Simple Accounting Rule Change Could Save Wall Street: CEI’s Berlau

The $700 billion-plus bank bailout from Henry Paulson, President George W. Bush’s Treasury Department, is unnecessary because a simple accounting rule change would help markets rebound, writes the estimable John Berlau of the Competitive Enterprise Institute.

The so-called mark-to-market accounting rules enforced by the U.S. Securities and Exchange Commission have helped to cause Wall Street’s problem. As Berlau explains:

For decades, lenders used historical cost accounting, meaning that a loan would be booked at its cost at the time it was made. Payments would be recorded as they came in, and the book value of the loan would only change if it was sold or became impaired, perhaps because of default.

The pressure to change this method came after the collapse of U.S. savings and loans in the 1980s, and the Japanese banking crisis of the ’90s. Regulators and accounting bodies argued that traditional accounting allowed banks to “hide” bad assets on their books, and that financial instruments needed to be valued based on what they would trade for in a market today.

So over the past decade, various mark-to-market accounting rules became part of the official U.S. Generally Accepted Accounting Principles (GAAP), and began to be required by the Securities and Exchange Commission, bank regulatory agencies, credit rating agencies and in the Basel II international framework for measuring bank solvency.

The new accounting rules have contributed to the recent market meltdown. Berlau cites Yale finance Professor Gary Gorton who wrote in a paper presented at the Federal Reserve’s summer symposium last month: “With no liquidity and no market prices, the accounting practice of ‘marking-to-market’ became highly problematic and resulted in massive write-downs based on fire-sale prices and estimates.”

Berlau continues

These write-downs, based on accounting standards, can jeopardize balance sheets and solvency — much like a spreading contagion. In effect, a single bank’s fire sale can decrease the “regulatory capital” (or the total dollar value of assets that government regulations require banks and other financial institutions to keep as a reserve to immediately make good on their obligations to depositors and other creditors) of others. So “partly as a result of GAAP capital declines, banks are selling . . . billions of dollars of assets — to ‘clean up their balance sheets,'” notes Mr. Gorton, creating a “downward spiral of prices, marking down — selling — marking down again.”

Some have proposed that capital gains taxes be temporarily suspended in order to attract capital to Wall Street, but Berlau argues that reforming this destructive accounting rule would go along towards helping to repair the economy. Some “relatively simple changes to mark-to-market rules, like suspending the rules for illiquid but performing loans if a firm meets other solvency requirements, would lead to more accurate information and could quell demands for more ’emergency’ bailouts,” he writes.

Berlau, director of the Center for Entrepreneurship at the Competitive Enterprise Institute, has written two articles for Capital Research Center: “Eco-Terrorism: When Violence Becomes An Environmentalist Tactic,” Organization Trends, February 2007, and “Bush Administration Targets Muslim Charities Aiding Terrorists: Nonprofits Raise Money For Terror Organizations,” Organization Trends, April 2002.

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