By relaxing the US financial system’s mark-to-market accounting standards, the government is effectively deactivating the financial “early warning system” that let investors know that a global credit crisis was brewing, says Jennifer Yousfi in Money Morning.

As part of the just-passed U.S. bailout bill, the government has reiterated the Securities and Exchange Commission’s authority to relax the mark-to-market standards. If the SEC actually follows through on that directive, many professional investors worry that we won’t catch on to the next leg of the ongoing credit crisis until it’s way too late.

While politicians point to mark-to-market rules as the cause of the billions in write-downs and losses suffered by financial firms in recent quarters, in fact, it was mark-to-market accounting that first exposed the underlying problems in the complex markets for mortgage-backed securities (MBS) and credit-default swaps (CDS).

“Mark-to-market is reality-based accounting,” said Money Morning Contributing Editor Shah Gilani in a phone interview yesterday (Tuesday). “Anything else requires a looking glass and a ticket to Wonderland.”

“To me, mark-to-market accounting is the clarion sound of beagles barking, letting transparency hunters know down which dark hole the fox is hiding,” said Gilani, a former hedge-fund manager who recently penned a five-part investigative series on the U.S. credit crisis – including an alternate bailout plan that he says would’ve cost taxpayers very little.

Without the early warnings raised by mark-to-market accounting standards, the problems in the CDS market could have gone unnoticed for much longer, leaving no time to hedge or prepare for the ultimate carnage to the financial sector.

“In the past couple of weeks, fair-value accounting has been under attack,” JPMorgan Chase & Co. (JPM) analyst Dane Mott wrote in a recent report, Bloomberg News reported. “Blaming fair-value accounting for the credit crisis is a lot like going to a doctor for a diagnosis and then blaming him for telling you that you are sick.”

Prior to the current credit mess, mortgage-backed securities were priced according to Markit’s ABX Index, which used the average weight of four series in the index to track the price of housing derivatives. But once the subprime market collapsed, the ABX Index plunged - and has yet to recover.

Mark-to-market accounting standards kicked off a round of write-downs at global financial firms that highlighted the overexposure of many to these risky securities. Without such standards, investors would have been unaware of the coming credit crunch.

The Rise of Fair Value

Mark-to-market accounting, or fair-value accounting as it is sometimes called, arose partly in response to the U.S. Savings & Loan Crisis of the late 1980s and early 1990s. Financial institutions had inflated the value of assets on their books, which ultimately led to their financial collapse.

In order to bring more order and transparency to financial firm balance sheets, there was a shift from valuing balance-sheet assets at their purchase price to holding assets at fair market value – or the price the assets would fetch out in the marketplace if they were sold.

In mid-November, with the U.S. subprime mortgage crisis already taking its toll on global financial firms, the Financial Accounting Standards Board (FASB) released Statement No. 157, entitled “Fair Value Measurements.”

Due to the timing of its issuance, FASB 157 has been pointed to by many as a cause for the financial crisis currently gripping the United States and other markets abroad. But it is important to note that FASB 157 only clarified the fair-value accounting practices that had already been in place for decades – with perhaps one noted exception.

“FASB 157 is not the primary cause of this crisis - greed and poor judgment are,” Paul Shifrin, a principal at SC&H Group LLC, a Maryland CPA and management-consulting firm, said in an interview with Money Morning.

What FASB 157 did introduce was an asset hierarchy based on the market available for the assets. Assets are assigned to one of three categories based upon how liquid the assets actually are and, in turn, how easy they are to value, or price:

• Level 1 assets are fully liquid, and easy to price.
• Level 2 assets can be priced with the benefit of “comparable assets.”
• And Level 3 assets are completely illiquid and nearly impossible to price.

A Growing Crisis

As the market for MBS and collateralized-debt obligations (CDO) dried up, financial firms were caught holding billions in securities for which there was no longer a market. That led to a steep decline in prices and huge write-downs, which translated into escalating quarterly losses. These complex securities, which had been “Level 1” assets, were quickly becoming “Level 3” assets.

But rather than place the blame on the over-leveraging or the risky securities in question, some politicians and banking lobbyists blamed mark-to-market accounting for the resulting huge losses at global financial firms.

“Onerous mark-to-market rules for certain financial assets that have no market value have worsened the credit crisis, and changing them has been a priority for House Republicans,” U.S. Rep. John Boehner, R-Ohio recently told The Wall Street Journal reported.

Congress and such financial-firm lobbying groups such as the American Bankers Association have called for a relaxing of the mark-to-market rules. But doing so would represent a grave error, says Money Morning’s Gilani.

“Nobody is going to trust anybody,” says Gilani. “That’s a real problem if you do away with mark-to-market accounting.”

And that’s an even bigger problem in a market that is already seized up with a crisis of confidence.

The main argument against fair-value accounting is that in a “disorderly market” such as the one we have now due to the ongoing credit crunch, mark-to-market doesn’t take into account the actual cash flow of CDO securities or if the owner plans to hold those securities until maturity. In other words, the security could be worth more than the current sale price if it is held and not sold.

“It’s a knee-jerk reaction from politicians and the banks are trying to find a scapegoat to blame for their own errors in judgment,” said SC&H Group’s Shifrin.

If mark-to-market rules are relaxed or eliminated, financial firms will be able to hide future errors in judgment from investors, allowing corporate executives to falsely protect their companies’ share prices, and to protect their own salaries and bonuses.

“To suggest you don’t track and report fair values means you end up in a world where management still knows the real prices, as do market counterparties, but not the investors,” Sam DiPiazza, chief executive officer of the accounting firm PricewaterhouseCoopers, told The Financial Times.

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