By relaxing the U.S. financial system’s mark-to-market accounting standards, the U.S. government is effectively deactivating the financial “early warning system” that let investors know that a global credit crisis was brewing – and kept it from turning into a total global meltdown, professional investors warn.

As part of the just-passed U.S. bailout bill, the government has reiterated the Securities and Exchange Commission’s authority to relax the mark-to-market standards. If the SEC actually follows through on that directive, many professional investors worry that we won’t catch on to the next leg of the ongoing credit crisis until it’s way too late.

While politicians point to mark-to-market rules as the cause of the billions in write-downs and losses suffered by financial firms in recent quarters, in fact, it was mark-to-market accounting that first exposed the underlying problems in the complex markets for mortgage-backed securities (MBS) and credit-default swaps (CDS).

“Mark-to-market is reality-based accounting,” said Money Morning Contributing Editor Shah Gilani in a phone interview yesterday (Tuesday). “Anything else requires a looking glass and a ticket to Wonderland.”

“To me, mark-to-market accounting is the clarion sound of beagles barking, letting transparency hunters know down which dark hole the fox is hiding,” said Gilani, a former hedge-fund manager who recently penned a five-part investigative series on the U.S. credit crisis – including an alternate bailout plan that he says would’ve cost taxpayers very little.

Without the early warnings raised by mark-to-market accounting standards, the problems in the CDS market could have gone unnoticed for much longer, leaving no time to hedge or prepare for the ultimate carnage to the financial sector.

“In the past couple of weeks, fair-value accounting has been under attack,” JPMorgan Chase & Co. (JPM) analyst Dane Mott wrote in a recent report, Bloomberg News reported. “Blaming fair-value accounting for the credit crisis is a lot like going to a doctor for a diagnosis and then blaming him for telling you that you are sick.”

Prior to the current credit mess, mortgage-backed securities were priced according to Markit’s ABX Index, which used the average weight of four series in the index to track the price of housing derivatives. But once the subprime market collapsed, the ABX Index plunged - and has yet to recover.

Mark-to-market accounting standards kicked off a round of write-downs at global financial firms that highlighted the overexposure of many to these risky securities. Without such standards, investors would have been unaware of the coming credit crunch.

The Rise of Fair Value

Mark-to-market accounting, or fair-value accounting as it is sometimes called, arose partly in response to the U.S. Savings & Loan Crisis of the late 1980s and early 1990s.