Why Has the Credit Crunch Been so Bad? Look to Washington.
Posted By Heidi N. Moore On September 22, 2008
Wall Street Journal Online
The turmoil of the past six months has resulted in the Big Five Wall Street independent investment banks falling under greater federal regulation. But did federal regulation help them get them into this mess in the first place?
Consider two regulatory changes that may not have started the credit crunch but amplified the effects: the move toward mark-to-market accounting and the abolition of the short-selling uptick rule. Deal Journal examines how those two well-intentioned rules caused Wall Street to go horribly awry.
Mark-to-market accounting: This rule was officially put into place last November, though some banks adopted it earlier. Mark-to-market accounting suffered its biggest repudiation this weekend when Morgan Stanley and Goldman Sachs Group were transformed into bank holding companies. That should mean huge write-downs every quarter are a thing of the past. Here’s why: As broker-dealers, Morgan Stanley and Goldman had to “mark to market,” or determine the market value of all its assets every quarter, even assets for which prices would be hard to determine. FAS 157 required all banks to mark their assets to whatever price other banks were selling similar assets. So if you were holding a mortgage security and another investment bank sells a similar mortgage security at, say, 22 cents on the dollar, you must value your mortgage securities at 22 cents on the dollar, too. Imagine that you are trying to sell a 2006 BMW. Your neighbor sells his ‘87 Taurus for $1,000. Under the mark-to-market rules, that 2006 BMW would be on your books at $1,000, too. As bank holding companies, though, Morgan Stanley and Goldman can account for their assets on a “held to maturity” basis.
FAS 157 was designed to ensure that banks were fairly pricing hard-to-value assets such as mortgage-backed securities: that they weren’t, in effect, pricing every mortgage-backed security or loan on their balance sheet as if it were a 2006 BMW. But marking to market often imposed fire-sale prices because a lot of mortgages weren’t selling, meaning that a real market price was difficult to determine. Yale finance Professor Gary Gorton summarized the situation at a Federal Reserve convocation last month: “With no liquidity and no market prices, the accounting practice of ‘marking-to-market’ became highly problematic and resulted in massive write-downs based on fire-sale prices and estimates.”
What marking-to-market mostly seem to be good for was freaking out investors about potential investment-bank write-downs. The shareholder runs at Bear Stearns and Lehman Brothers Holdings were partially fueled by fears that write-downs on their toxic mortgage-related assets would metastasize and overwhelm their healthy capital.
Destruction of the “uptick rule”: In July 2007, regulators abolished the “uptick rule” that prevented short-sellers from betting on stocks that were already falling. Since July 2008, the short-selling arena has seen regulators temporarily ban naked shorting, which is selling shares short without first borrowing them. Then regulators banned short-selling in certain financial stocks, let those bans lapse, and then most recently announced plans to ban nearly all short-selling.
How would keeping the uptick rule have controlled short-selling? Well, the rule, in place since the 1930s, prevented “bear raids,” or attacks in which short-sellers try to drive a target’s stock down. Without the requirement that short-sellers wait for a stock price to rise before placing their bet, there was no barrier to keep short sales from driving already falling stock prices even lower. This year, stocks of all the big, publicly traded independent investment banks–Morgan Stanley, Goldman Sachs, Lehman Brothers, Merrill Lynch and Bear Stearns–were hit by rumors, panicky selling and yes, short selling.
If you are wondering how a subprime mortgage crisis became a market-wide stock crisis, you can start with mark-to-market accounting and the loss of the uptick rule.
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