Mark-to-market accounting has received a lot of criticism during the current financial crisis. But a recent email from Less Antman, a CPA and financial planner, offers the best explanation I've seen of why government-mandated capital requirements are the real source of the problem. Economists now realize that reserve requirements, designed to make banks more liquid, have the unintended reverse impact during a panic, tying up cash that banks need to pay out in order to stem the panic. As a result, reserve requirements are fast disappearing as a tool of bank regulation. Similarly, capital requirements, designed to make banks more solvent, also have the reverse impact during a crisis. What follows is Less's analysis:

"Any discussion of mark-to-market accounting must differentiate between the beneficial effects of honestly reporting assets at what they are actually worth and the destructive impact of inflexible regulations that utilize the principle. Current discussions have blurred the distinction.

"(1) The Financial Accounting Standards Board (FASB) determined that securities held by a company which it intends to sell when funds are needed for another purpose ought to be reported at fair market value rather than historical cost. This seems eminently sensible to me.

"(2) The FASB allowed an exception for debt securities which would eventually mature at a fixed price, and which the company had the positive intent and ability to hold to maturity. Mark-to-market accounting is specifically not required when the company elects to classify the security as one to be held to maturity.

"(3) In spite of ignorant comments to the contrary, 'market' doesn't mean that the last trading price of a security must always be used, nor that a security whose market has virtually disappeared due to unusual circumstances must be valued at zero or near zero. The FASB explicitly permits the use of alternative market measures in such circumstances, such as the complicated derivative pricing model known as Black-Scholes. For instance, Berkshire Hathaway (Warren Buffett's company) has $8.1 billion (at cost) of derivatives on its books, all carried under mark-to-market accounting, but none of them currently priced based on the non-existent market for those derivatives.

"I am fully supportive of the use of mark-to-market accounting on balance sheets. It is clearly the most honest way to report derivatives. So what's the problem with mark-to-market accounting? I see the following government-created problems associated with them:

"(1) Mark-to-market was adopted by regulators as the basis for determining minimum capital requirements. Creating an inflexible regulation based on an inherently volatile measure was always an accident waiting to happen.

"(2) While foresighted bank executives might have chosen to maintain capital in excess of regulatory requirements so that a decline in value wouldn't trigger a crisis, it would have made no business sense to do so, since it would have reduced their lending income and ability to pay competitive rates on deposits or offer other benefits to attract customers. In a free market, they would have been able to do so, since they would have gained a reputation advantage from their greater safety, but with FDIC insurance protecting all deposits, customers don't shop based on safety, as they assume they are protected by the government from the loss of their deposits. Thus, only the rates and benefits offered by a bank matter to a customer, not the reliability of the bank, thanks to the FDIC."

(JRH interjecting: I might add that Less's point here is well supported by the historical record. Prior to government deposit insurance, U.S. banks voluntarily maintained capital-asset ratios in the range of 10 to 20 percent, way above current mandated levels.)

"(3) With banks thus always seeking to keep only the minimum required capital, the problem was further exacerbated by the Basel capital requirement formula, which requires less than half the capital if kept in the form of AAA securities compared to high quality individual mortgages (as I discuss in my article on Credit Default Swaps, forthcoming in the April 2009 issue of The Freeman). This caused an explosive increase in the worldwide demand for AAA securities as a result of the needs of regulatory arbitrage.

"(4) With capital of virtually every international bank invested as heavily as possible in AAA securities critical to the financial competitiveness of the bank, the problem was further exacerbated by the ratings cartel created by the SEC in 1975, which effectively mandated that companies obtain a rating from Moody's, S&P, or Fitch, who were thus effectively insulated from the destructive effects of reputational damage by a system that made it impossible for them to be put out of business by more accurate upstart rating services. This also prevented better methods of risk measurement (such as Credit Default Swaps) from replacing ratings.

"(5) Fannie and Freddie fed the supply by creating AAA securities in gigantic sums, initially from the securitization of high-quality mortgages, then from lower-quality mortgages that had components artificially improved in quality from the creation of 'tranches', and finally from lower tranches artificially improved in quality as a result of Credit Default Swap protection from AAA-rated companies such as AIG (also discussed in my CDS article). AAA ratings that were, in many cases, undeserved.

"(6) It is also possible, although I haven't thought this through, that the mortgage lending boom itself was stimulated by the need for AAA securities to satisfy regulatory arbitrage needs worldwide, and once it was clear that low-quality mortgages could be turned into AAA securities, the lowering of lending standards was inevitable, even absent the CRA and FHA mandates.

"So, thanks to various government interventions, banks operated with the minimum capital required by the mark-to-market application of the law, consisting almost entirely of artificially created AAA securities benefiting from artificially high market pricing resulting from sloppy ratings. And then reality bit, and an honest revaluation of these securities based on mark-to-market accounting, linked to inflexible government regulations, brought down the banking industry. And that is the extent to which I believe mark-to-market accounting can be blamed for this crisis."