Thursday, August 27, 2009

How Did Going From 2 1/2% Foreclosures to 5% Break our Banks?

Have you ever wondered how home mortgage foreclosures going from a normal average of 2-3% to 5% caused our economy to tank? There is more to the story, called Mark to Market.

The higher up the economic food chain you go the more you hear about Mark to Market Accounting Systems today. It didn’t start the down turn, but it has proven to be a major catalyst driving it deeper faster than if it wasn’t in use. With a little study we learn that it isn’t the first time, and we have a track record to predict our future by its use in the past.
In the book “A Monetary History of the United States,” Milton Friedman and Anna Schwartz tell us that mark-to-market accounting rules caused banks to fail in the Great Depression, not from bad loans, but from writing down bond values at the call of regulators. As William Isaac, former head of the FDIC, tells us in his submission, FDR eventually called together a panel in 1938 that suspended those rules. By then the Depression has lasted 8 years.
Friedman believed that government’s role in the guidance of the economy must be severely restricted. He wrote extensively on the Great Depression, which he called the Great Constriction, arguing that it had been caused by an ordinary financial shock whose duration and seriousness were greatly increased by the contraction of the money supply caused by mark to market. Friedman believed that the depression was far from a failure of the free enterprise system, it was a tragic failure of the government.
Suspending mark-to-market accounting could fix major problems at no cost. It is too bad that many people dismiss this issue without really understanding its economic impact. Franklin Roosevelt suspended mark-to-market in 1938, and between then and 2007 there were no panics or depressions. But when FASB 157, a statement from Federal Accounting Standards Board, went into effect in 2007, introducing mark-to-market accounting, look what happened.
There are two things that are essential when fixing financial market problems, time and growth. It takes time to allow things to work out, and growth to make working things out easier. Mark-to-market removes both. This is because these accounting rules force banks to write off losses even before they actually happen, with this we lose time. This happens because it actually prices in more losses than have, or may ever occur. It forces banks to take artificial losses to capital without looking toward actual performance of loans.
Growth is affected by wiping out capital. It creates a so-called “fair value” and increases the odds of asset fire sales making markets much less liquid. This happened in 2008, investment banks failed, and the government proposed bailouts. This drove prices down even further, hurting the economy. Growth suffers, bad loans multiply, and it is a downward spiral.
In the 1980s and 1990s, there were at least as many, and more, bad loans in the banking system as a share of the economy. What was different was that there was no mark-to-market accounting. This gave banks time to work through the problems. The U.S. cut marginal tax rates and raised interest rates helping the economic growth. Time and growth allowed those major banking problems to be absorbed. There were nearly 3,000 banks that failed at that time yet without creating an economic catastrophe.
In the 1930s, mark-to-market accounting limited the amount of time available to fix problems. At the same time the U.S. raised taxes, increased spending and economic interference, and became protectionist. This hurt growth. The reason the Great Depression was so bad is that we did then what we are trying to do now. Maybe it is time we learned from history, and not repeat it. On April 12th of this year, there was an agreement to "soften" the rules. They should have started coming into effect during the second quarter of this year, hopefully they will be softened enough to help. There seems to be a better way by going to a Rolling 3 year average to find a better number.

If you would like to read a very good article on it, on April 12th Forbes has one, just Google Mark to Market Accounting.

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