The WSJ has an editorial today about how accounting rules, adopted to prevent a future Enron, are at the root of the financial crisis. Mark to market accounting rules were developed to prevent future companies from inflating earnings the way Enron did by valuing future contracts at artificially high prices. That seemed admirable at the time but no one took into account how it might affect future companies:

Call it the revenge of Enron. The collapse of Enron in 2002 triggered a wave of regulations, most notably Sarbanes-Oxley. Less noticed but ultimately more consequential for today were accounting rules that forced financial service companies to change the way they report the value of their assets (or liabilities). Enron valued future contracts in such a way as to vastly inflate its reported profits. In response, accounting standards were shifted by the Financial Accounting Standards Board and validated by the SEC. The new standards force companies to value or “mark” their assets according to a different set of standards and levels.

The rules are complicated and arcane; the result isn’t. Beginning last year, financial companies exposed to the mortgage market began to mark down their assets, quickly and steeply. That created a chain reaction, as losses that were reported on balance sheets led to declining stock prices and lower credit ratings, forcing these companies to put aside ever larger reserves (also dictated by banking regulations) to cover those losses.

It sound okay on the surface but the reality is somewhat different. The market value of a mortgage today means nothing to a bank if it intends to hole it to maturity. What difference does it make if the value of your house falls if you don’t intend to sell it? As the Journal puts it:

The value of the underlying assets — homes and mortgages — declined, sometimes 10%, sometimes 20%, rarely more. That is a hit to the system, but on its own should never have led to the implosion of Wall Street. What has leveled Wall Street is that the value of the derivatives has declined to zero in some cases, at least according to what these companies are reporting.

There’s something wrong with that picture: Down 20% doesn’t equal down 100%. In a paralyzed environment, where few are buying and everyone is selling, a market price could well be near zero. But that is hardly the “real” price. If someone had to sell a home in Galveston, Texas, last week before Hurricane Ike, it might have sold for pennies on the dollar. Who would buy a home in the path of a hurricane? But only for those few days was that value “real.”

I said in a recent post that a few years from now we’ll see someone’s picture on the cover of Forbes or Fortune who bought the things that nobody wants today and made a fortune. The WSJ echoes that:

A few years from now, there will be a magazine cover with someone we’ve never heard of who bought all of those mortgages and derivatives for next to nothing on the correct assumption that they were indeed worth quite a bit. In the interim, there will almost certainly be a wave of regulations designed to prevent the flood that has already occurred, some of which are likely to trigger another crisis down the line. Until we can have a more rational, measured public discussion about what government and regulations can and should do vis-à-vis financial markets, we are unlikely to break the cycle.

To get things stabilized, the government should do something along the lines of what I suggested in a post the other day:

1. There has been a lot of talk about the “good bank/bad bank” model for Lehman in which bad assets are roped off in a seperate company while the rest of Lehman goes about its business. Why not expand this to any financial institution that wants to participate? Set up a “bad bank” to which any of the players can contribute bad assets and capital. In exchange, require the investment banks to submit to capital requirements like the commercial banks.

2. Allow the “bad bank” to maintain its balance sheet by valuing the assets at current valuations until the assets are sold and the price known. You need a mechanism to prevent banks from contributing things they’ve valued too highly so, losses need to somehow revert to the contributing bank.

3. Reform the accounting rules so that this doesn’t happen again in either direction. If the banks hadn’t been able to mark up and get more leveraged we wouldn’t be in this mess.

4. Give the “bad bank” a sunset date. The goal should be to liquidate these assets in an orderly fashion instead of a fire sale. Give it 5 years with an option for 2 more.

5. Reform the ratings agencies so that they are responsive to the buyers of investments rather than the issuers.

Mark to market accounting should be suspended and re-evaluated. Until that happens the credit contagion will continue.