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Warren Buffett Agrees With Me: "Mark to Market" is the Problem

March 12, 2009

Warren Buffett Agrees With Me: "Mark to Market" is the Problem

Ahem. Warren Buffett (does he really need an introduction?) is one of the world's richest men and a trusted, if informal, economic advisor to President Obama. And, during a three-hour CNBC interview last Monday he made exactly the argument I first made in my October blog post on our 1to1 Media blog: One of the biggest problems behind the meltdown of our commercial banking system is that newly adopted "mark to market" accounting rules have an exaggerated and unjustified effect on banks, as opposed to other businesses.

In an earlier life, I once served as the director of accounting for a medium-sized airline (I bet most of you didn't know that!), and my argument last October was that well-intended, post-Enron changes to our financial regulatory system had "pushed perfectly healthy commercial banks into virtual bankruptcy, for no good economic reason...because most of these banks had no shortage of actual cash when they began to fail. Rather, because of the mark-to-market rule, they were required to take big paper losses on their portfolios of risky mortgages, even though the vast majority of these mortgage-backed securities were still generating healthy interest payments.

"For an ordinary company this would not be a disaster [and] wouldn't pose a threat to its financial solvency or its continued existence as a business [because] smart investors would look beyond the accounting rules to value the company based on perceived economic reality.

"Unfortunately, commercial banks are constrained by many other government rules, including a requirement to maintain certain ratios of capital and liquidity to support the loans they make. For that reason, when this new accounting rule requires a bank to mark any of its mortgage-backed securities down substantially, the bank has to hurry and line up replacement capital for its balance sheet or risk being in violation of other banking regulations. If the bank isn't able to maintain its capital ratio, then other rules require the government to declare it insolvent and take it over."

During Monday's marathon interview, Buffett endorsed this position, suggesting that while "mark to market" is a good policy for financial disclosure (I agree), when it is applied specifically to the regulations that govern bank capitalization it is like "putting gasoline on the fire."

Why? For the same reason that I outlined in my October post: Because the "mark-to-market rule requires a bank to write down its mortgage-backed security and take the resulting loss even if the asset itself is still performing fairly well." That is, even if a bank is still making decent money on an impaired but functioning security, if the security has little or no market value (as it wouldn't in a financial panic), the bank still has to mark it down to near zero. Again, for an ordinary corporation this is punitive but not ruinous, but for a commercial bank, the mark-to-market rule represents a non-cash bankruptcy event.

Businesses are swimming in a sea of problems caused by foolishly short-term thinking. But our democratic political system apparently is not immune from short-termism either, because at least this aspect of the Sarbanes-Oxley Act has now exacted a tremendous, almost unprecedented long-term cost on our economy, in return for an extremely short-term political benefit - providing cover to those who were in power during the last round of corporate scandals.

But Warren Buffett's argument is a hopeful sign. Holman Jenkins, the Wall Street Journal financial columnist, maintains that Mr. Buffett "clearly called for suspension of mark-to-market accounting for regulatory capital purposes."

Maybe the financial geniuses who got us into this mess in the first place will actually listen to Warren Buffett...

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