Daily Real Estate News  |  September 23, 2008  |   Bad Accounting Blamed for Current Crisis
Some critics blame the current financial crisis on new accounting rules that require debts to be marked to market.

Financial Accounting Standard 157, which U.S. regulatory agencies put into effect last November, requires accountants to look at market "inputs" from sales of similar financial assets – even if there isn't an active trading market. That means that less-leveraged banks holding mortgages that haven't been impaired often have to adjust their books based on another bank's sale – even if they plan to hold their loans to maturity

The latest mortgage delinquency rate is just 6.4 percent – historically high, but not anywhere close to the mortgage default rate of more than 40 percent in the depths of the Great Depression.

Yale finance Prof. Gary Gorton wrote in a paper presented last month at the Federal Reserve's summer symposium: "With no liquidity and no market prices, the accounting practice of 'marking-to-market' became highly problematic and resulted in massive write-downs based on fire-sale prices and estimates."

In effect, a single bank's fire sale can decrease the reserves of banks and other financial institutions.

"Partly as a result of GAAP capital declines, banks are selling . . . billions of dollars of assets – to 'clean up their balance sheets,'" says Gorton, creating a "downward spiral of prices, marking down – selling – marking down again."

Source: The Wall Street Journal, John Berlau (09/20/08)