How to Start the Healing Now

The most amazing paradox of
2008 is the continued growth of
the U.S. economy and the sorry
state of the U.S. financial markets.
Despite major financial-market
problems, real GDP has increased
by 2.1% in the year ended in the
second-quarter — 3.1% if we
exclude housing. Not everything
is great, but we all must agree that
the economy has remained
remarkably resilient.
This paradox works both ways.
Financial problems have not yet
dragged down the economy, but it
is also true that the economy is
not the cause of financial-market
problems. Most of the loans that
have been going bad in recent
months would have gone bad
even if the economy had been
growing twice as fast. So what is
to blame for the “worst financial
crisis since the Great
The answer seems simple. Markto-
market accounting rules have
turned a large problem into a
humongous one. A vast majority
of mortgages, corporate bonds,
and structured debts are still
performing. But because the
market is frozen, the prices of
these assets have fallen below
their true value. Firms that are
otherwise solvent must price
assets to fire-sale values. Not only
does this make them ripe for
forced liquidation, but it chases
away capital and leads to a further
decline in asset values.
For example, the prices of assets
on the books of Washington
Mutual, when it was bought by J.P.
Morgan at a fire-sale price, were
cited as a reason to mark-down the
assets on the books of Wachovia.
This, some say, forced the FDIC to
arrange its sale to Citibank.
The same is true of what happened
to Fannie Mae and Freddie Mac,
which had positive cash flow when
they were nationalized by the
Treasury. Here’s something you
won’t believe: Fannie Mae and
Freddie Mac have not drawn a
dime from the Treasury’s $200
billion facility that was created to
bail them out. It was the use of
mark-to-market accounting that
allowed Treasury to declare them
bankrupt. On a cash flow basis,
they were solvent.
Mark-to-market accounting causes
so much mayhem because it forces
financial firms to treat all potential
losses as if they were cash losses.
Even if the firm does not sell at the
excessively low price, and even if
the net present value of current
cash flows of these assets is above
the market price, the firm must run
the loss through its capital account.
If the loss is large enough, then the
firm can find itself in violation of
capital requirements. This, in turn,
makes it vulnerable to closure,
nationalization or forced sale.
Because the government has been
so aggressive with the use of these
capital regulations, private capital
has been scared away. Just
about the only transactions
taking place in the subprime
marketplace have been sales to
private equity firms that do not
have to mark assets to market
prices. Their investors agree to
commit capital for the long
haul, and because they are able
to bend the current holders of
these assets over the knee of the
accounting rules they get prices
that virtually guarantee a huge
Despite all this evidence, the
government has yet to provide
relief from mark-to-market
accounting. However, the
Financial Accounting Standards
Board will meet today to
discuss potential changes. One
thing it ought to consider is that
the Treasury plan tips its hat to
the problem by acknowledging
that its goal is to put a floor
under distressed security prices.
Warren Buffet understood this
and invested in Goldman Sachs
before the law had passed, but
with full expectation that it
would. Other investors will
follow. There is no shortage of
liquidity in the world.
Nor would relaxing mark-tomarket
rules temporarily in the
U.S. — let’s say for three years,
for troubled assets issued
between 2003 and 2007 —
undermine our standing
internationally, as some allege.
If a $700 billion bailout fund
Wednesday, October 1, 2008 – VOL. CCLII NO. 78
and the takeover of Fannie Mae,
Freddie Mac and AIG have not
already undermined foreign
confidence, then nothing will. On
the same day the bailout bill failed
in the U.S. House of
Representatives, the dollar soared.
Another argument is that
changing the accounting rules is
like sweeping the problem under
the rug, which could lead to a
Japanese-style decade of lost
growth. However, back in the
1990s, Japan took six years to get
real overnight lending rates below
zero. It also increased tax rates.
This was what caused Japan’s lost
decade — a policy-induced
deflationary recession, not just an
unwillingness to book losses.
But it took the Federal Reserve
only six months to cut real rates
below zero, starting last
September, and U.S. tax rates are
unlikely to be hiked anytime soon.
Even Barack Obama says he would
not raise taxes in tough economic
times. As a result, the U.S. is not
anywhere near the kind of
environment that would allow that
to happen. Nor will relaxing markto-
market rules allow losses to be
hidden or ignored. Basing prices
for illiquid assets on cash flows
would still reflect impairment, but
not allow them to dip down to firesale
Once private investors know they
cannot be taken out by accounting
rules and illiquid markets, their
cash will flow freely. And if the
real issue is to find a proposal that
will help fix the problems in our
financial markets urgently, then the
current Treasury plan fails the
test. Because of government
bureaucracy and legal issues,
the first purchases by the
Treasury plan will not be made
for at least two weeks and
possibly four weeks. Mark-tomarket
accounting changes
could start the healing
overnight and prevent the U.S.
from moving further away from
free-market capitalism.
Mr. Wesbury is chief
economist for First Trust
Portfolios, L.P
Reprinted with permission of the
Wall Street Journal © 2008 Dow
Jones and Company, Inc. All
Rights Reserved