The Trillion-Dollar Question: Are the Bookkeepers At It Again?

Why should America attempt an expensive, controversial, and possibly ineffective bailout strategy for the current financial crisis when a virtually costless and simpler change could solve much of the problem?

We accountants don't like publicity. Fortunately, we don't get much. Most of the public remembers Enron, but fewer remember Arthur-Andersen, the big accounting firm that went down with them. Questionable accounting was a big part of the reason for Enron's failure. I think accountants may be behind the scenes again in the current financial crisis. Are there any of us bean counters in those meetings? If there are, my bet is that they are sitting on their hands and keeping their mouths shut even though they might know about a much better (and cheaper) solution. Accountants, after all, don't talk much; and they don't like to admit errors.

Pouring 700 billion of our money into failing financial institutions seems akin to throwing spaghetti against the wall. Keep throwing until something sticks. They tell us that credit will dry up if we don't inject cash. No credit would be disastrous for the economy, but they have not explained well enough why the banks have failed so suddenly and drastically that emergency room surgery is required. Knowing why would help us poor taxpayers feel better about how the problem should be solved. Ever wonder how many other bank failures are out there waiting behind the curtain to take their bows? Are we going to throw even more money at them too?

Should we consider a solution that requires no money, or at least a lot less? Here's one. Have the SEC suspend the accounting rule called mark-to-market. By a relatively simple accounting adjustment, troubled banks' assets and capital could be increased and credit kept available. Accounting purists, cover your ears. Eyes glaze and minds wander when I say balance sheet, so let's use the acronym BS, a more appropriate description. BS's have two sides: assets on the left, liabilities and capital on the right. Banks are required to maintain certain levels of capital (the difference between assets and liabilities) in order to make loans. When assets shrink, capital shrinks. When the ratio of capital to assets drops to a certain level, (think ten-to-one), banks are not allowed to make loans. And if it drops too low, they can be classified as insolvent. This can happen overnight, and it did.

Why? Wall Street is essentially driven by emotion and the news of the day, so when nobody wants a particular security, the price falls fast and hard. Do I believe in efficient markets? Yes, eventually, but markets are often wrong for periods of time ... think years. Therefore, we are marking assets down to near zero based on markets that fluctuate wildly from minute to minute. The media have hammered us with news about drops in home prices and increases in mortgage delinquencies to the point that nobody wants to own these assets. A few rotten apples have spoiled the whole barrel. Sub-prime loans and the securities they are bundled into have plummeted in value, sometimes to zero, because nobody wants to touch that barrel, even if most of the apples are still good. Banks marked them to their current value, billions in capital disappeared with the stroke of a pen (excuse me, stroke of a key.)

So why do we have mark-to-market? Accountants have always had a hard time figuring how best to state asset value on a balance sheet. We depreciated buildings in years when their value was skyrocketing and thus understated asset values and capital. When interest rates shot up in the Seventies, banks owned tax-free bonds yielding two to three percent and had long-term loans at 6%. You could buy identical bonds with yields double or triple that and make loans at 20%. The market value of these banks' loans and bonds dropped by more than half. If they had marked to market, regulations would have prohibited many of them from making future loans. Many would have been declared insolvent and taken over by the FDIC. Yet, these banks were essentially sound. They held their loans and bonds to maturity and only suffered temporary market losses that were never realized or reported.

CPA's continued to struggle with asset valuation. What is fair? What is conservative? Enter Enron. Inside accountants at Enron recognized correctly that valuing assets at cost was often invalid, so they started playing fast and loose with asset values, using something called mark-to-model. A sharp CPA could design a believable computer model that could make the value come out wherever his boss wanted it to be. He could also convince outside auditors and regulators of the soundness of his model.  Embarrassed that they had been caught looking the other way, FASB (Financial Accounting Standards Board) passed rule 157 that requires assets to be marked to market. Asset valuation based on the optimism of its owner was replaced with the skepticism of a risk-averse buyer. Sounds nice and conservative.

Enter the law of unintended consequences.

Suspending the mark-to-market rule would allow banks and accountants to revalue their assets based on more sound criteria than the euphoria or panic that pervades the floor of the New York Stock Exchange minute-by-minute. Sub-prime mortgages will likely have much higher values if considered in a longer-term perspective -- such as hold-to-maturity. I believe that the vast majority of mortgages will perform in the long term.

Presto. Up goes assets; up goes capital; banks can make loans again. Cash infusions may still be required, but this will buy us enough time to seriously examine what steps need to be taken to get runaways like Fannie and Freddie under control, how to renegotiate rates with distressed borrowers who really can handle a mortgage, and how to keep this from happening again. Can this be done? If we can approve 700 billion, surely we can do this and keep our money. 

Jim H. Ainsworth-former CPA, CFP, CLU, Registered Investment Advisor, Licensed Securities Principal, was twice named one of the most influential accountants in America by Accounting Today magazine.  He welcomes comments at http://www.jimainsworth.com
Why should America attempt an expensive, controversial, and possibly ineffective bailout strategy for the current financial crisis when a virtually costless and simpler change could solve much of the problem?

We accountants don't like publicity. Fortunately, we don't get much. Most of the public remembers Enron, but fewer remember Arthur-Andersen, the big accounting firm that went down with them. Questionable accounting was a big part of the reason for Enron's failure. I think accountants may be behind the scenes again in the current financial crisis. Are there any of us bean counters in those meetings? If there are, my bet is that they are sitting on their hands and keeping their mouths shut even though they might know about a much better (and cheaper) solution. Accountants, after all, don't talk much; and they don't like to admit errors.

Pouring 700 billion of our money into failing financial institutions seems akin to throwing spaghetti against the wall. Keep throwing until something sticks. They tell us that credit will dry up if we don't inject cash. No credit would be disastrous for the economy, but they have not explained well enough why the banks have failed so suddenly and drastically that emergency room surgery is required. Knowing why would help us poor taxpayers feel better about how the problem should be solved. Ever wonder how many other bank failures are out there waiting behind the curtain to take their bows? Are we going to throw even more money at them too?

Should we consider a solution that requires no money, or at least a lot less? Here's one. Have the SEC suspend the accounting rule called mark-to-market. By a relatively simple accounting adjustment, troubled banks' assets and capital could be increased and credit kept available. Accounting purists, cover your ears. Eyes glaze and minds wander when I say balance sheet, so let's use the acronym BS, a more appropriate description. BS's have two sides: assets on the left, liabilities and capital on the right. Banks are required to maintain certain levels of capital (the difference between assets and liabilities) in order to make loans. When assets shrink, capital shrinks. When the ratio of capital to assets drops to a certain level, (think ten-to-one), banks are not allowed to make loans. And if it drops too low, they can be classified as insolvent. This can happen overnight, and it did.

Why? Wall Street is essentially driven by emotion and the news of the day, so when nobody wants a particular security, the price falls fast and hard. Do I believe in efficient markets? Yes, eventually, but markets are often wrong for periods of time ... think years. Therefore, we are marking assets down to near zero based on markets that fluctuate wildly from minute to minute. The media have hammered us with news about drops in home prices and increases in mortgage delinquencies to the point that nobody wants to own these assets. A few rotten apples have spoiled the whole barrel. Sub-prime loans and the securities they are bundled into have plummeted in value, sometimes to zero, because nobody wants to touch that barrel, even if most of the apples are still good. Banks marked them to their current value, billions in capital disappeared with the stroke of a pen (excuse me, stroke of a key.)

So why do we have mark-to-market? Accountants have always had a hard time figuring how best to state asset value on a balance sheet. We depreciated buildings in years when their value was skyrocketing and thus understated asset values and capital. When interest rates shot up in the Seventies, banks owned tax-free bonds yielding two to three percent and had long-term loans at 6%. You could buy identical bonds with yields double or triple that and make loans at 20%. The market value of these banks' loans and bonds dropped by more than half. If they had marked to market, regulations would have prohibited many of them from making future loans. Many would have been declared insolvent and taken over by the FDIC. Yet, these banks were essentially sound. They held their loans and bonds to maturity and only suffered temporary market losses that were never realized or reported.

CPA's continued to struggle with asset valuation. What is fair? What is conservative? Enter Enron. Inside accountants at Enron recognized correctly that valuing assets at cost was often invalid, so they started playing fast and loose with asset values, using something called mark-to-model. A sharp CPA could design a believable computer model that could make the value come out wherever his boss wanted it to be. He could also convince outside auditors and regulators of the soundness of his model.  Embarrassed that they had been caught looking the other way, FASB (Financial Accounting Standards Board) passed rule 157 that requires assets to be marked to market. Asset valuation based on the optimism of its owner was replaced with the skepticism of a risk-averse buyer. Sounds nice and conservative.

Enter the law of unintended consequences.

Suspending the mark-to-market rule would allow banks and accountants to revalue their assets based on more sound criteria than the euphoria or panic that pervades the floor of the New York Stock Exchange minute-by-minute. Sub-prime mortgages will likely have much higher values if considered in a longer-term perspective -- such as hold-to-maturity. I believe that the vast majority of mortgages will perform in the long term.

Presto. Up goes assets; up goes capital; banks can make loans again. Cash infusions may still be required, but this will buy us enough time to seriously examine what steps need to be taken to get runaways like Fannie and Freddie under control, how to renegotiate rates with distressed borrowers who really can handle a mortgage, and how to keep this from happening again. Can this be done? If we can approve 700 billion, surely we can do this and keep our money. 

Jim H. Ainsworth-former CPA, CFP, CLU, Registered Investment Advisor, Licensed Securities Principal, was twice named one of the most influential accountants in America by Accounting Today magazine.  He welcomes comments at http://www.jimainsworth.com