I have long opposed mark to market accounting, which requires that financial institutions mark their financial assets to market prices even when market prices bear no relationship to the true economic value of those assets based on cash flows. Mark to market accounting was put into place by the Securities and Exchange Commission and the Financial Standards Accounting Board beginning in the early 1990s over strenuous objections from the Treasury, the Federal Reserve and the FDIC.

I argued during the crisis of 2008-2009 that mark to market accounting senselessly destroyed over $500 billion of capital in U.S. financial institutions. Because banks are able to loan about $8 for every dollar of capital they hold, the $500 billion market to market write-offs destroyed $4 trillion of bank lending capacity, wreaking havoc on the financial system and the economy and contributing to millions of people losing their jobs and homes and starving small businesses of credit. We have yet to recover.

A subcommittee of the House Financial Services Committee invited me to testify (alongside the SEC and FASB) at a hearing on mark to market accounting on March 12, 2009. The hearing resulted in the SEC and FASB agreeing to modify (regrettably, not repeal) mark to market accounting to alleviate its more pernicious effects. Many credit that event with calming the financial crisis and turning around the markets.

My testimony that day included a slide (below) showing the impact of mark to market accounting on just one $3.65 billion portfolio of mortgage backed securities held by one of our nation’s largest banks. The chart showed that the bank expected a maximum of $100 million of losses on the portfolio but had enough extra collateral to cover those losses so no net losses were expected. Yet, mark to market accounting required the bank to write off over $900 million of the portfolio.

The bank recently updated the chart showing the performance of this same portfolio as of March 31, 2011 (updated chart below). The portfolio declined to $2.1 billion due to prepayments and normal amortizations. The bank now expects total net losses of $28 million. The mark to market charge on the portfolio has been reduced from over $900 million at the end of 2008 to just $44 million, even though nothing has really changed except market perceptions of value!

These two charts tell you everything you need to know about mark to market accounting. It was very bad accounting during the Great Depression when President Roosevelt ordered it eliminated in favor of historical cost accounting, and it was very bad accounting during the crisis of 2008-2009 when it helped bring our nation’s financial system and economy to the brink of collapse.