollar of equity on the books they lose, over 10 dollars in credit disappears from the economy. By the time Lehman fell, over $500 billion in write-downs had occurred, which is over $5 trillion dollars in credit. That is over one-third of the amount of credit the economy needs in a year.

Here is how it played out. Because write-downs mean a shortage of credit, everybody scrambled to sell their assets to raise capital to continue to make investments and to meet their reserve requirements, private collateral calls, and margin calls. Because everyone was dumping their assets, asset prices dropped. That meant banks not only incurred actual losses from selling at lower prices, but they also had to mark their remaining assets down on their books even further, given the new lower sales prices. That meant another round of calls and scrambling, and so on. It was a classic negative feedback cycle, or what they call a write-down spiral.

By the end, no one was making investments, and everyone was taking write-downs on their assets, no matter how profitable the cash flow on them. And contrary to myth, the investment banks had generally good investments. Most investment banks had made adjustments in 2005-2006 for the bad housing market. Contrary to popular myth, their losses were not from defaults. Banks and AIG did not make "bad bets." The losses were almost entirely mark-to-market write-downs or derived from mark-to-market write-downs. As an example, one bank had only $32,000 in credit losses on their mortgage-backed securities. But they had to take $288 million in write-downs! That is an extreme example, but that is what would have happened eventually to every bank that held assets subject to the mark-to-market rule.

According to liberals, that is.

Amazing how a little rule change can be used to cripple and kill.

Wendy, thank you for this.

I'm bookmarking it and studying it, as you are speaking in areas foreign to me and I need to learn!

Bob Larimer

ValleyForge@hotmail.com

http://www.myspace.com/worshipbandleader

Look me up on FaceBook!

In thinking some more on the subject, I would correct two things I wrote. First, it was silly of me to suggest that a fractional reserve system is necessary for mark-to-market to do its damage. The fractional reserve system merely changes the nominal terms of the losses. However, even if there were no fractional reserve system, the same amount of damage would have occurred in real terms, i.e, as a percentage of GDP.

Second, Sarbanes-Oxley is only one legal root for accounting rules. It formalized the accounting rule system, but banks were still required to obey the FASB's dictates before that.

Thank you for this. As I am an engineer, and not an accountant, I too, will have to re-read this a few dozen times to absorb its content:

A comment; you write:

"First, it was silly of me to suggest that a fractional reserve system is necessary for mark-to-market to do its damage. The fractional reserve system merely changes the nominal terms of the losses. However, even if there were no fractional reserve system, the same amount of damage would have occurred in real terms, i.e, as a percentage of GDP."

This appears, shall I say, fishy. For one, I believe your multiplier ratio is severely understated (9:1). Ignoring this, lets say the the required reserves was 1%....or how about 0.1%, or how about 0.001%, the situation becomes increasingly unstable, requiring fewer and fewer "bad loans" or "toxic assets" to do the system in. It seems that mark-to-market accounting just more easily exposes the frailty of a system that multiplies money out of thin air, the "asset value" is over inflated due to easy money,. The system is one big ponzi scheme that depends on the multiplication of debt to remain "solvent" [sic], and profits and profit growth depend on growing a house of cards of debt. Its the definition of a bubble, which IMO, would be far less likely to occur if we did not have a government backed fractional reserve system. Without, banks could try to leverage their assets at an individual level, but the bank runs would be held to individual levels, and not the "cluster of errors" that are sponsored by the federal government. Bubbles that pop are far more damaging in a fractional reserve system, and the damage that occurs.

Now the fishy-ness I speak of, is the claim that as a percentage of GDP, the same amount of damage would be done...well, I guess in theory (I'd have to run the numbers). But in practice the house of cards has a lot farther to fall, and assets humbled, lives disrupted, careers ended, artificial economies based on fiction ended, which makes me think as a percentage of gdp, the government sponsored fractional reserve system would be a lot worse. Think of all the realtors, lenders, and builders whose lives have changed....just one segment of the economy was disproportionately affected....that segment was a house of cards.

Thanks for the post, much to learn and absorb here.