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Bernanke Finally Fingers Mark-to-Market -- By: Brian S. Wesbury & Robert Stein

Late last month, during testimony before Congress, Federal Reserve chairman Ben Bernanke made the following eye-popping statement: ?Commercial real-estate loans should not be marked down because the collateral value [the estimated value of the property on the market] has declined. It depends on the income from the property, not the collateral value.?

It would have been much better for the economy if Bernanke had been this clear about mark-to-market accounting back in 2008. If he had, the U.S. might have avoided the Panic of 2008.

But it?s never too late, and now that mark-to-market ideology is affecting the ability of the Fed to exit its quantitative-easing policy, Bernanke is finally onboard.

A little background is in order.

In November 2007, the Financial Accounting Standards Board (FASB) reinstated mark-to-market accounting for the first time since 1938. This rule uses bids (exit prices) to value assets. So far, so good. However, in 2008, the market for asset-backed securities dried up. The prices of bonds that were still paying in full fell by 60 or 70 percent, and these losses often were driven through income statements. This wiped out regulatory capital, caused bankruptcies, and created a vicious downward spiral in the economy.

In retrospect, it is clear that this accounting rule was a potent pro-cyclical force behind the 2008 panic.

Finally, on April 2, 2009, the FASB allowed banks to use ?cash flow? to value bonds when the markets are illiquid -- the same sentiment that Bernanke expressed before Congress. This fixed the immediate problems in the system, and the economy and financial markets have been on the mend ever since. In fact, the stock market bottom of March 9, 2009, came on the very day news broke that Reps. Barney Frank and Paul Kanjorski would hold a hearing to force the FASB to change the misguided accounting policy.

However, overzealous bank regulators are now enforcing their own version of mark-to-market accounting. Regulators are making banks write down loan values and increase loan-loss reserves based on appraiser-driven valuations. And yes, these are the very same appraisers who over-valued properties five years ago. Now, because appraisers often use foreclosures and distressed sales as comparable recent transactions, they are undervaluing properties.

To the regulators, it doesn?t matter if a loan is still being paid on time. And it doesn?t matter if a lower valuation of the collateral will force an already stressed borrower to come up with more cash. Regulators have decided that they want banks better capitalized, and one way they can do that is to reduce the value of a bank?s assets and then force these banks to raise money from shareholders.

This, in turn, is undermining bank lending, hurting small businesses, and keeping the unemployment rate high. And the worst part is that it?s just not necessary. Mark-to-market accounting does not solve problems; it creates them by acting as a pro-cyclical force. Milton Friedman understood this, and he wrote about the devastating link between mark-to-market accounting and the Great Depression bank failures. Franklin Delano Roosevelt finally figured this out in 1938 -- he suspended the rule and the Depression ended soon thereafter. Coincidence? We think not.

Similarly, in 2009, with mark-to-market rules in place, two stimulus bills totaling over $1 trillion, the $700 billion Troubled Assets Relief Program (TARP), zero percent interest rates, and trillions of dollars in other Fed and Treasury actions did not turn the market around. Private money did not flow into the banking system until the FASB finally allowed cash flows to be used to value assets when markets are illiquid.

Once the rule was changed, banks were able to raise $100 billion in private capital. And since the rule change, TARP money has been repaid by institutions that were forced to take it, while the Treasury and Fed?s Public-Private Investment Program never got off the ground.

But as long as bank regulators still impose mark-to-market-style rules -- indeed, as long as such rules remain even a threat to the system -- the system will not fully heal.

For example, a viable market for the securitization of asset-backed loans is highly unlikely to reappear until mark-to-market accounting is dead and buried. Why would anyone buy asset-backed securities when there is still the potential for market-driven declines in value to undermine the ability of the financial system to hold these securities even if cash flows are not impeded?

If you don?t believe this, read the exchange between Bernanke and congressman Kanjorski:

REP. PAUL KANJORSKI: I?m particularly interested in#...#the commercial real estate problem. Could you give us your assessment of [that problem]#...#and if there?s any action we in the Congress should take?

CHAIRMAN BEN BERNANKE: Congressman, it remains probably the biggest credit issue that we still have. Yesterday, Chairman Baird talked about the increase in the number of problem banks. A great number of those banks are in trouble because of their commercial-real-estate positions.#...#The Fed has done a couple of things here. We have issued#...#guidance on commercial real estate, which gives a number of ways of helping, for example instructing banks to try to restructure troubled commercial-real-estate loans, and making the point that commercial-real-estate loans should not be marked down because the collateral value has declined. It depends on the income from the property, not the collateral value. We?ve also, as you know, had this TALF program, which has been trying to restart the CMBS -- commercial mortgage-backed securities -- market with limited success in quantities. But we have brought down the spreads, and the financing situation is a bit better. So we are seeing a few rays of light in this area, but it does remain a very difficult category of credit, particularly for the small- and medium-sized banks in our country.

While Mr. Bernanke did not directly link accounting rules with his attempt to ?restart? the CMBS market, it is clear that if mark-to-market accounting remains alive, this market will not be easily resurrected. No matter how much money the Federal Reserve throws at the market for securitized assets, the private sector will remain skittish if there is the potential for an accounting rule to wreck the market again.

This is very important for the Fed?s exit strategy and for the growth of the loan market in the years ahead. Without securitization, bank lending will continue to drag while the Fed worries about withdrawing support from the system. The U.S. needs a viable securitization marketplace, and mark-to-market accounting remains a big stumbling block.

Simply, mark-to-market accounting needs to die. It should be stabbed in the heart with a cedar stake, shot with a silver bullet, and then buried under six feet of garlic powder. Like the evil killer in a horror flick, we need to make sure it never gets up off the floor again.

While we do not agree with everything Ben Bernanke is doing these days, his recent comments, which finger the impact of accounting rules and conventions on the economy, are right on the money. Hopefully the SEC, Treasury, the FDIC, Congress, and the FASB were listening.

-- Brian Wesbury is chief economist and Robert Stein is senior economist at First Trust Portfolios L.P.

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Full post as published by Bench Memos - National Review Online on March 08, 2010 (boomark / email).