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June 21, 2010

Sarbanes-Oxley's Contribution to the Financial Crisis

 “In the age of financial regulation reform, everyone forgets that the last time we had financial regulatory reform, it led to one of the great mechanisms of the 2008 financial crisis.”
The Enron and Worldcom scandals at the turn of the century rocked the investment community.  As usual, Congress felt it had to get involved since the existing regulatory regime wasn’t working (sound familiar?).  Congress passed the Sarbanes-Oxley Act in order to increase the transparency of public companies’ financial health.  It required creative tactics such as the signing of the financial statements by the top officers in the organization.
However, one little requirement in the bill would help exacerbate one of the world’s worst financial crises- mark to market accounting.  Mark to market accounting involves reporting the value of assets at the price they would sell for today.  The purpose of this was to make it harder for companies to hide the shortfalls of asset valuations or to artificially “write up” the value of assets.
As a result of this, when mortgages became securitized in 2003 and 2004, those securities were easily able to be “written up” from 2004 to 2007 as home valuations skyrocketed.  This “bubble” allowed for homeowners to take out loans on equity that was artificial and for banks to lend out against assets that were over-valued. 
As the housing market declined, the mark to market rule went from being the Cinderella of the economy to the pumpkin.  As more homes foreclosed, the value of these houses plummeted.  Banks who were taking these homes onto their balance sheets through foreclosures had to constantly write-down their values.  This is what caused the banking system to become insolvent and bring about the financial crisis.
The fatal flaw in the accounting system was the government requiring a fixed asset to be priced in real-time.  Any fixed (or illiquid) asset that is not easy to sell should be priced at an historical basis.  For example, a house that was worth $100,000 two years ago, $80,000 last year, and $60,000 today would be worth $60,000 today.  However, under a balanced historical cost rule, the valuation would be $80,000 (the average of the three years) or a little less if you wanted to place more weight on current valuations.
How would this have helped us?  First, it would have made the housing bubble smaller as writing up the value of the houses and other fixed assets would have been less steep.  Secondly, banks would have had time to realize that housing was on a downward trend and could have adopted strategies to mitigate against the depreciation of assets.  During the crisis, valuations were changing so rapidly that no financial institution had time to implement new strategies to hedge or minimize losses.  As a result, mark to market also increased the amount of fear that spread throughout the financial markets in the fall of 2008.
As you can see from the latter video today, FASB eased the mark to market accounting rules last year, which help alleviate the banks’ asset valuation problems.  This actually helped the banking system more than TARP did (otherwise how did you expect the banks being able to pay TARP back at a profit to the government and a loss to the banks?), and allowed the banking system to get back on solvent ground.
I believe that while easing mark to market was correct, it did not do enough.  Banks should have been given the option to either stick with mark to market, or go back to the historical valuation system.  Additionally, if the banks would have chosen to go back to the historical valuation, they should have also restated their earnings going back to Sarbanes Oxley.  This would give an accurate account of the pricing of these assets (and earnings) going back to 2001.
By restating earnings and valuations, the investment community can have an idea how the bank performed under one set of financial reporting rules, as opposed to being under one type of valuation up to 2002, under mark to market valuation from 2002 to 2009, and being under another type of valuation from 2009 onward.  While it may be expensive and time consuming for banks to restate all of those earnings, the information gained by doing so can certainly benefit the investment community.

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