Do accounting rules matter? The dangerous allure of mark to market.

Author:Epstein, Richard A.
  1. INTRODUCTION: HISTORICAL COST VERSUS MARK-TO-MARKET ACCOUNTING II. THE S&L CRISIS AND THE RISE OF MARK-TO-MARKET ACCOUNTING III. THE FRAGILE THEORETICAL CASE FOR MARK-TO-MARKET ACCOUNTING IV. THE IMPORTANCE OF VALUATION A. Private Valuation B. Government Valuation V. The Many Senses of Valuation A. Threshold Issues B. Valuation Methods Revisited C. Valuation in Roiled Markets VI. DO ACCOUNTING RULES MATTER? A. Theoretical Starting Points B. Accounting Rules Matter 1. They Matter for Regulation 2. They Matter for Private Valuation C. Default Rules Matter Too D. What About the Government? VII. CONCLUSION "There is no such uncertainty as a sure thing." ([double dagger])


    There is nothing like profound financial dislocation to spur inquiry into the first principles of political economy. In some cases, that inquiry is over grand issues about the relationship of state to market. In other cases, it is about seemingly smaller theoretical issues that loom very large in practice. This Article is about one such issue, the question of whether mark-to-market accounting is the proper technique to apply to hard-to-value assets. That question raises a tension between two techniques of valuation, each with its own imperfections.

    The first technique uses historical cost as the benchmark for valuing certain assets. In essence the method starts with cost and then makes certain formal adjustments to estimate the value of an asset that has not been sold. For example, the normal rules for valuing a real estate improvement start with its cost. Thereafter it reduces that basis by an allowance for depreciation, which is granted by regulation wholly without regard to the actual changes in value of the underlying asset. In the end, a fully depreciated asset will be carried on the books as if it were worth zero, even if it still has positive value in use or salvage. (1)

    A simple example illustrates the point. An asset that costs $100 with an assigned 20-year life could have its basis adjusted downward under the "straight-line" method by $5 each year, so that at the close of the second year it is carried at $90. A tax deduction is given for a $10 reduction in value, whether the market value of the asset is $70 or $110. (2) The difference between this "adjusted" basis of $90 and the market value is taken into account as income (or loss) only on the disposition of the asset. (3) Although in the interim one could fairly describe the asset as mispriced, the approach could be justified on the ground that the administrative costs of accurate annual pricing are too high relative to the gains from more precise valuation.

    As a matter of general theory, improvements in real estate will always depreciate so that on average these adjustments tend to reduce the gaps between market value of the asset and its value on the books. Historical cost accounting for corporate shares does not have that downward directional bias, which reduces the reliability of the method. The market for shares is often thick so that there is no need to rely on historical cost accounting at all, as values can be continually and accurately updated. Not surprisingly, the alternative to this system of historical cost requires the revaluation of unsold assets to market on a periodic basis. Accountants typically refer to this system as "fair-value accounting." Tax lawyers and others prefer the equivalent term "mark to market." Mark-to-market accounting became popular (4) after thrifts were accused of hiding "bad" assets by using historical-cost accounting in the years leading up to the S&L crisis in the 1980s. (5) The business reality turns out to be more complex, for historical-cost accounting can only "hide" true values from people who do not want to discover them. (6)

    In this Article we shall explore the tensions between these two areas from historical, economic, and legal perspectives to support the proposition that for all its manifest weaknesses, the hidden virtues of historical cost accounting could render it the sounder approach to accounting issues with hard-to-value assets. Part II reviews some of the historical events that led up to the mark-to-market system. Part III examines the theoretical vulnerabilities of the theory of mark-to-market accounting. Part IV deals with the importance of valuation issues, as it applies to both private and government actors, in setting the appropriate accounting rule. Part V addresses the many different approaches that can be taken toward this critical valuation problem. Part VI then seeks to assess the extent to which the choice of accounting rules matters in light of the previous analysis.


    The evolution of the S&L crisis during the 1980s played out as follows. Thrifts used deposits to fund long-term, fixed-rate mortgage loans. When interest rates are stable and thrifts do not need to compete aggressively on price for depositors, this business model is harmonious. But, in the 1970s, inflation drove up interest rates, which induced new competitors-like money market funds-to enter the market. To attract depositors in this environment, thrifts had to pay higher rates on deposits. At this point the thrifts faced this deadly combination: long-term assets delivering low rates of return (since the contracts were made when rates were low) paired with the higher rates of interest needed to attract deposits to fund these assets. This asset-liability mismatch drove many thrifts into insolvency. (7) Historical-cost accounting gave no explicit warning of the impending meltdown, because thrift financial statements did not reflect the losses from the change in interest rates.

    As we discuss, these tranquil balance sheets could have fooled no one, since everyone knew--or could easily calculate--the values (both real and as reported) of all assets and liabilities. Even though this asset-liability mismatch happened relatively quickly, market observers could see the day of reckoning approaching. (8) For example, Lincoln Savings and Loan Association, of the Keating Five scandal, collapsed in 1989, but its problems were well known for many years before that. (9) But the peculiarities of thrift regulation provided cover for the deterioration in assets by carrying them on the books for more than their actual value. In 1987 and 1988, that regulatory forbearance let Lincoln invest in nearly $2 billion in Arizona real estate, most of which proved worthless. The bailout of Lincoln eventually cost the taxpayers over $3 billion. (10)

    As this incident reveals, the historical-cost accounting system has two dominant features. The first is that it helps forestall regulatory action to take over or shut down a bank, thrift, or other financial institution. If regulators are duty-bound to put a bank into receivership once it is found critically undercapitalized or insolvent, positive financial statements supply valuable cover precisely because they do not accurately reflect the bank's economic position. Accounting regulation becomes a powerful tool in the cause of regulatory discretion in cases where no discretion should be allowed.

    The S&L crisis did not reach fever pitch because the markets believed thrift balance sheets. It came to a boil because of excessive forbearance by regulators. (11) The root cause of this was political tampering. Thus in the Keating Five scandal, five senators intervened with regulators on behalf of their donor and friend, thrift owner Charles Keating. (12) The resulting delay of regulatory intervention took place under the prevailing accounting rule, which provided a patina of solvency when there was not even a glimmer of hope. (13) The phenomenon can be generalized. Too often, government officials practice regulatory forbearance in response to political pressure from bank owners or out of a desire to avoid shutting down institutions that supply valuable services to well-connected constituents.

    One important change put in place after the S&L crisis was a nondiscretionary system of regulatory intervention for undercapitalized banks, under the so-called prompt corrective action regime. (14) The combination of mark-to-market and prompt corrective action was designed in part to take politics out of the government valuation process. (15) unfortunately, history has a way of repeating itself. During the housing bubble, Representatives and senators resisted calls for more regulation of mortgage giants Fannie Mae and Freddie Mac because they helped make housing cheaper for low-income families. For instance, when problems with Fannie and Freddie surfaced for all to see, Senator Charles Schumer said: "I think Fannie and Freddie over the years have done an incredibly good job and are an intrinsic part of making America the best-housed people in the world ... if you look over the last 20 or whatever years, they've done a very, very good job." (16) This incident--and countless others like it, known and unknown--shows that regulatory tampering will exist regardless of the accounting rule.

    The second feature of historical-cost accounting is that it gives a bank a longer window in which to conduct additional (risky) lending in order to bring the bank back from the brink of insolvency. This go-to-Vegas strategy is possible only if the bank's leverage ratio frees up money to lend. The difference between the stated value of assets and of liabilities determines that ratio. If under historical-cost accounting, assets are reported at inflated values and liabilities are relatively fixed, there is greater capacity to lend. The new regime created a heads-I-win, tails-you-lose mentality. (17) Not surprisingly, failing thrifts took advantage of mispriced assets under the historical-cost accounting method to make additional risky loans that were in the interests of bank shareholders but not the taxpayers, who eventually had to bail out...

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