Rule 157

One can argue the merits of FASB Rule 157, which institutes fair-value, or mark-to-market, accounting principals to financial institutions. On the one hand, it is probably true that accounting practices have not accurately portrayed the strength/weakness of many financial institutions. It is also possible that this change is largely responsible for the insolvency of the financial markets. What cannot be argued is that, on November 15th, 2007, Rule 157 took effect, and within a matter of 6-12 months our nation was in what President Obama has called the "our greatest economic crisis since the Great Depression."

So what is it that Rule 157 changed? It changed the way that Mortgage Backed Securities are valued on the books of these financial institutions. As of the November 15th, 2007, financial institutions had to report the value of these Mortgage Backed Securities based on their value if they were to be sold right now. Is there anyone out there that is looking to sell their house right now, for any reason other than necessity? No? I didn't think so. Why not? Because home values have gone in the tank. If we were to sell now, we would be locking in our losses, and no one wants to do that.

This is the climate into which Rule 157 was introduced. At regular intervals, quarterly, I believe, Mortgage Backed Securities have to be revalued base on their value if they were to be sold on that date, regardless of whether or not, in reality, they were going to be sold on that date. We all know that there are a lot of properties that have been foreclosed on, and that this is one of the contributing factors to the precipitous decline in home values. There are also a good number of homes that people continue to make their mortgage payments on where the notes are worth more than than the homes' current value. They are "upside-down".

Here's a question for you. As long as the note is ultimately paid in full, do you think that a bank cares if the mortgage is upside-down or not? Of course not. It is only when the note is not repaid, and the collateral is seized, that it makes any difference what the value of the property is. Even then, if the bank decided to hold the property, it is entirely possible that, in time, the value of the property would increase so that it was worth more than the remaining value of the note. Rule 157 doesn't care about any of these things. Under Rule 157, every quarter, these Mortgage Backed Securities are revalued, and the institutions that hold them have to write off any of the losses against their books.

As I stated earlier, you can certainly argue that this is a better method of accounting. The problem is that it is a change in accounting practices. What business, any business, wants more than anything is stability, and this change that was instituted by Rule 157 caused instability in the marketplace. How could it not? These mortgages and Mortgage Backed Securities were issued under one set of rules, with one set of assumptions, and then those rules were changed. The value of their assets was reduced, and the value of their liabilities was increased.

But the damage didn't stop there. With fewer assets and greater liabilities, banks no longer had as much capital to do their business, and the business of a bank is to make loans. Less capital meant that banks no longer had the ability to make as many loans as they used to. The credit market started to contract. As the credit market contracted, businesses could no longer get loans for capital expenditures, which further weakened the economy. Company after company started cutting costs, reducing capital expenditures, laying off employees.

This is where we are today. The crisis has gotten into our national psyche. People that are fortunate enough to remain employed are afraid that they may not be employed tomorrow. They are reducing their spending, which only exacerbates an already weakened economy. The downward spiral continues.

Rule 157 isn't the sole cause of the current financial crisis, and I am certain that someone with more economic background could quibble with my interpretation of the sequence of events. Unfortunately, repealing or modifying Rule 157 probably would not be enough to bring us out of our downward spiral. In retrospect, however, the change in accounting practices was a blow that an already wobbly economy could not take. Whether you think that the rule was an improvement or not, the fact is that, twelve months after its institution, we are in a world of hurt.