During the second Presidential debate in October of 2008, candidate Barack Obama was asked to comment on the recent failures in our financial system. Setting what would be one of the prevailing themes of his campaign, and beyond, Mr. Obama made the following statement:

Let’s, first of all, understand that the biggest problem in this whole process was the deregulation of the financial system.

Is deregulation truly the cause for what is going on in our economy today?

If that is the case, then why are the least regulated sectors of the financial market, the least impacted by the credit crisis?

Hedge funds for instance are chugging right along, yes the market has lost significant value, but the mechanics are functioning properly.

It is the most highly-regulated segment of the financial industry, commercial banking, that is reeling under the impact of this economic downturn, with more bank failures in the first three months of 2009 than anytime since the 1980’s.

In The Man Who Sold the World, I discussed how deregulation brought about by the Commodity Futures Modernization Act of 2000 (CFMA) made it easy for AIG’s Financial Products Division to make billions by selling bond insurance packages known as Credit Derivative (or Default) Swaps (CDS), and how the crash of the housing market in America brought AIG to its knees, as bondholders filed claims on their losses.

To many, the story ends right there…greed and deregulation makes for a much simpler explanation (and better headlines) than the intricacies of banking regulations and the market. But while deregulation was certainly the reason why CDS came into being to begin with, and greed ran rampant in Joe Cassano’s AIGFPD, neither greed nor deregulation explains why banks failed to the degree that they did, inciting the filing of the claims that brought AIG down.

That explanation can be found in an accounting standard known as mark-to-market (MTM) accounting, or the US Financial Accounting Standard Board Rule 157 (FAS 157).

The U.S. Financial Accounting Standards Board Rule 157 was set in place in the aftermath of the Enron scandal, as a reaction to that company’s accounting “standards”. In a nutshell, Rule 157 requires all publicly-traded firms to “mark” (price) assets at current market value. In other words, it forces those firms to tell us what their assets would sell for in the current environment.

The aim of MTM is to establish a realistic picture of a publicly-traded company’s current worth.

Sounds great, doesn’t it?

Who wouldn’t want to know what their investments are worth every day?

This accounting practice works great with stocks, as they are traded daily, and in huge quantities. It doesn’t work for mortgage-backed securities, and those are the assets at the center of this financial crisis.

Here’s why.

Driven by government-mandated lower lending standards (a politicized push to sell more houses to lower-income people) many people who couldn’t realistically afford to buy houses, entered into unrealistic mortgage agreements. Adjustable rate, interest-only mortgages and NINJA (No Income, No Job, No Assets) loans became more prevalent as lending institutions, at the bequest (and with the approval) of Fannie Mae and Freddie Mac, sought to comply with the government’s directive to penetrate America’s lower-income consumer market.

As those Adjustable Rate and interest-only mortgages matured, the increased monthly payments became prohibitive to a substantial number of borrowers. Foreclosures began to rise, interest rates climbed, and loans became more difficult to obtain.

As foreclosures climbed, the supply of homes for sale increased, and as is always the case, increased supply meant lower prices. New home sales decreased by more than 25%, and by September 2008, average U.S. housing prices had declined by over 20% from their mid-2006 peak.

This is where FAS 157 comes into play. It became a standard precisely as the subprime credit market collapsed.

FAS 157 divides assets into three categories, according to ease of evaluation, with home mortgages labeled as a Level 3 asset, or the most difficult level of assets to value. A home’s value is based on many variants, and to seemingly identical homes may evaluate differently, based on everything from location, to features and upgrades.

Indeed, a home’s worth to a buyer is impacted by something as intangible as location; what is a plus for one buyer, could very well be a minus to another.

According to the accounting rule, banks were forced to report losses (albeit on paper only) as the value of their mortgage holdings began to plummet. FAS 157 pushed perfectly healthy commercial banks into virtual bankruptcy, for no good economic reason. I say “perfectly healthy” because most of these banks had no shortage of actual cash when they began to fail. Rather, because of the mark-to-market rule, they were required to take big paper losses on their portfolios of risky mortgages, even though the vast majority of these mortgage-backed securities were still generating healthy interest payments.

The major portion of the mortgages underlying AIG’s credit default swaps, are 20-year and 30-year home loans, so limiting the valuation of these “hold-to-maturity” investments to current value limits the ability to establish their true worth. The majority of these loans – even the subprime ones – are NOT in default, or even behind in their scheduled payments; less than 2% of US households received at least one foreclosure notice in 2008. Most commercial banks have no intention of unloading these mortgages, yet the mark-to-market accounting rule forces a bank to revalue this kind of asset as if it had to get rid of it in 30 days, at whatever price it could get.

Take your house as an example.

Let’s say that you borrowed against your equity to the point where you are now upside down; you owe more to the bank, than what the house is currently worth. You are however, meeting your monthly obligations and have every intention of doing so until you are either able to sell the house (at a profit, or as a loss), or pay your mortgage off.

FAS 157 forces the bank to take a loss on your home, in spite of the fact that there may never be a loss at all.

Forced to mark down their mortgage-backed securities based on FAS 157, and in order to stay within government regulations, including requirements to maintain certain ratios of capital and liquidity to support their loans, banks were forced to line up capital for their balance sheets. Those that were unable to do so were declared insolvent and taken over by the Federal government. Washington Mutual was one such bank; declared insolvent by Federal regulators, it was sold to JP Morgan Chase and Co. for $1.9 billion. WaMu’s assets at the time it was declared insolvent were significant…$307 billion, including $188 billion in deposits.

The fact that no bank was willing to buy WaMu until it failed shows how badly confidence has eroded in a banking system awash with record profits just a few years ago. Faced with deepening losses on mortgages, credit cards and other loans, big and small banks across the country are struggling with what many bank executives say is a crisis far deeper than the savings-and-loan debacle.

The seizure of Washington Mutual is likely to send tremors through the thrift industry. Many of WaMu’s smaller brethren are also struggling with a wave of bad loans and some have already been ordered by regulators to raise capital and stop growing. — WSJ

Banks are not lending because they need to retain capital to stay within liquidity-to-loan-ratio regulations while their assets devalue. Their assets are being artificially devalued by a change in accounting regulations intended to increase transparency in financial reporting.

The treacherous triumvirate of subprime lending, mark-to-market evaluation, and credit derivatives is proving to be the most formidable adversary faced by this nation’s economy in recent history. The case can be made that regulation…the wrong type of regulation is “the biggest problem in this whole process”, contrary to what then candidate, and now President Obama wants us to believe.

None of this excuses consumers from fault…after all, it was consumers who ran up their unsustainable debt, but it does explain how this crisis came about.

I am fairly certain of one thing however: crafting the destructive policies mentioned above was done with the best of intentions in mind.

Good intentions that paved the road to financial Hell.