Is the financial crisis the result of accounting rule changes?

As an inhouse lawyer for a Fortune 500 company in the 90s, I can definitively say that many corporate mistakes are based on a desire to get the accounting to “work out” in accordance with the goals of corporate executives.

In one instance, I was asked to convert a relatively simple 2-way transaction into an incredibly complex 3-way agreement so that the transaction could be structured as a lease. Leasing was considered to have certain tax advantages for the customer, and the structure of this particular lease was to lead to accelerated revenue recognition for my company.

It was clear as crystal that all three parties were taking significant risks to engage in the transaction. The fact that the two-way relationship was already getting clouded up with performance issues did not cause either of the two parties to hesitate in bringing in a third party to finance the new lease-based transaction.

I’ll never know how the thing turned out, but to me it seemed like juggling flaming battons on an oil freighter, so I left corporate life for private practice.

I bring up the dark underbelly of accounting rules because the financial crisis occuring before our very eyes makes no sense to me. The vast majority of mortgages are not in default.

9 in 100 mortgages is in default. http://www.freerepublic.com/focus/f-news/2086579/posts. This is up from merely 1 in 100 mortgages back in 2007. However, even if absolutely no payments are received by any mortgage in default, one would expect the mortgage holders to be incurring at most a 9% loss. Here in Detroit, a 9% operating loss is not something that causes talk of bankruptcies or bailout. The 9% loss would of course be off-set by the profitable mortgages and other profitable non-mortgage operations.

So what in the heck explains the magnitude of the financial crisis? Why are taxpayers being saddled with hundreds of billions of loan guarantees and other bailout activities?

How can this crises be so deep, broad, and dangerous if only 9 in 100 mortgages is in default?

Accounting rules. Or more specifically, accounting rules accentuating the temporary lack of a debt marketplace for mortgage-backed securities.

See http://online.wsj.com/article_email/SB122178603685354943-lMyQjAxMDI4MjIxMjcyODI2Wj.html for an explanation by someone much more familiar with accounting, banking, and bailouts than I am.

The biggest culprit is a change in our accounting rules that the Financial Accounting Standards Board and the SEC put into place over the past 15 years: Fair Value Accounting. Fair Value Accounting dictates that financial institutions holding financial instruments available for sale (such as mortgage-backed securities) must mark those assets to market. That sounds reasonable. But what do we do when the already thin market for those assets freezes up and only a handful of transactions occur at extremely depressed prices?

The answer to date from the SEC, FASB, bank regulators and the Treasury has been (more or less) “mark the assets to market even though there is no meaningful market.” The accounting profession, scarred by decades of costly litigation, just keeps marking down the assets as fast as it can.

This is contrary to everything we know about bank regulation. When there are temporary impairments of asset values due to economic and marketplace events, regulators must give institutions an opportunity to survive the temporary impairment. Assets should not be marked to unrealistic fire-sale prices. Regulators must evaluate the assets on the basis of their true economic value (a discounted cash-flow analysis).

If we had followed today’s approach during the 1980s, we would have nationalized all of the major banks in the country and thousands of additional banks and thrifts would have failed. I have little doubt that the country would have gone from a serious recession into a depression.

If we do not halt the insanity of forcing financial firms to mark assets to a nonexistent market rather than their realistic economic value, the cancer will keep spreading and will plunge the world into very difficult economic times for years to come.

Apparently even mortgage debt that is being paid on time has to be written off because of the stampede to dump all mortgage-backed assets. Thus, banks are facing dramatic losses not because a significant number of mortgages are in default, but because the market for mortgage-backed securities is essentially zero, triggering all of the banks to take on paper losses for the assets that they hold.

Given the relatively small number of foreclosures (I realize that 9% is actually not that small, but statistically speaking, it shouldn’t be more than a rounding error), this is the only explanation I have read that actually makes sense to me.

Of course it begs the following questions:

If this is the or a source of the problem, why can’t we fix it by going back to the old rule?

Why is nobody besides the author of the WSJ article raising this issue?

What do the RedState financial guys think about the analysis and proposed solution?

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