What really caused the financial market crisis?

Two acts by our government caused the massive disruption we see in the capital market. They are the Sarbanes-Oxley Act, and the “mark to market” regulations.

Sarbanes-Oxley was passed in 2002, in response to the irresponsible accounting procedures of Enron, Tyco, and others. It places significant additional cost on publicly traded companies and accounting firms, along with another government bureaucracy to oversee compliance. While this was seen as “reforming” the rogue accounting used by some corporations, it also adds huge compliance costs to U.S. companies.

Mark-to-market is the requirement that assets be carried on company books at their market value. On the face if it, that seems reasonable. In “normal” times, that may even be true. When the times aren’t anywhere close to “normal”, this rule needlessly destroys equity.

Consider a loan agreement you might have with someone you know. The payments have always been made, and there is collateral. If the loan has outstanding principal of $10K, naturally you would carry this loan on your balance sheet as a $10K asset. (That’s what a reasonable buyer would pay for it, and the interest earned would represent their profit on the purchase.)

However, now consider that same loan in today’s economy. The payments are still being paid, but now your borrower’s future isn’t at all secure. They could lose their job, and the collateral is no longer worth enough to cover the balance if he defaults. (To make it worse, there is no ready market for the collateral in this economy, so understanding the amount of principal that could be recovered in a worst-case situation is unknown.) If the best offer you could get for that loan is now $4K, then your $10K asset just suffered a $6K write-down on your balance sheet. None of this means you’re not going to get paid on time in the future. However, the “market” for the loan is now much weaker.

That’s what happened to our financial institutions. Mark-to-market caused $600 billion to be written off their balance sheets. Most of these loans are still being paid (yes, delinquencies are up, but not to critical levels.) However, the market for both the loans, and the commercial and residential real estate that collateralize them has dropped … so the financial institutions “lost” that equity from their balance sheets. (Part of the “troubled loans” that are causing us all trouble are the loans to lower-income borrowers banks were forced to make to satisfy their government-imposed Community Reinvestment Act responsibilities.)

On top of that, banks have to maintain reserves against possible loan losses (which have increased as delinquencies increased). That means they need more cash in the vault than before … at the same time their equity has vanished. Banks, then, have no choice but to avoid making loans (to preserve the cash they have, and avoid having to add more cash to their reserves for new loans.)

Rather than admit that “mark-to-market” is not reasonable in a struggling economy, our government has tried to find a way to “take the ‘toxic assets’ off the banks’ books.” That sounds nice, but even the government can’t put a valuation on those mortgage-based securities. (Those are typically $100 million worth of mortgages all wrapped up together … which have been sold and re-sold … and about which no one knows what percentage of the loans are performing, troubled, or in default.) Instead, we’re making no-interest loans to banks (or buying their stock) to provide cash. To date, we’ve pumped in $300 billion to offset the $600 billion write-downs … and can’t understand why credit isn’t flowing as it did in the past.

I believe it would be smarter (and far less expensive!) for the government to:

• Suspend Sarbanes-Oxley – which would dramatically reduce accounting expense for U.S. companies (and make them more competitive, globally)
• Suspend mark-to-market – which would restore billions in equity to U.S. financial institutions
• Eliminate the cap on FDIC insurance for all deposits – which would eliminate risk of capital loss for large depositors (and keep them from finding “safer” places for their money) – further capitalizing the banks
• Guarantee some of the loans that are troubled – protecting the banks that continue to try to collect on their loans from risk of failure if they prove to be uncollectable.

These relatively simple steps would restore the credit markets quickly (which would go far toward restoring the overall economy.) They would also cost far less than the hundreds of billions of dollars we’re spending, today. Over time, and after the current crisis is over, reasonable restrictions on “Enron-style” asset valuation could be restored. However, this hasn’t happened because no one in government has the backbone to call for eliminating or suspending these restrictions.

The result is that we all get to pay: higher taxes to pay for the government spending; higher inflation that always follows such wild spending; less access to credit for people who are credit-worthy; and prolonged recession because businesses can’t get operating capital.
Finally, this housing / credit crisis was not caused by a lack of regulation, irresponsible corporate behavior, and greed. It was caused by government interference in the mortgage market, and knee-jerk accounting rules that were imposed on businesses. The market works, when government gets out of the way and LETS it work.