Paulson bailout would worsen contagion-spreading accounting rules

by John Berlau on September 22, 2008 · 1,225 comments

in Economy, Legal, Nanny State, Politics as Usual, Precaution & Risk

My colleague Hans Bader is correct that most of the aims of Treasury Secretary Henry Paulson’s $700 billion bailout — stopping the “contagion” of securitized loans that have become illiquid — could be achieved if mark-to-market accounting rules were “immediately relaxed by federal agencies like the SEC that enforce them.” As I wrote in my Wall Street Journal op-ed this weekend, because the mark-to-market rules require writedowns of performing loans based on the last sale of similar assets, good “banks holding mortgages that haven’t been impaired often have to adjust their books based on another bank’s sale — even if they plan to hold their loans to maturity.” (And commenter “Topcat” misses the point of the post. Because agencies like the SEC and Federal Deposit Insurance Corporation use mark-to-market to measure the solvency of banks and brokerages, these firms are certainly not “free to disregard the regulatory rule for valuation and apply their own.”)

But the bailout — in addition to putting taxpayers on the hook and massively increasing government’s role in the economy — would likely make mark-to-market and hence the credit crisis worse, according to experts who have reviewed Paulson’s plan. Paulson proposes a “reverse auction” approach by which government would choose the lowest selling price to by a financial firm’s mortgage-backed securities. But unless mark-to-market rules were changed, this sale would force other firms to write down their assets to this price.

An Associated Press story paraphrases American Enterprise Institute scholar Vincent Reinhart, a former Federal Reserve monetary affairs director, as saying that “if the auctions set too low a price for mortgage-related assets, other institutions with bad debt may be forced to take the distressed valuation onto their books under mark-to-market accounting rules.” A Wall Street Journal news article similarly observes that “buying for pennies on the dollar … would further hurt financial institutions, since they would have to write down the losses and take additional hits to their balance sheets.”

So if paying too low would add further risk to the credit market, and paying too high would add further risk to taxpayers, the rational thing would seem to be not to have a bailiout at all. It would also seem rational to instead put forth a bill preventing the SEC, the FDIC and other agencies from enforcing mark-to-market rules like Financial Accounting Standard 157 from the quasiprivate Financial Accounting Standards Board.

But Paulson, although frequently described as a “pragamatist,” isn’t being rational on this, despite condemnations of mark-to-market from officials of the Bank of England and academics from Yale and Wharton. Instead, he offered a staunch defense of mark-to-market rules in a July speech at the New York Public Library, saying, “I think it’s hard to run a financial institution if you don’t have the discipline which requires you to mark securities to market.”

Makes one wonder if Paulson really wants to save the economy or just build a Big Government that serves Wall Street

Topcat September 22, 2008 at 8:16 am


I thought your point was simply that banks were having to take a write-off on their books, and thus a paper loss. My point back was the marketplace is free to discern a different value than the accounting rules allow anytime it pleases, and does all the time. Private equity groups, Warren Buffett, et al would be buying these loans like penny candy if the value was really there. The lack of activity on that front suggests there isn't a major difference between the market's impression of these loan's true value, and that required by the accounting rules.

That being said, I acknowledge your point that paper writedowns would affect the bank's ratios, and thus to a degree, their liquidity. But I still don't see it as a 'big picture' perspective. My viewpoint dissents from the others in this forum in that I think everyone here is working overtime to blame these continuing cycles of marketplace mania and fraud on the government instead of asking why the so-called discipline of 'reputation risk' has been unable to keep Wall Street in check.
Like the WSJ, everyone here tells us the marketplace is self-regulating even as it delivers fraud and catastrophe over and over again.

You can look backwards for some rule change, or subsidy that has set these events in motion, but it doesn't change anything. Wall Street has shown NO ability to police itself, and we wouldn't be facing yet another Wall Street-spawned crisis if they could.

Jack King September 22, 2008 at 1:17 pm

I think that the government is doing just the same thing as Roosevelt did in the 30's. Our founding fathers never envisioned any thing like the national octopus we have to contend with at present.

McCains first reaction, hands off, was right!

fedgovernor September 22, 2008 at 6:15 pm


Once you allow banks to buy securities and hold them, then you have to have mark-to-market rules that are transparent. Otherwise, bank management will lie to the owners and steal the banks capital.

Bank managers have an incentive to lie to the owners of the bank. The incentive is their pay package, which is predicated on the recording of profits.

If bank managers aren't required to accurately book the value of the things they buy with the owners money, then the bank managers will steal the capital by making up values (and thus, profits) out of thin air. The value of a security might be debateable, but the value of a bank manager's bonus isn't. That's real money.

That's why you can have either:

1) A rule that banks can't own securities (heh)


2) A rule that says that banks must accept the market's estimation of the value of those securities.

Look … bank management stands to make MILLIONS in pay by overstating the value of assets owned by the bank.

That can't be allowed to happen, bub. Or else the banks are being robbed from the inside.

Tony September 24, 2008 at 9:39 am

Is anyone suggesting that bank managers not be required to accurately book the values of the assets they buy? The entire point is that current accounting rules REQUIRE banks to INACCURATELY book the values of their assets.If another institution, for whatever reason, sells a $100k mortgage backed by a $250k house for $10k, then all your $100k mortgages are now suddenly valued at $10k. If you are required to have at least $100M on hand, and you meet that requirement by holding 2000 mortgages for $100k each, now you're AIG.

Tony September 24, 2008 at 9:43 am

PS – and while I tend to agree that the gov't should not be rewarding or even protecting private individuals or institutions for the consequences of their irresponsible actions, keep in mind that for at least a couple of decades now there has been federal legislation effectively requiring that financial institutions make loans to people that they know aren't going to be able to pay them back.

James L September 30, 2008 at 8:13 am

Of course the bank managers can't be allowed to simply make up values. The idea of suspending the mark-to-market rules is to place the securities at book value rather than an uncharacteristically low market value to prevent what is essentially a massive margin call. The problem is something that you pointed out in your response. The idea that marking the value of a security is a measure of profit (or loss) is only true on paper. The profit is not there until the security matures or is sold at which point the profit (or loss) is realized. Until then it is simply capital appreciation. The issue with mark-to-market accounting comes down to an issue of the debt-to-asset ratio.

Brooks September 30, 2008 at 5:02 pm

Many years ago, a mutual fund was buying "lettered stock" and not marking these securities to the market. Their Board would put arbitrary price on these stocks and this fund showed 179% gain in one year. When the "market" discovered this false reporting, the fund went bankrupt. A broker/dealer was reporting its sales of limited partnerships, to customers, at "book" value (what they sold it for) rather then mark to market values. When this fraud was discovered, the true values were about 10% of the value reported. They went out of business. Mutual funds must "mark to the market" at the close, every day. Without mark to the market, there would be no way to know if your investment firm had financial integrity and liquidity. The investment firm's ability to meet its continuing commitments to its customers could not be tested without the mark to market rules. There is a market for those distressed CMOs but no one wants to sell, at those prices. Mark to market rules helped to expose those toxic investments for what they were, bad.

Lance Free & Jay October 1, 2008 at 12:35 pm

Mark to Market Solution, Not ReversalSimply stated, the mark-to-markdown rule states you must assign the value of your bank’s assets according to what the market says they are worth at the time. When the market value of a home drops, the buyer has defaulted on the mortgage, the artificially created demand for homes all across the board has collapsed and years worth of supply has to be worked through, there is no value to the property the bank holds since there are all sellers and no buyers. The value is zero according to the market value. Plain and simple, if you are not willing to make significant concessions to rid yourself of the property in order to keep the defaulting party in the home or find a new buyer (doubtful) at a steep loss, you are required to carry the property at the total loss of mark-to-markdown. Similarly, a third-party will never buy the mortgage which has failed. Banks and investors are not in the business of home ownership and maintenance until the housing supply is exhausted and the mortgage purchaser can recoup the price of the home plus carrying costs on the original mortgage terms acquired by the third-party!Suspension of the mark-to-markdown rules would be a return to the over leveraging of capital that created the mess in the first place. One, it allows the banks to create a subjective value for an asset (the mortgage and underlying price of the physical asset of the home) which the market says is worthless and the bank has failed to find a buyer at any price. Two, this is the same situation which infected Freddie and Fannie since it encouraged them to by theses assets on the faulty assumption the home market would be climbing, the underlying mortgages were payable on reasonable terms, mortgage payments would be made and values maintained in perpetuity. NOT! Finally, the suspension of the accounting rules would be a market ruse which essentially permits the bank to again over leverage by over valuing assets for more cheap Fed money. And, lacking confidence on how any other bank has subjectively valued its unsaleable assets, no bank is going to loan another bank money or issue new loans into a market which has been artificially created.As the L.A. Times reported,. "Accounting purists say a rule change would raise the risk that the banks would resort to fantasy accounting — "mark to make-believe" — that would overstate the value of their assets to investors. The Center for Audit Quality, an advocacy group for the accounting industry, issued a statement Tuesday urging Congress to reject any suspension of mark-to-market rules, saying that would undermine investor confidence by allowing companies "to mask the actual value of financial assets at a given point in time." No one can say the investment banks, which effectively started the dominos tumbling, were not part of and fueling the mortgage problem. And yet, it was in 2004 that the same investment banks petitioned an obtained SEC approval to allow them special status to leverage their assets up to 40 times compared to the previous 12 times applicable to themselves and banks. This was known as the "Alternative Net Capital Requirements for Broker-Dealers That Are Part of Consolidated Supervised Entities" and which allowed investment banks, including Goldman Sachs being run by Paulson, to subjectively determine "net capital to include securities for which there is no ready market". Now, the proposal is to allow every financial institution to make its own determination of market value! Talk about not learning from a mistake.As an relevant aside, everyone should be calling for Paulson to step aside from participation in the execution of this plan – whatever the final terms. In February 2006, at the latest, Paulson’s Goldman Sachs Group began using an internal and copyrighted Powerpoint presentation entitled "A Primer on the Sub-Prime Market" by the "Goldman Sachs Structured Products Strategy" division. That document indicates how to sell the securities and then states, "Given the belief that house prices in the U.S. are too high, there are several trades that can be executed to short house prices". In the Spring, Goldman Sachs thereafter sold mortgages tronches, totaling $496 million, to the unwitting clients who lost an estimated 300 million. Goldman however handsomely profited again on the failure of these securities by shorting the market and sales!! See, Sloan article in Washington Post. Instead, notables like PIMCO Investment founder Gross, and David Einhorn of Greenlight Capital, are knowledgeable about the debacle and the house of cards on which it was built. In fact, Mr. Gross stated on CNBC he would run the program for free!A more appropriate response to the "mark-to-markdown" rule would be allow a limited waiver of the rule for any mortgage renegotiated with the "primary residence" homebuyer which puts them back in the foreclosed or abandoned home. As a result, the home would be sold, the home occupied, a simplified mortgage based upon actual ability to pay in place, renegotiation taking place at the local level with knowledge of local markets, federal intervention avoided, excess supply removed from the market, a bottom up approach utilized and liquidity enhanced. The changed mortgage could the be valued at the new market as reasonably estimated by the bank. The "Plan" would then be buying assets which tend to re-establish the fair market value and others are more likely to step in when the toxicity is removed. Note the proposed rule waiver would only be applicable to a primary residence. Sorry, no help for flippers and speculators.For any one interested in an examination of the greed in sub-prime mortgage the NY Fed noted the overreaching of the effects of the usurious terms " begs the question why such a loan was made in the first place." Please search, read and digest: "Understanding the Securitization of Subprime Mortgage Credit", Staff Report No, 318, by the Federal Reserve Bank of New York, March 2008Sorry, we were so rude as to inject a comment on the issue of "mark to market" and its application.Lance Free & Jay DeeLance Free Consulting

Lisa_P November 16, 2008 at 10:21 pm

Treasury Secretary Henry Paulson has dashed all hopes on the rocks of using part of the remaining $700 billion bailout package for buying up troubled assets, such as devaluing mortgages. Instead, much of the remaining funds will be spent on investing in consumer credit. Since payday cash loans are a form of consumer credit, the payday loan industry should be eligible for some funding, but the likelihood of that is slim. The investment will likely go to the most used forms of consumer credit, such as car loans, student loans and credit cards, due to these forms of credit far harder to obtain because of “illiquidity.” “This is creating a heavy burden on the American people and reducing the number of jobs in our economy,” says Paulson. That may be, but what he is doing is admitting to a mistake in the first part of the bailout plan! If only the rest of our leadership were willing to at least obliquely hint at admitting their mistakes. Granted, it is us the American people who have to pick up the pieces and move forward, but on the upside is that part of the bailout is to encourage the return of investors, which will help stimulate spending, bring the job market back, and with that means less unemployment and fewer people having to depend on payday cash when times are hard. The industry will still be there for people, but it’s meant only as a short term tool. Read more on Payday Cash

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