The failure to learn the lessons of financial history led to the financial crisis of 2008 and that same failure is hampering efforts to find a way out of it. In 1938 President Roosevelt and his Secretary of the Treasury Henry Morgenthau ordered bank regulators to abandon mark to market accounting (MTM) in favor of historical cost accounting because MTM was inhibiting lending and prolonging the Depression.
In his quest to increase bank lending, President Obama should take a page from President Roosevelt’s book and demand that the Financial Accounting Standards Board immediately reverse the MTM rules it imposed beginning in the early 1990s.
The FASB re-instituted MTM despite strong objections from the Chairmen of the Federal Reserve and Federal Deposit Insurance Corporation and then Secretary of the Treasury Nicholas Brady. Brady’s March 24, 1992 letter was prescient:
[MTM] could result in extremely volatile earnings and capital. This volatility would not be indicative of a bank’s operating results and would therefore be misleading to . . . users of financial statements . . . . Moreover, [MTM] could even result in more intense and frequent credit crunches, since a temporary dip in asset prices would result in immediate reductions in bank capital and an inevitable retrenchment in bank lending capacity.
This is precisely what happened in 2008. MTM forced banks to write down assets when the market collapsed even for performing assets and destroyed $600 billion of capital. If the FASB would reverse its insidious MTM rules, bank lending capacity would jump by nearly $5 trillion!
Stated simply, MTM requires that loans and other financial instruments held by banks be continuously marked to market prices. Historical cost accounting records assets at their original cost (adjusted for depreciation and amortization) and leaves them at that price unless the bank (or its accountant or regulator) decides the value of the asset is permanently impaired.
Robert Herz, FASB’s Chairman, has been a staunch defender of MTM and FASB’s right to promulgate accounting rules without government oversight. In a recent speech before the AICPA National SEC Conference, Herz justifies MTM’s blind reliance on markets and models as somehow more “transparent” than historical cost accounting, which relies on the time-honored practice of valuing assets based on projected cash flows.
Herz cites, approvingly, a Government Accountability Office 1991 report that concluded historical cost accounting masked the S&L problems in the 1980s and urged implementation of MTM so that “banks’ true financial condition could be reported promptly . . . .”
Herz admits that the FASB implemented MTM to prevent a future S&L crisis. If this isn’t within the purview of a systemic risk regulator I don’t know what is.
The GAO report and the FASB’s reaction to it were simply wrong. As Chairman of the FDIC during the S&L debacle, I know that historical cost accounting did not mask or prolong the S&L problems. Resolution of the S&L problems was delayed by the substitution of “regulatory accounting principles (RAP)” for “generally accepted accounting principles (GAAP).”
The former Federal Home Loan Bank Board’s official policy, supported by the Reagan Administration and Congress, was to allow the S&L industry time to grow out of its problems by adding new higher yielding assets. This policy required overriding GAAP accounting.
The FDIC coped with problems of the same type and magnitude in the FDIC-insured savings bank industry. The FDIC rejected calls to implement RAP and allow savings banks to pursue rapid growth. This is a major reason why the savings bank problems cost the FDIC only $2 billion vs. nearly $150 billion of taxpayer losses in the S&Ls.
Overriding GAAP accounting, sanctioning rapid growth by poorly capitalized and managed S&Ls, and failing to properly supervise S&Ls were villains in the S&L crisis, not historical cost accounting.
The FASB’s ignorance of this simple truth is evidenced by the major recommendation in Herz’ speech in which he urges that bank regulation be “decoupled from U.S. GAAP reporting requirements.” Herz would have us return to the separation between RAP and GAAP that cost taxpayers $150 billion in the S&L debacle!
It is highly inappropriate for the FASB – five anonymous accountants selected by trade groups – to take it upon itself to determine what caused the S&L crisis and endeavor to correct it through accounting policy. In its effort to “fix” an accounting system that was not broken, the FASB wreaked havoc on the banking industry and the economy, costing millions of people their jobs, homes and life savings and costing taxpayers hundreds of billions of dollars to help repair the devastation.
The FASB’s blunders cry out for establishing formal government review of the potential systemic effects of accounting policies. Financial reform legislation that fails to address this critical issue invites the next crisis.
Bill Isaac is chairman of LECG Global Financial Services.
He headed the Federal Deposit Insurance Corporation during the banking crisis of the 1980s.