Did Mark-to-market Accounting Destroy the Economy?

Mark-to-market accounting basically means that assets will be valued according to what the market price of the asset at the time. This is a commonsense practice. What is your house worth, what is your car worth, what is your time worth? The answer is the same for all: it is worth what the market will bear.

Frank Holmes argues that this simple and commonsense practice (recently suspended by the Financial Accounting Standards Board, here is the original guideline) says yes, in a recent article on the Kitco website. Unlike most analysts on this issue, he provides some data. Holmes argues that the FASB accounting rule (implemented at the beginning of 2008) caused a vicious cycle: the rule caused banks to write down losses that were at that point unrealized, which then caused them to be under-capitalized, causing them to then restrict lending.

Here's his chart (in $bil):

What makes Holmes' argument spurious is that the very time when the graph begins its sharp descent corresponds with the end of the peak performance of the stock market (the Dow hit its record in Oct 2007, with a long downward slide since). (To be fair, Holmes notes this when he says credit market became 'impaired', meaning they were on the way down, but because of rigidity in some derivatives markets, supply and demand did not clear.)

It simply does not matter whether banks 'realize' their losses or not. As long as the market value of the asset is below what they paid for it, there is a loss. If a person buys a 1000 shares of a stock at $10 a share and that stock falls to $7, that person has lost $3,000. If he sells, the loss is realized. If he decides to keep the stock, he has a paper loss, or an unrealized loss. Perhaps he decides he doesn't want to take the loss, and hopes the market improves taking the stock back to $10, or even above. Fine, but that doesn't change the fact that the asset is worth $7,000 today. No amount of wishful thinking will change that, and this is why the suspension of mark-to-market accounting will do nothing to solve the financial crisis.

In fact, the FASB rule did not cause banks to restrict lending. It simply revealed how short banks are. That information was readily available well before FAS 157 (the mark-to-market rule) took effect. Federal reserve data shows that bank reserves had fallen to well below 1% of deposits. That only works during the boom years; when markets began to flag, and then seriously head downward, banks pulled back their lending because they saw banks failing, being taken over by the FDIC, and those that were still left standing panicked, beginning a mad rush for deposits that took bank reserves to about 12% (as of 4/8/09, reserves $861 bil, deposits of $7,361 bil). Eric deCarbonnel has a nice article on bank reserves steadily moving to basically zero.

It was the over-use of leverage that created the conditions for the financial collapse, and the main culprit is the fractional reserve banking system. Don't blame honest accounting for the collapse.