A colleague of mine likes to characterize the debate over the Paulson plan as a heavyweight title fight with a lot of undercards. He's right--the crisis has merely brought to a head a wide spectrum of battles that have been brewing for years between regulators and financial interests. What makes this a little different from boxing is that all these debates are interrelated, and most of them tie into the main event--i.e., the Paulson plan.
The most significant undercard fight--because it directly deals with how much taxpayers will have to give out under the Paulson plan--has to do with "mark-to-market." I won't do justice to the intricacies of the issue (for a longer, better explanation, see this piece by Slate's Daniel Gross), but suffice it to say that when it comes to financial products--for example, the mortgage-backed securities that the Paulson plan seeks to buy--there are two ways to value them. The first is what the market is willing to pay for them right now, the "mark-to-market" value. The second is a hypothetical price, often based on a model that predicts what they'll be worth at some point in the future (hence the name "mark to model"). You can imagine how different sides line up here: Accountants and regulators, who prize transparency, push for "mark-to-market" pricing, while the banking industry believes that day-to-day market pricing doesn't reflect the underlying value of the products, while their models do.
There are already a variety of mark-to-market rules in effect--FAS 157, an accounting rule ascribing mark-to-market rules to certain assets, went into effect last fall--but regulatory types have been pushing to expand them to cover nearly all types of assets. Banking lobbyists have been somewhat successful in stymieing that expansion.
But the last few weeks have brought the issue to a head, and both sides see an opening. In a letter to SEC Chair Chris Cox, American Banking Association President Edward Yingling recommended a suspension of marking-to-market. Yingling and others, such as the Competitive Enterprise Institute's John Berlau, even posit that the current mark-to-market requirements contributed to the present crisis by introducing undue instability and downward pressure into derivatives markets.
And in the other corner ... we have the heavyweight Chartered Financial Analyst (CFA) Institute and an army of former regulation gurus (like past SEC chairs Arthur Levitt and Richard Breeden). They argue that, in fact, it is the lack of universal mark-to-market rules that caused the crisis. Banks, they say, unrealistically and perhaps fraudulently hyped the value of their products based on biased or just unreasonable modeling; when mortgages started failing, the real values became apparent and the market had a long way to fall. In a letter to Congress and the SEC on Tuesday, the CFA Institute wrote that "the causes of the massive asset write-downs we have observed have nothing to do with financial reporting, but everything to do with the need for effective stewardship."
It might seem that, with the crisis in full swing, placing blame is a moot point. But the mark-to-market debate makes all the difference as Congress and the Treasury hash out how to value distressed assets under the Paulson plan. Banks argue that these assets are so low in value right now, and so infrequently traded, that it's impossible to set a fair market value--and even if you could, it would be so low that the sale wouldn't give them the cash necessary to reliquidify the economy. Better, they say, to price the assets according to their models, because these assets will inevitably gain in value, making up for the higher initial cost.
Set aside the fact that the people who got us into this mess are now asking the Treasury to let them continue with business as usual. Set aside the fact that there is, as Robert Samuelson points out this morning, no guarantee that those assets will actually gain in value. Set aside the irony that groups like the Competitive Enterprise Institute, which ostensibly favor free markets, are asking Congress to let banks rig prices to artificially elevate the current value of their assets. Contrary to what the president said last night, we are not in an acute crisis. The economy is not about to collapse. The investment banking sector has disappeared, and we're still alive (in this vein, for a good argument against the bailout, see James K. Galbraith in this morning's Washington Post).
What we face, rather, is a chronic problem of illiquid markets, borne from a sudden, deep distrust of the banking sector's pricing schemes. This recommends a different approach--reform, not rescue. Rushing to a bail out and suspending accurate accounting rules is only going to exacerbate the underlying disease. Rather, as the CFA Institute notes in its letter, "The process of stabilizing the global financial markets and reinvigorating liquidity starts with improving the transparency of financial institutions. Without such transparency, investors will remain skeptical about the depth of problems plaguing the system and will be unwilling to invest in those institutions or put their capital at risk." In other words, the economy is strong enough to take some tough medicine. Which means finding ways to expand--not suspend--mark-to-market. It won't get the Dow back to 13,000 by December, but it would do a lot to wring out the investor distrust that will otherwise keep markets illiquid for a long time.
UPDATE: In a follow up to my original post above, the ABA called to say that they are not asking for a suspension of existing mark-to-market rules per se, but rather a relaxing of the definition of "fair value" that underlies the rules: "We would recommend that, given current market turmoil, the SEC provide immediate guidance that intrinsic value or economic value are appropriate proxies for fair value. The current accounting standards never anticipated the wide variance and price disconnects that we are experiencing today, and there needs to be a more appropriate and accurate measure that approximates true fair value." Regarding future rules, they say they're not looking for a complete temporary stay, but rather "a thorough analysis as to whether the proposed standards are clearly to the benefit of users of financial statements, whether fair value is pro-cyclical, and whether the impact of the proposals on the marketplace has been adequately taken into account and provided for" before any new rule can go forward. Both of these quotes come from the letter from ABA President Edward Yingling to SEC Chair Chris Cox, which I mentioned in the original post. My feeling is that there is only a fine semantic difference between the two readings, but I'll leave it to readers to decide themselves.