The Chartered Accountant

forcing otherwise healthy banks to write down their
assets because another, more sickly bank had to dump
similar assets in a fire sale. MtM, he argued, was one
reason that all MBS were affected by a relatively low
rate of mortgage defaults (6.4% versus 40% during
the Great Depression). 16 The pro-cyclical effect of
MtM, critics say, intensifies the business cycle, fostering
economic instability, allowing banks to loan more
in the good times, but devastating them in the bad
times. 17 Proponents of MtM, including Treasury Secretary
Henry Paulson, believe that banks should have
the discipline to record their assets at fair value. 18 The
debate continues whether mark-to-market was a cause
of the crisis or just an accurate barometer of it.
Soon retail banks found that they could not meet the
capital adequacy requirements set by regulators as
their assets were declining rapidly in value. To meet
regulatory requirements, they had to raise capital, but
capital was increasingly scarce. With inadequate capital
to cover the loans already on their books, banks
simply could not loan more money. Since most financial
institutions were in the same boat, the entire
credit market ground to a halt. Other types of loans,
such as corporate short term loans, credit cards, auto
loans, and student loans were affected. Municipalities
delayed bond issuances in fear that they would not
be able to raise needed capital to meet their budgets.
Automakers’ sales started to plummet because people
could not finance new cars. Not surprisingly, the U.S.
stock market began a long and unchecked downward
slide, eventually losing 40% of its value from October
2007 to October 2008.
Taxpayers to the rescue
On October 3, 2008, in an attempt to finally stop the
panic, the US Congress passed a $700 billion bailout
package. The bailout package, officially called
the Emergency Economic Stabilization Act (EESA),
enabled the Treasury to broadly intervene in private
companies in order to purchase their MBS, give them
access to capital, and allow them to obtain government
loans. The $700 billion could be used to aid the
economy in three ways:
1. Provide liquidity to consumer and commercial
credit markets and foreclosure intervention
2. Capital Purchases – purchase non-voting equity
DECEMBER 2008 1012 THE CHARTERED ACCOUNTANT
GLOBAL PERSPECTIVE
stakes (preferred stock) in the company in exchange
for capital
3. Direct Aid or Loans to Failing Institutions – direct
assistance through loans with terms negotiated
on a case-by-case basis
In return for the assistance, the Treasury placed restrictions
on executive pay, including caps on tax
deductibility, limits on incentives that “encourage
unnecessary and excessive risks”, a ban or limit on
severance packages, and the ability in some cases to
recoup or clawback compensation already paid out.
These pay provisions were in response to the public
outcry that the bailout would spend US taxpayer
money to rescue companies when their executives
pocketed millions of dollars in bonuses, stock awards,
and golden parachutes.
The Federal Deposit Insurance Corporation (FDIC)
of the US government is also guaranteeing unsecured
credit issued by financial institutions for a fee. Ultimately,
the US tax payers will be on the hook if these
financial institutions default and the US government
is forced to make good on its guarantee. Whether the
fee charged by the FDIC is adequate to cover this risk
will be known only in the future and will depend, in
part, on how deep the current recession will last.
Who’s to Blame?
We have already discussed the role of the run-up and
the eventual crash in real estate prices, the unsustainable
euphoria that accompanies bubble markets, the
securitization of home mortgages, and the low interest
rate environment as factors that set the stage
for the financial meltdown. While all this created a
nice dry tinder box, who or what set the match to
it? Upon review of the suspects, nearly every entity
that was involved in the subprime crisis bears some
blame.
The US government bears responsibility for the poor
oversight and regulation of both the subprime and
the CDS market. In particular, the former Federal
Reserve Chairman, Alan Greenspan, decided not to
regulate the CDS market and has since regretted his
decision in testimony before the Congress. A central
clearing house and more transparency in what was
being bought and sold in the CDS over-the-counter
(OTC) market may have helped to avoid the credit
16Berlau, John, “Maybe the Banks Are Just Counting Wrong,” The Wall Street Journal, September 20, 2008, http://online.wsj.com/article/SB122186515562158671.html,
accessed November 12, 2008.
17JPMorgan, “Solvency, mark-to-market and insurance,” webpage, http://www.jpmorganchase.com/cm/ContentServer?c=JPM_Content_C&pagename=jpmorgan%2Fam
%2FJPM_Content_C%2FGeneric_Detail_Page_Template&cid=1159362822564, accessed November 12, 2008.
18Michael Grynbaum, “Paulson Weighs In on Mark-to-Market Debate,” New York Times DealBook Blog, July 22, 2008, http://dealbook.blogs.nytimes.com/2008/07/22/
paulson-weighs-in-on-mark-to-market-debate/, accessed November 12, 2008.