Late in 2007, the Financial Accounting Standards Board formally adopted rule 157, or “Mark to Market” accounting, promulgating rules for valuing mortgage-backed securities held on the balance sheets of financial institutions. The valuation methodology under 157 addressed a long-standing problem in the industry: how should financial institutions account for these complex securities which are not registered and traded on any public exchange? Prior to 157, banks essentially used their own valuation models which varied widely and did not offer pricing transparency. So the cause was noble.

Unfortunately, however, 157 is and was fundamentally flawed, because the primary “input” for valuing these securities was liquidity in the primary marketplace for the securities- not the principal balance of the underlying loans or value of the underlying collateral. In extreme market conditions like we are currently experiencing- where there are no buyers- liquidity-driven valuations grossly undervalue the securities.

Why? Because in spite of the fact that there are few buyers for the securities, the fact remains that the securities are backed, as the name implies, by real mortgages on real homes. Certainly, residential real estate values have fallen and will continue to fall, up to 50% in some markets. But consider that (a) overall, the average loan-to-value ratio for all mortgages in the US is under 60% according to the Federal Reserve- in other words, they are well-secured; and (b) in spite of the gloom-and-doom in the press, the vast majority of all mortgages, including 70%+ of SUBPRIME mortgages, are paying on time. Certainly there have been and will be real, actual losses as lenders liquidate foreclosed properties; but these realized losses will be far less than the write-downs that have been forced on the banks due to 157. I don’t know at what percentage of par the banking industry as a whole is carrying mortgage-backed securities on their balance sheets, but it is less than 50% in many instances. Again, these extremely low carrying values are being applied to ALL mortgages held in securitization pools- most of which are paying on time and are well secured.

The profound impact of the write-downs on the overall economy can not be overstated. It was these 157-induced write-downs which caused the failure (or near failure) of Bear Stearns, Lehman Brothers, Washington Mutual, Wachovia, FDMC and FNMA; and by extension (via credit default swaps), AIG- and many others. The bank failures resulted in the seizing up of credit markets, investor panic, a plunge in consumer confidence, and caused what should have been a de-levering-induced, mild recession to evolve into what surely will be a deep and prolonged recession. Yet, most people simply are not aware of the impact 157 has on mortgage carrying values. I think most would be stunned to know that their own mortgage is probably being carried at far below the principal balance by some financial institution. In other words, their own mortgage is one of the “toxic” mortgages they read about almost every day in the news.

Political leaders and those in the finance and accounting communities who understand this issue seem to shrug it off, as if to say “the rules are the rules.” But if people can accept that 157 substantially undervalues bank assets, and that bank capital problems are at the root of the current economic crisis, why is there no momentum to change it? It has been done before: In the 1980s, regulators allowed banks to carry Latin America debt at par, in spite of the fact that it was trading as low as $.10 on the dollar during that crisis; some analysts believe that EVERY MONEY CENTER BANK at that time would have failed had they been forced to carry the LatAm debt at market.

Now is the time to apply rationality to asset valuation. Doing so would reduce bank regulatory capital problems, increase lending activity, and help our economy begin to emerge from the deep recession we are now in.