This post appeared yesterday on RealMoney . Click here for a free trial, and enjoy incisive commentary all day, every day.How can a component of the Dow Jones Industrial Average teeter on the edge of bankruptcy? The AIG ( AIG) story involves more than first meets the eye. There is a wide disparity between what is happening and the general public's understanding. Most media accounts emphasize the federal intervention, the potential cost of a bailout, the moral hazard arguments, and the fact that taxpayers may be on the hook for losses. These are all valid public-policy issues and worthy of discussion. Many of the accounts emphasize the rapidly rising total of capital requirements with little explanation of why these took place. (Ratings downgrades requiring more collateral for AIG.) Meanwhile, there is an increasing chorus of support for one key factor behind the problem: last year's implementation of FAS 157. This well-intentioned measure, introduced by accountants to avoid a Japan-like situation where institutions maintained assets on the books at unreasonable prices, instituted a procedure for mark-to-market evaluation. It is a good idea, implemented at the wrong time in the wrong way.
Why This Is ImportantFAS 157 rules have (at least) two negative effects:
- Requiring asset evaluations based upon the fire-sale prices of other firms. These forced sales into illiquid markets are unlikely to reflect the true value of the underlying assets.
- Requiring potential buyers to assume assets that are immediately marked down, placing additional stress on their capital.