The Financial Crisis Explained

http://www.futureofcapitalism.com/2011/08/the-financial-crisis-explained

Paul Caron's Tax Prof blog notices a new paper by libertarian law professor Richard Epstein and M. Todd Henderson headlined "Do Accounting Rules Matter? The Dangerous Allure of Mark to Market." The paper says not to cite it or circulate it without permission, but Tax Prof has posted the abstract, which I am going to go ahead and circulate here:

This paper examines the relative strength of two imperfect accounting rules: historical cost and mark to market. The manifest inaccuracy of historical cost is well known, and, paradoxically one source of its hidden strength. Because private parties know of its evident weaknesses they look elsewhere for information. In contrast, mark to market for hard-to-value assets has many hidden weaknesses. In this paper we show how it creates asset bubbles and exacerbate their negative collateral consequences once they burst. It does the former by allowing banks to adopt generous valuations in up-markets that increase their lending capacity. It does the latter by forcing the hand of counterparties to demand collateral even when watchful waiting and inaction is the more efficient course of action when the downward cascades generated by mark-to-market accounting may trigger massive sell-offs at prices below true asset value. The fears of private suits and regulatory sanctions on counterparties can compound the problem. Mark to market generates the functional equivalent of bank runs for which the functional equivalent of the automatic-stay rule in bankruptcy is the appropriate response.

I took particular pleasure in footnote 27, which is to an article by Julie Satow in the September 18, 2008, New York Sun. The Epstein-Henderson article is 43 pages of fairly densely argued prose about accounting rules, which are an arcane topic to begin with. But it's well worth the time and effort for anyone wondering about the causes of the financial crisis and how to prevent another one.

by Editor  |  Aug 6, 2011 at 10:39 pm Related Topics:  Capital Markets Regulation, Education receive the latest by email: subscribe to the free futureofcapitalism.com mailing list