The turmoil of the past six months has resulted in the Big Five Wall Street independent investment banks falling under greater federal regulation. But did federal regulation help them get them into this mess in the first place?

Consider two regulatory changes that may not have started the credit crunch but amplified the effects: the move toward mark-to-market accounting and the abolition of the short-selling uptick rule. Deal Journal examines how those two well-intentioned rules caused Wall Street to go horribly awry.

Mark-to-market accounting: This rule was officially put into place last November, though some banks adopted it earlier. Mark-to-market accounting suffered its biggest repudiation this weekend when Morgan Stanley and Goldman Sachs Group were transformed into bank holding companies. That should mean huge write-downs every quarter are a thing of the past. Here’s why: As broker-dealers, Morgan Stanley and Goldman had to “mark to market,” or determine the market value of all its assets every quarter, even assets for which prices would be hard to determine. FAS 157 required all banks to mark their assets to whatever price other banks were selling similar assets. So if you were holding a mortgage security and another investment bank sells a similar mortgage security at, say, 22 cents on the dollar, you must value your mortgage securities at 22 cents on the dollar, too. Imagine that you are trying to sell a 2006 BMW. Your neighbor sells his ‘87 Taurus for $1,000. Under the mark-to-market rules, that 2006 BMW would be on your books at $1,000, too. As bank holding companies, though, Morgan Stanley and Goldman can account for their assets on a “held to maturity” basis.

FAS 157 was designed to ensure that banks were fairly pricing hard-to-value assets such as mortgage-backed securities: that they weren’t, in effect, pricing every mortgage-backed security or loan on their balance sheet as if it were a 2006 BMW. But marking to market often imposed fire-sale prices because a lot of mortgages weren’t selling, meaning that a real market price was difficult to determine. Yale finance Professor Gary Gorton summarized the situation at a Federal Reserve convocation last month: “With no liquidity and no market prices, the accounting practice of ‘marking-to-market’ became highly problematic and resulted in massive write-downs based on fire-sale prices and estimates.”

[Read more…]