What Caused the Credit Crunch?

According to a small but powerful group of America's financial decision makers—mostly supply-siders and those in their thrall—the chief cause of the credit market meltdown is not folly, or reckless lending, or the demise of America's financial management. It's an accounting rule.

Mark to market is a seemingly innocuous term for the requirement that companies, banks, hedge funds, mutual funds and the like report the market price of the financial instruments they hold and trade. (Here's some good background from Morningstar.) Mutual funds that own stocks make such a report every day. Publicly held firms like Bear Stearns must do so at the end of every quarter, and hedge funds must do so on a rolling basis to reassure their creditors that the assets they've put up for collateral are still worth something. Mark to market is thus crucial to the functioning of transparent markets.

For mutual funds, marking to market is a simple affair. But for those who hold thinly traded assets or assets for which there isn't a ready market (mortgage-backed securities, corporate debt, venture capital investments, etc.), doing so is more of a challenge. In these cases managers mark to market either by comparing analogous assets or by estimating "what market participants would use in pricing the asset or liability."

In the past five years Wall Street firms created huge volumes of new kinds of complex securities, such as subprime bonds and collateralized debt obligations, which are investment vehicles built out of subprime bonds securities. These securities lacked long trading history or deep markets. To value them many outfits slipped the surly bonds of mark to market and assigned a value to them based on so-called mark to model. (In other words, educated guesses based on algorithms.)

When credit started to go bad, market participants had to write down the value of such assets. For institutions holding on to bank loans—assets for which there is an active secondary market—marking to market was relatively simple. If markets priced bank debt of companies with a particular credit rating at 85 cents on the dollar, banks had to write down 15 cents of the value of each dollar of the loan. This process helped drive the massive write-downs seen at banks like UBS and Citigroup.

But for the complex new financial instruments, the valuations became far more unstable. Many hedge funds and financial institutions had borrowed huge sums of money to buy assets for which there wasn't an active market. When that debt started to go bad, it triggered a chain of unfortunate events. In many instances funds were forced to sell assets to meet margin calls. Occasionally creditors would seize assets and sell them. (That's what happened to the Bear Stearns hedge funds that failed last year.) This spiraling activity had the effect of further depressing prices for such instruments. In some instances buyers disappeared entirely. The valuations of these new instruments also plummeted because of market psychology. In establishing value for assets, funds and banks often relied on newly created indices, such as the Markit ABX indices. Since those indices are actively traded by investors, they can be driven up and down (mostly down) by speculation and fear. The end result: the banks and funds holding subprime bonds (which is to say pretty much the entire global financial complex) have been forced to massively cut the mark-to-market value of their holdings because those values are based on the incredibly pessimistic indices.

In recent weeks some have been arguing that just as Abraham Lincoln suspended habeas corpus in a time of war, perhaps regulators should suspend mark to market in this time of crisis. Paul Craig Roberts, a veteran supply-sider and former Reagan administration official, wrote on March 11 that the mark-to-market rule "is imploding the U.S. financial system by requiring financial institutions to value subprime mortgages at their current market values." His solution: suspend the rule, let financial institutions "keep the troubled instruments at book value, or 85-90 percent of book value, until a market forms that can sort out values, and allow financial institutions to write down the subprime mortgages and other troubled instruments over time." In other words, let's assign an imaginary happy value to these assets until the seas grow calmer. Steve Forbes echoed the sentiment in his column in Forbes, calling for a 12-month suspension of mark to market in "exotic financial instruments (primarily packages of subprime mortgages)." The reason: "It's preposterous to try to guess what these new instruments are worth in a time of panic." This line of thinking quickly wormed its way into McCain's big economic speech. He put it in more anodyne terms: "First, it is time to convene a meeting of the nation's accounting professionals to discuss the current mark-to-market accounting systems. We are witnessing an unprecedented situation as banks and investors try to determine the appropriate value of the assets they are holding, and there is widespread concern that this approach is exacerbating the credit crunch." For its part, the Securities and Exchange Commission issued an opinion letter in which it told firms, "[I]t is appropriate for you to consider actual market prices, or observable inputs, even when the market is less liquid than historical market volumes, unless those prices are the result of a forced liquidation or distress sale."

The language is technical, but the arguments here are simple and really quite silly—especially coming from folks who value market indicators over all else. These folks are saying that when markets are volatile and irrationally pessimistic, it's just not fair to force people to act as if the market prices are real.

But you'll notice that they never made that argument back when markets were irrationally optimistic, as they were from 2003-2006. No hedge fund manager ever told a bank that it should lend him less money because the value of the collateral he was putting up was clearly a product of unwarranted optimism or that he shouldn't collect management fees based on the assets under management because their value was clearly inflated. Nobody ever complains about the market's ruthlessness and inefficiency when it's making them money.