Paul Davies, in “True impact of mark-to-market accounting in the credit crisis,” discusses a paper by Tobias Adrian of the New York Fed and Hyun Song Shin of Princeton University that claim that mark-to-market accounting play a direct, perhaps central role in the credit bubble, and that it works just as dramatically in reverse.
Once they explain the thesis, it’s so blinding obvious that one wonders why that sort of thinking hasn’t gotten top billing sooner. When asset prices rise (say because interest rates fall), the balance sheet gains lead directly to increases in a firm’s equity. Financial institutions tend to maintain the same level of gearing, so when equity goes up, they want to increase their balance sheet size. Similarly, when asset prices fall, the losses are hits to equity, and balance sheets contract.
These expansions and contractions happen system-wide, and lead to what is perceived as increases and falls in liquidity. The authors argue that liquidity tantamount to the rate of growth in aggregate balance sheets.
I’ve only skimmed the paper, but it looks suitably rigorous and has lots of analyses and charts. It’s puzzling that it hasn’t gotten more attention.
The writeup by Davies presents the findings faithfully and makes some observation of his own.
From the Financial Times:
Back in April 1993 the eyes of the world were on the beseiged Balkan town of Srebrenica, which the UN declared a safe haven for Bosnian muslims, and on Northern Ireland, where secret talks between leaders from rival factions kick-started a tentative peace process.
In the same month, a less-noticed development saw US accountancy regulators approve a rule that paved the way for today’s widespread use of mark-to-market accounting standards. This rule, which forced US banks to carry more securities at market value, emerged from the wreckage of the US savings and loan crisis when losses on loans had been hidden by the use of “historic cost” accounting.
Only now, in the middle of a global credit crisis, is the impact of the broad introduction of mark-to-market accounting becoming clear. The critical concerns are around how much these changes helped to inflate the credit bubble and whether they will increase the speed and destructive power of its collapse.
To be fair, the US banks protested at the outset that the move would change their role in the economy. So did the French banking federation before similar changes came to Europe in 2005. It warned that fair-value accounting “could even further increase the euphoria in a financial bubble or the panic in the markets in a time of crisis”. Tobias Adrian, an economist at the New York Fed, and Hyun Song Shin of Princeton University, have produced a string of work about this kind of “pro-cyclicality” in finance and the economy, culminating in a paper last September entitled Liquidity and Leverage .
This paper examines the links between asset prices and the value of banks’ capital bases when mark-to-market accounting is used. It postulates that banks are driven to lend more and grow their balance sheets as the value of their capital rises. This is because they target a more or less constant leverage multiple on their balance sheets.
The paper concludes it was inevitable that an industry buoyed by rising asset prices would pursue increasingly aggressive lending growth. This pushed credit upon ever more risky clients and loan structures, which then fed into asset price growth. This of course added more fuel to the fire – or created “positive feedback loops”.
The most disturbing conclusion is that this system should behave in exactly the same way in reverse, creating “negative feedback loops” with a destructive impact on all kinds of asset values – from structured finance to house prices and equities.
In a way this is nothing new – the old adage about a banker is that he gives you an umbrella when it is sunny and asks for it back when it starts to rain.
But there are two important differences. First, fair-value accounting will speed up the process. One of Adrian and Hyun’s conclusions is that it was the speed of balance sheet expansion that caused the most blatant excesses of US mortgage lending.
Second – this isn’t mentioned in the paper – there is the impact of securitisation, the practice of converting illiquid individual loans into saleable securities.
This accelerated the speed at which banks could increase lending because it reduced the amount of capital needed for each new loan. It was so widely adopted because of the way it turbo-charged returns on capital.
Banks’ use of pseudo off-balance-sheet vehicles to house securitised bonds further boosted this process, particularly from 2005 onwards, as can be seen in the asset-backed commercial paper market.
What we will see over the remainder of this year is an ongoing painful reduction of capital values and leverage levels throughout the economy, centred around banking.
Investors need to believe this re-adjustment has at least stabilised before they will return. Each new wave of price falls in leveraged loan markets or asset-backed securities markets — and each post-earnings restatement of losses from the likes of AIG, Credit Suisse or whoever is next – illustrates that the prognosis is not good either for the financial world or the wider economy.
The lesson for regulators is that the solution to one problem almost always contains the seeds of another.
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Who are these guys? That’s it blame the CPAs instead of the Fed. Any effects from the accounting are insignificant.
I don’t think the problem is mark-to-market accounting. It’s more that risk scenarios have to be counter-scenario and assume a reversion-to-mean element. For instance if housing prices are stable, the risk scenario might be -10% for housing; but if they have gone up 20% in the past year, the appropriate risk scenario should be -30%.
To “independent accountant”: these guys are right on the mark. And they are NOT blaming it on the accountants.
Their research seems to support the theories of Hyman Minsky.
Also combine with the Mark-to-market: a) elimination of usury laws in late 1970’s; b) compensation systems that encourage quarterly exaggerations of “market”; c) securitization and the increased systemic leverage ratios that result from that process; d) the “leveraging up” of pension fund assets by their movement of funds to hedge funds who can leverage; etc, etc.
Many, many self-reinforcing, positive feedback mechanisms. All of which contributed to the massive growth of debt in the US since 1980.
And all of which are now working in reverse and feeding upon each other in the reverse direction. Much more pain ahead.
From yesterday, and the point being, we have no regulation, no accountability, just corruption and collusion and if this is not dealt with we will have a systemic collapse connected to hyper-inflation within months. These retarded people can not sit by in denial thinking that a Fed cut in March will in some way fix a mess related to a lack of accounting integrity. This is a mess fueled by FASB dis-honesty, GAAP fraud and system wide corruption that will result in further chaos. We need 100o Spitzers to reign in this madness ASAP or we will be in a non-stoppable crash within weeks!!! Wake up!!!
We have a global financial network based 100% on The Enron Model and the end result will be total collapse!!!!
Indeed, Enron’s unscrupulous actions were often gambles to keep the deception going and so push up the stock price, which was posted daily in the company elevator. An advancing number meant a continued infusion of investor capital on which debt-ridden Enron in large part subsisted. Its fall would collapse the house of cards. Under pressure to maintain the illusion, Skilling verbally attacked Wall Street Analyst Richard Grubman[3], who questioned Enron’s unusual accounting practice during a recorded conference call. When Grubman complained that Enron was the only company that could not release a balance sheet along with its earnings statements, Skilling replied “Well, thank you very much, we appreciate that . . . asshole.” Though the comment was met with dismay and astonishment by press and public, it became an inside joke among many Enron employees, mocking Grubman for his perceived meddling rather than Skilling’s lack of tact.
“This accelerated the speed at which banks could increase lending because it reduced the amount of capital needed for each new loan. It was so widely adopted because of the way it turbo-charged returns on capital.
Banks’ use of pseudo off-balance-sheet vehicles to house securitised bonds further boosted this process, particularly from 2005 onwards, as can be seen in the asset-backed commercial paper market.”
I think everyone can agree that this is a non-trivial dynamic, but I also think it’s a mistake to put too much weight on it as a cause of our current problems. In typical academic fashion, Adrian and Shin abstract from securitization. Davies, however, is wise enough not to copy this bit of academic obfuscation. (Alright I admit it’s just another example of economists’ incredible ability to engage in analysis without synthesis — i.e. on breaking things down without bothering to put them back together again.)
“Second – this isn’t mentioned in the paper – there is the impact of securitisation, the practice of converting illiquid individual loans into saleable securities.
This accelerated the speed at which banks could increase lending because it reduced the amount of capital needed for each new loan. It was so widely adopted because of the way it turbo-charged returns on capital.
Banks’ use of pseudo off-balance-sheet vehicles to house securitised bonds further boosted this process, particularly from 2005 onwards, as can be seen in the asset-backed commercial paper market.”
The real source of the credit crisis is the way securitization was practiced in the current decade. Everything else is just a minor contributor to the crisis.
Sorry about the double quote above. Bad editting.