Banks told they can ignore the market. The market rejoices. Huh?

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The Financial Accounting Standards Board decided today to go ahead with its previously announced plans (albeit with some tweaks) to make it easier for banks to say the assets on their books are worth whatever they want to say they’re worth. The stock market reacted with seeming approval, with the S&P 500 up almost more than 3% on the day as I write this. One can never know for sure why the stock market does what it does on a daily basis—it could just be excitement about those Sizzling G-20 Wives—but the fact that financial stocks are up more than the overall market would seem to indicate that there’s something to the FASB-did-it explanation.

There is of course something very weird about this. Investors seem to be saying: Banks now have permission to lie to us more, so let’s bid up their stock prices! Then again, if investors are that dumb, maybe it makes sense for accountants to pay less attention to market prices in valuing the assets on banks’ books.

This is, in fact, the very quandary of mark-to-market accounting. If banks and other companies are allowed to ignore changes in the market prices for the assets they hold, they are basically being given permission to lie. (Check out my friend Paul Miller’s very clear statement of this position.) But the market is, over the short-to-medium term at least, a hyperactive ninny. Any corporate management or investor or regulator who puts too much stock in the verdict of financial markets is likely to be led astray—even more so when markets are booming and bubbling than in depressed times such as these.

The realization that markets are unreliable assessors of value appears to have been a factor in the decision by the Securities and Exchange Commission and banking regulators to move away from mark-to-market accounting in the 1930s. In the 1970s, though, the rise of the efficient market hypothesis—the theory that financial markets do an almost perfectly rational job of pricing securities—and the beginnings of a power shift that favored investors over entrenched corporate managements led the accountants to begin reconsidering their stance. The S&L crisis of the 1980s sped this reconsideration: Short-term interest rates that topped 20% in the early 1980s threw most of the thrift industry, with assets consisting largely of old 5% mortgages, into insolvency. But the accounting standards of the day allowed regulators and executives to ignore this reality for years, and the resulting clean-up cost more than $100 billion (which sounds like nothing now, but was a big deal then).

So in 1993, FASB decided to require that debt and equity securities on a bank or other entity’s books be marked to market prices if there was any chance they might be sold before they matured. In 2007 those rules were tightened up and clarified a bit. The main thing FASB decided today was to make it easier for companies to determine that the market for a particular security is “distressed,” and that therefore market prices can be ignored in valuing that security.

When a market isn’t really functioning, there’s definitely an argument to be made for ignoring it. But if so, then it would also seem to make sense to ignore the prices prevailing in a market that is out of its mind with exuberance. When’s FASB going to come out with a rule on how to determine that the market for a particular security is “hyper”?

As I’ve written here before, I truly do not know what the right answer is here. I tend to lean toward That Anonymous Dude’s verdict that “MTM is the worst form of accounting, except for all those other forms that have been tried from time to time.” But I also think that there’s a reasonable case to be made that, for the financial industry in particular, market-to-market accounting helps blow the bubbles bigger and dig the holes deeper.

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